A Small-Cap Dividend Darling

U.S. small-cap stocks are among this year's most notable laggards. Something else that has been widely documented is the outperformance offered by ex-U.S. small-caps, a scenario pertaining to both developed and emerging markets smaller stocks.

Speaking of outperformance courtesy of emerging markets small-caps, there is the WisdomTree Emerging Markets SmallCap Dividend Fund DGS. The $1.1 billion DGS is up 14.6 percent year-to-date, a performance that makes the 0.8 percent returned by the Russell 2000 Index seem silly. DGS is also ahead of the MSCI Emerging Markets Index by 210 basis points.

Since the start of the current bull market for U.S. stocks, a run that has included some bumpy periods for emerging stocks, DGS is up 151.2 percent compared to a gain of just over 97 percent for the MSCI Emerging Markets Index.

DGS's holdings include the 10 percent of the WisdomTree Emerging Markets Dividend Index with the smallest market caps. The ETF's constituents are then weighted by paid dividends, an approach that helps juice yield, and, potentially, returns.

Small-Cap Worries

A frequent concern about small-caps, particularly after an extended period of outperformance, is that these stocks can become overvalued. That may not be the case with DGS despite its recent bullishness.

“We specifically ask—knowing that the WisdomTree Emerging Markets SmallCap Dividend Index just underwent a period of outperformance—has it now become expensive compared to U.S. small-cap indexes?” said WisdomTree in a recent note. “If it hasn’t, we think there is 1) less of a chance that the opportunity was missed and 2) the potential for a diversifying effect if market participants forgo allocating the full percentage of their small-cap stocks to the U.S. and diversify some of that position in emerging markets.” 

At 11.4 times earnings, the WisdomTree Emerging Markets SmallCap Dividend Index, DGS's underlying index, trades at discounts to the MSCI Emerging Markets Index and MSCI Emerging Markets Small-Cap Index. Not only that, but the WisdomTree Emerging Markets SmallCap Dividend Index is significantly discounted relative to the S&P SmallCap 600 Index and the Russell 2000, according to WisdomTree data. 

DGS allocates about half its weight to Taiwan, China and Thailand. South Korea and South Africa combine for another 17 percent of the ETF's geographic weight. As it pertains to DGS, investors should remember the consumer catalyst.

“Small-cap emerging markets are really an access play on the emerging market consumer, as these companies derive the bulk of their revenue from inside their home markets,” said WisdomTree. “With the bulk of global population in emerging markets, many investors whom we speak with—even those nervous about emerging markets—recognize that the emerging market consumer will be an important force propelling global growth in the coming decades.”