Eric Dutram: Emerging market investments are definitely an attractive proposition for long-term investors. These nations are often characterized by high economic growth, diminishing levels of poverty, rising per capita income and moderately high levels of inflation to stir the growth process. (read Emerging Market Small Cap ETFs: Freefall Continues)
These markets have little correlation with developed markets and can make way for a compelling investment for investors looking for international diversification in their portfolio.
Exchange traded funds (ETFs) provide an excellent opportunity to tap into the growth potential of emerging markets. However, many products in this space have slumped badly over the last one year and year-to-date basis, especially the small cap ETFs.
Often times, this is because small cap stocks are more sensitive to economic trends and market sentiment. Therefore, during an uptrend or downtrend, these ETFs tend to out/under-perform the broader markets.
The Market Vectors Russia Small-Cap ETF (NYSEARCA:RSXJ), the Market Vectors Indonesia Small-Cap ETF (NYSEARCA:IDXJ) and Market Vectors Brazil Small-Cap ETF (NYSEARCA:BRF) are some products from this space that have underperformed in particular. RSXJ was negatively impacted primarily due to its high allocation towards the energy sector, and as a result it is down by almost 15% this year. The sector as well as the Russian economy as a whole was hit hard by falling crude oil prices. (read Why Russia ETFs Are Not A Debt Crisis Safe Haven)
Another ETF which is a relatively new product in the emerging market small cap ETF space, IDXJ, has lost nearly 13% since its inception back in March 2012. The product allocates a large proportion of its total assets in the financial sector (39.5%) while the Indonesian market is generally more volatile than other large emerging markets anyway.
The financial sector is highly correlated with prevalent economic trends and investors tend to shun this volatile sector during economic uncertainly. Therefore, given the extremely volatile global economic situation, investor appetite towards the financial sector was reduced substantially, especially in the case of risky Indonesian securities (see Three Financial ETFs That Avoid Big Bank Stocks).
Having discussed some products from the space that have suffered massively, it is prudent to note that other emerging market small cap ETFs have substantially outperformed their counterparts and generated positive returns despite the broad downturn in the space.
In this regard we would like to highlight two Chinese small cap ETFs that have been able to weather the storm both of which have crushed the trend so far.
The iShares MSCI China Small Cap Index (NYSEARCA:ECNS) has been able to post double digit returns so far this year. It has returned 10.38% year till date basis. Unlike other ETFs in this space, ECNS has a very well spread out portfolio, both in terms of individual stocks and sector holdings.
This ensured that performance of the ETF was not dependent on any particular stock or sector. The ETF has 337 individual holdings with only 12.38% allocation towards the top 10 holdings. This characteristic is what sets ECNS apart from the other three products from this space already discussed. BRF, IDJX and RSXJ have 33%, 63% and 57.06% allocations respectively in their top 10 holdings.
ECNS tracks the MSCI China Small Cap Index, which measures the performance of the small cap Chinese equities. The ETF debuted on September 2010 and has $15.53 million of assets under its management. Approximately 3,456 shares of ECNS are traded each day.
Also, another small cap focused China ETF, the Market Vectors China ETF (NYSEARCA:PEK), has been able to stay in the green so far this year. PEK, which tracks the CSI 300 Index, has returned 6.73% this year-till-date.
The benchmark index comprises of 300-A listed common stocks which are traded in the Shenzen or Shanghai stock exchanges. However, the ETF does not invest in any particular stock, but takes positions in swap contracts of the underlying index to replicate the performance of the index.
This removes some worries with respect to tracking error, but the fund often trades at a premium to its underlying thanks to a lack of swap partners and contracts.
Moreover the well diversified portfolio of the index enables PEK to reduce concentration risk. The top 10 stocks in the CSI 300 Index have been given only 20.53% weighting.
Chinese Economy in Focus
Clearly, the Chinese economy continues to lead the group of emerging nations. The country continues to grow at an above-average pace relative to its other emerging counterparts. With the CPI number reducing from 3.44% in April 2012 to 3.034% in May 2012, we witnessed a much needed reduction in the benchmark interest rates from 6.56% to 6.31%. Earlier, the Chinese central bank had incorporated five consecutive rate hikes from October 19, 2010 in order to tackle rising inflationary problems.
Additionally, it is worthwhile to note that although China generally has a heavy dependence on exports to developed nations, many of the companies in PEK and ECNS do not. Instead, they do a great deal of their business in the local Chinese economy, helping to insulate them from global troubles.
Given this and a modest increase in the value of the yuan, and it has clearly been a good time to be heavily invested in China when compared to other countries on the list.
Whether this trend can continue is unclear, but it does appear as though China small caps can hold up better in the global turmoil than some of their more natural resource-focused peers. Due to this, it may be best to shift towards these securities, especially if commodity prices stay weak and the outlook for developed markets remains uncertain.
Emerging Market Small-Cap ETFs: Comparative Analysis
The following table summarizes the relative performance of the five ETFs from the emerging market small cap space.
|Fund||Country||YTD Returns||Concentration in top 10 holdings||Expense ratio||Total Assets|
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