Emerging Market Small-Cap Stocks Have Been On A Roll And That Could Continue

Small-cap stocks have the potential to deliver bigger returns. That’s certainly been the case lately for emerging market (EM) small caps: they’ve outperformed their heftier-cap counterparts since the 2020 Covid selloff. And so far this year, the MSCI EM Small Cap Index has produced a gain that’s approximately 12 percentage points higher than the big-cap index, positioning it for its second-best relative return advantage in 14 years.

There are several factors behind this trend. First, the small-cap index has a significantly lower weight in China, at 7.4%, compared to the big-cap index, which has the country as its heaviest weight, at 29.5%. This lower exposure to China has worked in its favor since 2020, with the country implementing some of the world’s strictest pandemic restrictions and keeping them in place for the longest, hampering economic activity and weighing on its stock market. And although the country abandoned these restrictions some ten months ago, its economic recovery has still been underwhelming.

Second, China's economic underperformance affects non-Chinese stocks in the big-cap EM index more than those in the small-cap index, primarily because those bigger companies often have supply chains, investments, and operations based in China, which makes them more vulnerable to shifts in the country’s economic landscape. Smaller firms, on the other hand, are often more influenced by their local economies than by international factors. What’s more, the small-cap EM index's chunkiest country weight is India (at 25.7%), which has been a notable growth success story recently.

Third, EM small caps have been lifted by all the hype about young AI and EV companies. For example, the tech-heavy markets of Taiwan and South Korea, which are the small-cap index’s second- and third-biggest country weights at 21.3% and 14.4%, respectively, are seeing their semiconductor companies benefit from the booming demand for all things AI. So this outperformance could last for a while yet.

To gain exposure to EM small caps, you could consider the iShares MSCI Emerging Markets Small-Cap ETF (ticker: EEMS; expense ratio: 0.7%). A word of caution though: the potential for high returns also means potentially higher risks for investors. EM small caps are known for their hotter volatility and are often the first to be sold off when market sentiment turns sour. They resulted in significant losses for investors during events like the 2000 dot-com bust, the 2008-09 global financial crisis, and the 2018 US-China trade war, with the MSCI EM Small Cap Index lagging behind its big-cap counterpart by roughly 30% on each of these occasions.