The real action in emerging markets lies within the local economies of those countries, and not in large export-oriented companies that are closely aligned with demand in the U.S., Europe and Japan.

To really tap into the dynamic growth that emerging markets offer, investors need to go downstream and seek smaller local companies squarely focused on domestic economic activity.

"The large-cap emerging market stocks and funds are heavily weighted in globally-sensitive industries such as financials, basic materials and energy, while emerging market small caps are more likely to focus on consumer stocks, healthcare, and other consumption-oriented industries," notes Alec Young, Global Equity Strategist for S&P Capital IQ.

But identifying Chile's next hot retailer or Indonesia's fastest-growing real estate firm may be a bit much to ask from most investors. That's why the ETF route makes ample sense. It takes the basket approach to a country or a region's fastest growing firms, spreading around risk and providing exposure to a range of sectors.

Another plus for emerging market small caps is that they're a better value. S&P's Young notes that the average emerging market small cap trades for around eight times projected 2013 profits in anticipation of 16% projected profit growth. Emerging market large caps trade for ten times 2013 profits, roughly in line with the projected 10% earnings growth rate.

Emerging market economies have been growing at a more rapid pace in recent years than the big Western economies, which has led to outperformance for the domestically-focused small caps. S&P's Young notes that these small caps have outperformed emerging market large caps on a 1-year, 3-year, 5-year and 10-year time frame. A 14.9% gain for emerging market small caps thus far in 2012 handily eclipses the 9.8% gain for emerging market large caps.

Local, Regional and Global
A handful of ETFs have been launched in recent years to capture the growth of domestically-focused emerging market small-cap stocks. You can focus on just one country, an entire region or the broader global trend of rising middle classes.
If your aim is local, then you can't ignore China. Two decades ago, the Chinese economy wasn't even in the top 10. Today, it is has moved past Japan, and is expected to surpass the U.S. economy-the world's largest-within a few decades.  

Yet the transition from an export-driven economy to a consumer-driven economy hasn't been easy. Chinese consumers tend to have high savings rates because they lack the social safety net that consumers in other countries can depend on. But the government is slowly trying to develop that safety net, which could change the mindset of the Chinese consumer.

And as Chinese consumers come to rely on a stronger healthcare and retirement framework, consumer spending rates should move up to global norms, unleashing a potentially powerful domestic economic surge.

The track record of the Guggenheim China Small Cap ETF (HAO) reflects the slow-to-develop consumer economy, The fund has drifted down from $30 in late 2010 to a recent $20, right near two-year lows. Yet paradoxically, you want to own these emerging market ETFs when they have moved out of favor, as the muddied short-term outlook obscures a still-bright long-term view.  Another factor to consider: China's current economic slowdown has elicited a government stimulus effort aimed at boosting domestic consumption. That plays right into the hands of China's domestically-focused small caps.

The Guggenheim China Small Cap ETF invests in consumer stocks (28% of its portfolio), domestically-focused tech and internet companies (9%), travel and tourism firms (21%), along with more traditional sectors such as real estate and health care. The 0.75% expense ratio is typical for ETFs that must dig deeper than blue-chip focused funds to build a portfolio.

The Virtuous Cycle
Rising middle classes aren't merely a local theme. Entire regions are entering into a virtuous cycle, as growth in one country stimulates demand among neighbors. One example is Brazil, where its strong growth over the past decade has boosted the economies of Chile, Colombia, Argentina and others. And thanks to its dominant size in South America, Brazil is now home to an increasing number of companies steadily wading into other South American markets.

That trend makes the Market Vectors Brazil Small-Cap ETF (BRF) especially appealing. The ETF tracks an index created by Market Vectors that focuses on Brazilian companies in the smallest 10% of the Brazilian market (using $150 million as the minimum threshold). Consumer stocks make up roughly one-third of the portfolio, while financial and real estate stocks have a collective 24% weighting. The remainder is split between Brazilian manufacturers, utilities and technology firms.  The 0.59% expense ratio is in line with the peer group.

The WisdomTree Emerging Markets SmallCap Dividend ETF (DGS) is likely to be the safest ETF in this category, simply because it holds a huge amount of stocks (550), all of which have a history of stable dividend payments. Such a broad-based approach has led to lower volatility and better total returns than other small-cap funds, according to Morningstar.

Thanks to a relatively long track record of dividend payments, Taiwanese companies make up a hefty 26% of this portfolio. Thailand and South Africa, which also have financial markets that favor dividend payers, each accounts for more than 10% of the ETF's portfolio.

This fund is best suited for taxable investment accounts because dividend payments can be subject to foreign tax withholding, and you can only recoup those funds through an application for an offsetting tax credit against U.S. taxes-which is ineligible in tax-shielded accounts.

The wild price swings in emerging market investing sometimes requires a strong stomach. But the long-term trends are quite positive for these economies, and smaller-capitalization companies are the most direct way to play this trend.
 

David Sterman has worked as an investment analyst for nearly two decades. He was a senior analyst covering European banks at Smith Barney and was research director for Jesup & Lamont Securities. He also served as managing editor at TheStreet.com and research director at Individual Investor magazine.