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.