The Case for Emerging-Market Small-Cap ETFs

Emerging markets have materially underperformed their U.S. counterparts in 2013 due to fears about slowing growth and depreciating currencies. The good news is that stocks in those regions are now attractively valued, not only compared to U.S. equities but also based on their own historical valuations. Small-cap ETFs may be the best way to capitalize on the opportunity to invest in emerging markets at a convenient entry price.

Risks and valuation in emerging markets
The SPDR S&P 500 (NYSEMKT: SPY  ) ETF, which tracks the S&P 500 index, is up by more than 17% this year. But emerging markets have not joined the party. The Ishares MSCI Emerging Markets Index Fund (NYSEMKT: EEM  ) , following the MSCI Emerging Markets Index, is down by almost 10% in the same period.

Several factors can be seen as an explanation for this divergence in performance: Countries like Brazil are experiencing disappointing economic growth rates lately, and economists are concerned about the possibility of a hard landing in China among other economic difficulties affecting emerging nations.

Furthermore, the possibility of rising interest rates in the U.S. generates a flow of capital out of emerging countries and into the U.S., so local currencies are under pressure as global investors try to position themselves for higher rates in the U.S. In addition to that, escalating geopolitical problems around the world -- like the situation in Syria -- tend to generate a flight to safety, and this is another factor affecting emerging-market assets lately.

It's hard to predict how these variables may evolve in the short term, but on a longer-term basis, emerging markets are looking like a compelling opportunity. While SPY trades at a price-to-prospective-earnings ratio of 14.8, EEM carries a much lower valuation with a ratio level of 10.4 based on data from Morningstar. MSCI indexes for China and Brazil are even trading below financial-crisis levels when measured in terms of price-to-book-value ratios.

If emerging-market stocks were to trade in line with U.S. companies, then an ETF like EEM would need to outperform SPY by more than 40%. Even if emerging markets are now looking particularly risky, it's important to keep in mind that these countries traded at a premium versus developed nations not so long ago due to their superior long-term growth prospects.

Uncertainty over the coming months is remarkably high when it comes to evaluating emerging markets' prospects, so it's hard to tell whether the current slowdown is just transitory weakness or the beginning of something more serious. On the other hand, this kind of uncertainty is what usually creates buying opportunities for long-term investors, and current valuations certainly seem attractive for those who have the patience and discipline to hold their positions through the short-term volatility.

The smaller the better
The problem when it comes to large companies in some countries is that in many cases they are tilted toward politically sensitive sectors like energy, banks, utilities, or telecommunications. This means that heavy regulation, or even full-blown state ownership, is a distinct possibility, and this can mean bigger risks and smaller returns for investors.

Besides, small companies are more exposed to local economies and customers, so they may be a better choice when it comes to benefiting from long-term economic growth and rising consumption levels in emerging markets over the coming years.

A better approach than the traditional large-cap approach of ETFs like EEM could be SPDR S&P Emerging Markets Small Cap (NYSEMKT: EWX  ) , which tracks the S&P Emerging Markets Under USD2 Billion Index. The index includes all stocks with float-adjusted market capitalizations between $100 million and $2 billion and is reconstituted and rebalanced annually in September.

EWX has assets under management of $760 million and charges a reasonable expense ratio of 0.65% annually. The fund holds 17.3% of its assets in the technology sector, 15.3% in consumer cyclicals, and 13.2% in the industrial sector. EWX carries an average P/E ratio of 11 and a 2.4% dividend yield.

Another interesting candidate could be WisdomTree Emerging Markets SmallCap Dividends (NYSEMKT: DGS  ) , an ETF tracking the WisdomTree Emerging Markets SmallCap Dividend Index, which includes about 600 small-cap companies from 17 countries and weighs its holdings based on annual cash dividends paid. Its dividend focus, in addition to providing current income, helps avoid the most speculative and overvalued companies.

This ETF has an expense ratio of 0.63% and assets under management of $1.59 billion. The portfolio has 15.6% of its assets in technology, 16.9% in consumer cyclicals, and 13.8% in industrials. The fund trades at an average P/E ratio of 10 and pays a dividend yield of 4%.

Bottom line
The outlook for emerging markets has become more uncertain lately, but those risks are already reflected in compelling valuations for those markets. From a long-term point of view, current valuation levels look like a convenient entry price for investors with a long-term approach.

Smaller companies offer more exposure to sectors like technology, consumer goods, and industrials, while at the same time avoiding heavily regulated areas of the economy, so they may be the best way to make a long-term investment in emerging countries.

To learn more about a few ETFs that have great promise for delivering profits to shareholders, check out The Motley Fool's special free report "3 ETFs Set to Soar." Just click here to access it now.


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