Small cap stocks within emerging markets have outperformed large cap stocks (i.e., MSCI EM) by around 0.5% annualized since January 2000. However, Illiquid stocks (regardless of capitalization) have outperformed large cap stocks by around 3%. This illiquidity premium is related to, but not the same as, the small cap premium. This opportunity is all the more enticing as it sits atop emerging markets, an already attractive asset class, and offers active managers a large selection universe of approximately 2000 firms.
We have been investing in emerging market (EM) stocks across the capitalization spectrum since 1993. As is typical in quantitative processes, stocks have been chosen based on a trade-off between returns, risk, and transaction costs. Over this period, the contribution from small cap stocks has been additive, perhaps unsurprising as a long tail of over 2000 lesser-known under-followed securities offered plenty of opportunities for an active manager to add value. But, for every stock with a high expected return, there were other stocks with an even higher expected return that the optimizer would bypass because the transaction costs were too high. We viewed these high returns as a mirage because the extra return was outweighed by the prohibitive expense – after all, that is the precise purpose of a trade-off function. But what if there were a way to tap into these missed opportunities without incurring the corresponding costs?
We undertook a project to study this tail of stocks intensively and in doing so uncovered a notable finding – the premium in emerging lies not in size, but in illiquidity.
Small cap stocks within emerging have outperformed large cap stocks (i.e., MSCI EM) by around 0.5% annualized since January 2000. However, illiquid stocks (regardless of capitalization) have outperformed large cap stocks by around 3%.
The matrix shown in Table 1 makes the contrast clear. Note that the return premium has been in illiquid space (right column) and not in small cap (bottom row). In fact, note that investing in the liquid part of small cap (bottom left box) has actually cost approximately 4.8% relative to MSCI EM annualized since 2000. Of course, active management in this space can identify large alpha opportunities, but that’s a rather large hole to dig out of.