Equity investors in emerging markets (EM) typically focus on large-cap companies. But allocating to smaller companies can help broaden an EM allocation by providing a different mix of exposures to opportunities across countries and sectors—and can bring potential for higher added value.

Investors in EM equities are facing a rapidly changing market landscape. Some countries are coping with the impact of COVID-19 better than others. Companies are reconfiguring supply chains amid the pandemic and deglobalization trends. And efforts to upgrade economies are providing new growth prospects for many businesses. These trends are creating fertile ground for lesser known smaller-cap EM stocks, which offer investors different performance and risk dynamics relative to their large-cap EM investments.

Small-Caps Provide Different EM Exposures than Large-Caps

The EM small-cap universe looks very different from the large-cap benchmark (Display, below). In particular, the small-cap country allocation is not dominated by China, and the sector allocation has less exposure to industries driven by macroeconomic factors such as financials, consumer discretionary and energy. The EM large-cap benchmark is dominated by mega-cap stocks, with Alibaba, Tencent and TSMC accounting for 20% of the index, and the top five names (also including Samsung and Meituan) making up 25%. EM small-cap’s wider spread of more companies with unique business drivers provides opportunities both for improved diversification, and for finding compelling value-adding ideas through lesser-known stocks with strong potential.

The Outperformance Advantage

On a 20-year timescale, EM small- and large-caps have both outperformed large-cap developed markets (DM) by a wide margin (Display below, left). But over the last 10 years, as the large-cap median manager’s outperformance has dwindled, EM small-cap managers have still delivered significant excess returns (Display below, right).

Large-caps tend to receive more intensive analyst coverage, which may explain the shrinking outperformance. Beyond the advantage of more limited analyst coverage for small-caps, we believe that there are good reasons why carefully selected smaller EM companies should continue to deliver on their strong historical performance track record in the future.