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 MSCI EM large cap index country weights are more concentrated than small cap, with 40.7% in China and 65% in the top 3 countries (versus 11.8% and 52.8% respectively for small cap). In sector terms, both indexes have their highest weights in technology, but large caps have much higher weights than small caps to financials (19.1% versus 9.8%) and communication services (13.5% versus 4.2%).