I often describe emerging market small caps as a surprisingly low-volatility way to access exposure to emerging markets. Investors think of small caps as high volatility, and that is particularly true for indexes such as the S&P 500 Indexcompared to the Russell 2000 Index, but it may come as a surprise that for emerging market equities, large caps have been more volatile over the last nine years than dividend-paying small caps.¹

As an example, the beta of the WisdomTree Emerging Markets SmallCap Dividend Index to the MSCI Emerging Markets Index has been .92 since its inception.²
 
Small Caps Usually Lag During a Commodity Rally

This year has been a year of strong commodity prices and commodity gains. Taken at face value and with no other information, I would say this should lead to small caps underperforming large caps, given their lower exposure. And this has been true for the MSCI Emerging Markets Index family—where small caps returned 9.08% year-to-date through 9/30, compared to large caps, which returned 16.02%, a 6.94% difference.³
 
Year-to-Date Performance

Yet the WisdomTree Emerging Markets SmallCap Dividend Index, again a lower-volatility strategy with a beta below 1 since its inception, had returns that were 4 percentage points ahead of the large-cap MSCI Emerging Markets Index and 11 percentage points ahead of the MSCI EM Small Cap Index. What could explain this?
 
Country Allocations, but Now Taking Chips Off the Table

On a country basis, the WisdomTree strategy has been over-weight Brazil by a significant margin, and Brazil has been the strongest-performing market in emerging markets. Brazil has been a country with remarkably high dividend yields, and in our dividend-weighted approach, these companies have received an over-weight. After gains that averaged over 60% year-to-date, driven in part by a currency that was up over 21%, the Index is rebalancing and taking some chips off the table in these stocks, spreading them out to the other dividend payers in emerging market small caps.⁴
 
Relative Brazil Weight

Another very strong performer this year have been Taiwan technology stocks. Tech stocks have generally been an area of growth, and Taiwan companies have participated strongly. Taiwan thus saw a weight reduction to rival Brazil’s at this year’s rebalance, and Technology was the sector that received the greatest reduction in weight across all countries. These stocks were up, on average, over 22% year-to-date.⁵

Notable additions this year include an approximately 3 percentage point increase to South Korea. South Korea has not been known for its dividend payments, and it had one of the lowest dividend payout ratios historically. But over recent years, the South Korean government has changed tax incentives, and we are seeing the kind of dividend growth that makes Korea’s position in the Index less under-weighted than in years past.

Thailand has been a notable over-weight in the Index for years, and it is one of the recipients of higher allocation of weight away from Brazil and Taiwan, primarily on the back of higher dividend growth relative to others but with performance in line with others, thus improving the relationship between dividends and prices.
 
Emerging Market Allocations

WisdomTree has been an advocate for small-cap allocations within an emerging market portfolio. These types of companies are often relatively uncovered in traditional passive strategies that often target the large- and mid-cap segment of the markets. But this is a year when emerging markets are recovering, and the WisdomTree process focused on valuations and fundamentals has added value over traditional benchmarks. The key driver of this value-added approach is the annual rebalance, and with the rebalance now complete, we encourage investors to take a fresh look at the reconstituted Indexes.
  
¹Sources: WisdomTree, Bloomberg, 8/1/07–9/30/16. For emerging markets, the statement references the WisdomTree Emerging Markets SmallCap Dividend Index’s lower volatility compared to the MSCI Emerging Markets Index over the period.
²Sources: WisdomTree, Zephyr StyleADVISOR, 8/1/07–9/30/16.
³Sources: WisdomTree, Bloomberg, 12/31/15–9/30/16. Refers to the MSCI Emerging Markets Small Cap Index vs. the MSCI Emerging Markets Index.
⁴Sources: WisdomTree, Bloomberg, 12/31/15–9/30/16.
⁵Sources: WisdomTree, Bloomberg, 12/31/15–9/30/16. Refers to weighted average performance of the Information Technology sector within the WisdomTree Emerging Markets SmallCap Dividend Index. Taiwanese Information Technology stocks were up over 24% over that period.