Emerging market (EM) equities sold off sharply following the election of Donald Trump last November, perhaps owing to the protectionist rhetoric and tough trade talk from the president-elect. With that, the MSCI Emerging Markets Index fell 4.2% in the final quarter of 2016, breaking a streak of four consecutive positive quarters.

That sell-off represented a pause in the party, but certainly not the end of it. After the fourth quarter’s breather, EM came roaring back in the first quarter of 2017, returning 11.5%—capping the best quarter for the asset class in five years.

A core tenet of behavioral finance is that flows tend to follow performance. There are currently nearly 1,800 U.S.-listed exchange-traded funds (ETFs),¹ and the one that took in the most money in the first quarter of 2017 happened to be an EM ETF, raking in over $6.6 billion.² Given that EM ETFs represent a relatively small portion of the ETF universe (currently representing a combined $166 billion in total assets, about $75 billion less than the largest U.S.-focused ETF), this fund’s perch at the top of the list is quite impressive.

Finding Gaps in Portfolio Construction 

As we consult with our clients about how to best optimize their model portfolios, a few interesting trends typically emerge. We’ve found that many investors include U.S. small-cap stocks in their models, but fewer tend to include international small caps, and even fewer include EM small caps. 

To us, this is the opposite of how we recommend building portfolios, and we believe it represents a massive gap within a complete model. We believe that when it comes to portfolio construction, specific to emerging markets, a larger allocation to small-cap stocks is merited. 

Benefits of Small Caps That Are Unique to EM

Going beyond the obvious small-cap premium, there are several reasons why we have such strong conviction in EM small caps. 

Smaller, more domestically oriented companies will typically conduct more of their business in their local markets. This is an organic way to access the much-desired rise of the EM middle class consumer theme—which McKinsey referred to as “the biggest growth opportunity in the history of capitalism³”—without being constrained to just the two consumer sectors.