Smaller emerging market companies are drawing interest from investors wary of wilder frontier economies but willing to delve deeper into familiar territory in pursuit of returns.
Buying shares in firms with market capitalizations of less than $3 billion offers a way to tap into economies in which demand from a rising middle-class for consumer brands, telecoms and financial services is driving rapid growth.
And unlike risky frontier markets, many of the best opportunities are in countries already familiar to investors.
"The most exciting emerging markets are Thailand, Indonesia, Philippines and Mexico," said Todd McClone, emerging market fund manager at William Blair, citing their low interest rates, relatively strong currencies and rising consumer confidence.
"These countries are more geared to mid- to small-cap markets."
Investors have long been attracted to companies based in emerging economies where fast growth promises bumper returns.
But the broad emerging stock index is strongly weighted toward giants Brazil, Russia, India and China, whose economic performance in recent years has disappointed, and is dominated by their massive energy firms.
Just 11 companies account for 18 percent of the index's market capitalization, including Russian oil giant Gazprom and its Brazilian peer Petrobras, and South Korean technology firm Samsung.
Investors hungry for risk tend to favor smaller, less liquid stocks. Small-cap favorites include Eurocash, Poland's second-largest distributor of fast-moving consumer goods, and Thai consumer finance company Aeon.
Demand for such exposure has helped push MSCI's emerging market small cap index 3 percent higher this year, compared with a 1 percent fall in the broader gauge as a squeeze on company profits deters investors.
The small cap index encompasses the same countries as its wider emerging markets counterpart, but with larger weightings for several Asian markets, South Africa and Turkey, and less representation for Latin America.
It is also more heavily weighted toward stocks driven by consumer demand, which can include property and financial services companies, healthcare providers and, in Asian countries with ageing populations, pharmaceutical firms.
While Lipper data show there are not many global emerging market small cap funds, they include those run by big names such as JP Morgan and Templeton, and some are substantially sized.
Aberdeen Asset Management's $2.7 billion Emerging Markets Smaller Companies fund was one of three large, strongly-performing funds on which the fund manager slapped a 2 percent initial charge last month, an attempt to stem investor flows.
Specialist emerging market fund manager Ashmore has a $600 million emerging markets small caps fund, which is strongly overweight China, South Korea and Taiwan. One of its largest holdings at the end of last year was South Korea's Hyundai Department Store Co.
"Investors have reallocated to emerging markets, where they were under-invested," said Julie Dickson, product manager for equities at Ashmore. "Now they are taking the next step, by going deeper into emerging markets or by going into small caps."
Investors point to high returns on equity and high earnings per share for small cap stocks, as well as low valuations.
Emerging market small cap stocks are trading at a price to book of 1.3 times, below their long-term average, while the broader MSCI emerging market index is trading at 1.7 times.
Correlations are also lower between emerging market small caps and global stocks, making them attractive for investors seeking to diversify away from developed markets.
Low correlations are also a feature of less-developed "frontier" markets such as Nigeria or Vietnam, but their higher political risk and lower liquidity mean small caps are often the first port of call for more adventurous investors.
"If Spain is going to get kicked out of the euro, Berlusconi is going to run Italy, I am not going to reduce interesting frontier or small cap stocks," said William Blair's McClone.
Specialist emerging market investors may also seek to exploit a lack of information about small cap companies. With one in three small cap stocks covered by only two analysts, investors who can do their own homework have an advantage, said Claire Peck, client portfolio manager for emerging markets at JP Morgan Asset Management.
"The hidden costs of frontier markets are in liquidity," said Peck.
Small caps thus tend to underperform larger emerging market stocks when enthusiasm for the asset class wanes. That may be happening now, as higher Treasury yields and a possible end to Federal Reserve money-printing lure U.S. investors home.
Dedicated small cap investors are prepared to take the risk, however. According to Ashmore's Dickson: "Small caps may be a little bit less liquid, but that gives you the extra return opportunity."
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