Mexico, Pakistan, Saudi Arabia, China, and Brazil are notable emerging markets. Russia had been an emerging market country, but the war in Ukraine and sanctions have pushed the Russian economy further down on the totem pole.
While U.S. and European small-cap companies can offer significant growth with substantial risks, emerging market small-cap stocks carry greater risks but can provide even more upside potential as rewards are always a function of risks. The SPDR S&P Emerging Markets Small-Cap ETF product (EWX) owns shares in emerging market companies with upside potential and commensurate risk profiles.
EWX is a liquid ETF
The SPDR S&P Emerging Markets Small-Cap ETF’s fund summary states:
The Index is a float-adjusted market capitalization-weighted index representing the small-capitalization segment of emerging market countries included in the S&P Global Broad Market Index. Companies in EWX have market caps above $100 million and below $2 billion. State Street Global Advisors is the ETF’s administrator.
At $54.30 per share on July 17, EWX had over $803 million in assets under management. EWX trades an average of 46,349 shares daily and charges a 0.65% management fee.
Meanwhile, the blended annual dividend yield at $1.32 per share translates to a 2.43% yield, more than covering the expense ratio for long-term investors. EWX has been trading on NYSEArca since 2008.
EWX can diversify an investment portfolio
According to Seeking Alpha, EWX had 2980 holdings as of July 11, 2023. The holdings breakdown is diversified:
Source: Seeking Alpha
The broad emerging market ETF holding many companies with significant growth potential diversifies risk. While some companies will fade into the financial abyss, others could provide explosive returns.
Comparing EWX with U.S. small-cap stocks
EWX has posted gains since the end of 2022.
The chart highlights the 10.95% gain from $48.94 on December 30, 2022, to $54.30 on July 14, 2023.
Over the same period, the iShares Russell 2000 ETF (IWM), which tracks U.S. small-cap stocks with market capitalizations between $300 million and $2 billion, moved 10.8% higher from $174.36 at the end of 2022 to $193.23 on July 14, 2023. According to Seeking Alpha, IWM owned shares in 2,008 companies as of July 11, 2023. IWM and EWX have no exposure to a single company above 1% of their total assets.
EWX has kept pace with IWM on a percentage basis since the end of last year.
The factors favoring EWX
Three significant factors support higher emerging market small-cap stocks over the coming months and years:
- China is the world’s second leading economy and is nipping at the U.S.’s heels for a leadership position. While the U.S. Fed has tightened credit to battle inflation, which could weigh on economic growth, China has a pro-growth stance, including stimulus. As China emerges from its COVID-19 protocols, a return of economic growth could support Chinese and other emerging market stocks, which are inexpensive compared to their U.S. small-cap counterparts.
- The U.S. dollar index fell below the 100 level for the first time since April 2022 last week. A weaker U.S. currency can support gains in emerging market stocks as it strengthens emerging market foreign exchange values. Moreover, a lower dollar supports higher commodity prices, and emerging market countries tend to be significant raw material producers.
- The bifurcation of the world’s nuclear powers has caused a shift in global trade relationships. Saudi Arabia is selling crude oil to China in yuan. China is a leading force in rolling out a gold-backed BRICS currency to challenge the U.S. dollar’s leadership role as the global pricing benchmark and the world’s reserve currency. Tensions between Washington, DC, and Beijing have caused trade relations between China and other emerging market countries to improve. Chinese population and potential economic growth could support earnings growth in emerging market small-cap companies.
- A shifting global economic and geopolitical landscape favors small-cap emerging market companies and the EWX ETF product.
The risks of investing in EWX
Commensurate risks come alongside profit potential, and the following factors can cause significant volatility and the potential for losses in EWX and other emerging market investments:
- Sanctions, tariffs, export restrictions, and other geopolitically motivated events can undermine emerging market companies’ ability to earn profits and grow.
- Reporting standards for companies outside the U.S. and Europe can be dubious. Earnings and other financial reports may be less robust, and regulations can be weak, making for scandalous corporate activities.
- Local governments can suddenly nationalize emerging market companies or shut them down for political reasons.
- As witnessed in Russia, hostilities with other countries can lead to bans or other governmental decisions that make investments worthless.
I favor allocating a small percentage of portfolios to EWX or other small-cap emerging market exposure. However, the potential for significant appreciation comes with substantial financial risks. While EWX slightly outperformed IWM so far in 2023, and both have moved around 10% higher, I expect EWX to either significantly outperform or underperform IWM over the coming years. Therefore, a small allocation to EWX diversifies portfolios without undertaking undo risk levels.
On the date of publication, Andrew Hecht did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
