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Why Invest In Emerging Market Small Cap Stocks?

Summary The notion of a “small-cap premium” is deeply established in investors’ consciousness. Many investors include an explicit allocation to U.S. and international small-cap stocks in their portfolios in order to benefit from the implied outperformance of this market segment. Recently there has been a growing interest in whether making a similar allocation to emerging market small-cap stocks can be beneficial. We detail the motivations of EM small cap investors and whether empirical evidence supports those motivations. By Tim Atwill, Ph.D., CFA, Head of Investment Strategy and Mahesh Pritamani, Ph.D., CFA, Senior Researcher An investor in emerging market small-cap stocks typically has three main motivations behind their interest in the asset class: presumed higher return; better diversification with their developed equity allocation; and more “focused” exposure to the emerging markets, in that small-cap companies tend to be more domestically focused in their economic activities. Below, we lay out the empirical evidence which supports these motivations. We show that while the return advantage and “pure exposure” arguments are strongly supported, the diversifcation benefit is relatively modest. HIGHER RETURNS Historically, small capitalization stocks have been seen as having higher potential returns than mid- and large-cap stocks. However, the bulk of the research examining this premium has focused primarily on the U.S. markets, and, to a lesser extent, the international markets. Below, we compare the excess returns of the MSCI® Emerging Markets Small Cap Index to the MSCI Emerging Markets Index to evaluate whether a similar small-cap premium exists in emerging markets. (click to enlarge) Figure 1 shows that in most years, small-cap stocks earn a relative premium to large- and mid-cap stocks. However, as with most matters in investing, there is no such thing as a free lunch, and several years had notable underperformance. Moreover, the oversized small-cap premium in 2009 highlights the timing risk associated with trying to capture the small-cap premium. This is also evident in Figure 2 which shows the annualized small-cap premium on a rolling 3-year basis, where the realized premium ranges from -5.4% to 9.2%. (click to enlarge) These results indicate that although there is evidence of a small-cap premium in the emerging markets, one has to be invested for the long-term in order to earn it. LOWER CORRELATION WITH DEVELOPED ECONOMY EQUITIES Many argue that small-cap companies are more focused on their local economies, and because of this are less connected to the global economy. Accordingly, such small-cap stocks should provide higher diversification benefits within an investor’s portfolio, versus the benefit from buying equities of larger, more globally-focused companies, which are included in more traditional emerging markets equity allocations. To demonstrate the diversification benefits associated with investing in emerging market small-cap stocks, we calculate the correlation of the MSCI World Index (which represents the equities of the developed markets) to the MSCI Emerging Markets Index, as well as the MSCI Emerging Markets Small Cap Index. (click to enlarge) As can be seen, emerging market small-cap stocks have historically shown a modestly lower correlation with the developed markets than large and mid-cap emerging market stocks. That is to say, emerging market small-cap stocks should provide a higher degree of diversification if included in an investor’s portfolio. Moreover, Figure 3 shows that this diversification benefit persists over most time periods. Therefore, a portfolio which includes an allocation to emerging market small cap stocks should expect to achieve some minor benefits from this lower correlation, including lower predicted portfolio volatility versus a similar portfolio which only includes large- and-mid-cap emerging market stocks. A “FOCUSED” EMERGING MARKETS EXPOSURE One of the reasons for investing in emerging markets, in general, is to gain exposure to smaller, less developed economies which have the potential to grow at a faster rate than developed economies. However, given the globalization of the world economy, several emerging market countries now have a small number of companies that are global in nature and known worldwide. A prime example of this is Korea-based Samsung, a truly global company, whose consumer products (such as TVs and smart phones) are bought all over the world and whose profitability is more likely tied to the world economy than the local Korean economy. A portion of the MSCI Emerging Markets Index constituents is in such global companies, under-cutting to some degree this motivation for investing in the emerging markets. By avoiding such companies, an investor in the small-cap segment of the emerging markets has the potential to obtain an exposure more focused on the local emerging market economies. To quantify this, we look at each company within both the MSCI EM Small Cap Index and the MSCI EM Index, and calculate the percentage of revenue which comes from outside its “home” country. We then capitalization-weight these percentages for each index, and present the results below. (click to enlarge) As shown in Figure 4, emerging market small-cap companies do receive much less of their revenue from outside their home economies (approximately one-quarter, versus almost one-third for large/mid-cap stocks). In addition, this focus on local economies remained relatively static over the past decade, while globally, small-cap companies saw growth in foreign revenues. This data suggests that an investor in the small-cap segment of the emerging markets captures a “focused” exposure to the local emerging market economies, because small-cap names are generally more reflective of local economies, and that this focus is more persistent than is observed globally. CONCLUSION Investors currently hear many arguments for investing in emerging market small-cap stocks, and while these arguments appeal to intuition, we have found varying degrees of support for them in the historical data. After exploring the three most common reasons for investing in the emerging market small-cap stocks – earning a small-cap premium, realizing the benefits of increased diversification, and achieving a more focused exposure to the local economies in emerging market countries – we find supporting evidence for all three of these arguments. One can potentially earn a small-cap premium by investing in small-cap stocks, though there is the risk that small-cap stocks will underperform large- and mid-cap stocks over multiple years. Historical evidence also demonstrates that although emerging market small-cap stocks are less correlated with the developed markets, this diversification benefit is relatively modest in size. It also appears that small companies in the emerging markets are more focused on their local markets, and so are potentially well positioned to benefit from the higher expected growth rates in these developing economies. All in all, we find the data encouraging for those investors who are considering a long-term strategic allocation to emerging markets small-cap stocks.

Shopping For High Dividend ETFs? Beware Volatility

This article originally appeared in the October issue of REP. Magazine and online at Wealthmanagement.com Yield-starved investors turn to high-dividend payers to squeeze out some cash flow, but how do you squeeze extra yield out of the market without blowing your risk budget? In today’s low-yield bond market, it’s no wonder income-oriented investors have looked to dividends for supplemental cash flows. In February 2011, ten-year Treasury notes were paying nearly two percentage points more than the S&P 500 dividend yield (see Chart 1). The yield premium has since plummeted and, at times, actually turned into a discount. Blue Chips Stalled The ten-year and blue-chip benchmarks are now pretty much stalled at a two percent yield, forcing many investors to cast about for better-paying opportunities. Especially enticing are high-dividend exchange-traded funds (“ETFs”), which offer cash flows nominally devoid of duration and interest rate risk. Seven have track records stretching back more than five years: The 100 stocks making up the iShares Select Dividend ETF (NYSEARCA: DVY ) are screened on the basis of dividend growth and sustainability. Utilities account for more than a third of the portfolio’s capitalization. Financials, mostly REITs, come in second. The 50-stock SPDR Dividend ETF (NYSEARCA: SDY ), which screens the S&P 1500 Composite Index for stocks with 20 years or more of consecutive dividend increases, maintains a narrower portfolio. Consequently, SDY skews heavily toward REITs. Vanguard avoids REITs entirely in its high-dividend product. The 400+ stocks populating the Vanguard High Dividend Yield ETF (NYSEARCA: VYM ) are more or less evenly weighted by sectors and tilt toward large caps. First Trust sponsors two veteran high-dividend ETFs. The larger, First Trust Value Line Dividend ETF (NYSEARCA: FVD ), is built with low-beta issues found with Value Line’s proprietary “safety rating” methodology. Not surprisingly, FVD gives over nearly a quarter of its real estate to utilities. The loose inclusion criteria of the WisdomTree High Dividend ETF (NYSEARCA: DHS ) accounts for its 900+ stock portfolio and its relatively modest sector bets. Still, financials are weighted more heavily than utilities. FVD’s stablemate, the First Trust Morningstar Dividend Leaders Index ETF (NYSEARCA: FDL ), is a 100-stock portfolio comprised of companies that have boosted their dividends over the past five years. REITs are specifically excluded. Accordingly, FDL tilts toward utilities. Rounding out the set is the PowerShares High Yield Equity Dividend Achievers Portfolio ETF (NYSEARCA: PEY ), a 50-stock portfolio of large caps selected on the basis of their ten-year dividend growth histories. Utilities figure heavily in the mix-more so, in fact, than in the other veteran funds. When interest rates sag, income-hungry investors may be tempted to chuck fixed-income exposure in favor of high-dividend funds. That’s a very risky move, however. Remember: These funds are equity products. Replacing all or part of a portfolio’s fixed-income allocation increases exposure to stock market volatility and can further concentrate risk in certain industry sectors. Choices, choices So how do you squeeze some extra yield out of the market without blowing your risk budget? The first step ought to be identifying the high-dividend funds that provide the greatest diversification. There’s a couple of ways to look at this problem. From Table 1, you can see that the First Trust FDL portfolio, in addition to offering the highest dividend yield, has the lowest r-squared and beta correlations versus the S&P 500. That makes FDL pretty different and pretty attractive. FDL, however, posts the worst Sharpe and Sortino ratios of the lot. Not a good thing. The Sharpe metric, remember, rates a fund’s risk-adjusted returns using total volatility. The Sortino ratio does the same thing but only uses downside deviation as the representation of risk. If preservation of capital is paramount, a high-dividend fund sporting the best Sharpe and Sortino ratios ought to be a top pick. That makes the PowerShares PEY fund a standout. The next problem is the allocation issue. Just how much of the high-dividend fund do you add to your portfolio? And, where do you carve out room for it? Here, a little backtesting offers clues. Suppose you’re keen on dampening risk as much as possible while keeping your commitment to a high-dividend product at 20 percent of your capital. Let’s look back at the last five years to see how PEY might have performed. Classic 60/40 Portfolio Our benchmark will be a classic “60/40” portfolio: 60 percent stocks, represented by the SPDR S&P 500 ETF (NYSEARCA: SPY ), and 40 percent bonds, proxied by the iShares Core Aggregate Bond ETF (NYSEARCA: AGG ). Taking a 20 percent PEY carve-out from the bond side (a “60/20/20” allocation) produces a significantly higher average annual return than the benchmark but yields an inferior Sortino ratio. Splitting the PEY carve-out equally from the equity and bond sides (a “48/32/20” mix) improves both nominal and risk-adjusted returns but ticks up volatility. The sweet spot’s found by carving out a PEY allocation from the classic portfolio’s equity side (a “40/40/20” exposure). There’s a minimal impact on the portfolio’s average annual return but a significant reduction in volatility and, therefore, realized risk. Both risk ratios, especially the Sortino metric, are dramatically improved at the cost of just 10 basis points in annualized returns. High div/low vol packages Some newer high-dividend ETFs attempt to entice risk-averse investors by branding themselves as “low-volatility” portfolios. The oldest of these, launched in 2012, is the PowerShares S&P 500 High Dividend Portfolio ETF (NYSEARCA: SPHD ). SPHD’s index methodology screens the S&P 500 for 50 of the blue-chip benchmark’s highest-paying and least-volatile components, tilting the portfolio heavily toward utilities, consumer staples and financials. At last look, SPHD paid out a 3.5 percent dividend. It’s no surprise that SPHD is highly correlated to its parent index. Movements in the S&P 500 explain 77 percent of SPHD’s variance. SPHD’s beta, at .76, makes the fund a middling competitor to the veteran high-dividend products. Using SPHD in a “40/40/20” portfolio pares 50 basis points off the return earned by a classic “60/40” portfolio and an equal amount from the portfolio’s volatility. The significant improvement in the portfolio’s Sortino ratio bespeaks SPHD’s defensive sector concentration. SPHD isn’t the only ETF claiming low-vol street cred. The Global X SuperDividend US ETF (NYSEARCA: DIV ) is another 50-stock portfolio that screens stocks for low volatility, but its universe includes MLPs and REITs. Thus, the fund’s high-dividend yield is north of seven percent. The fund’s equal-weighting scheme magnifies the energy and financial sectors’ influence, which perhaps explains why a portfolio including DIV has Sharpe and Sortino ratios worse than a classic “60/40” mix. As with anything, it pays to look beyond the advertising for real evidence. Volatility is relative. Investors will soon have another exchange-traded high-div/low-vol option. Legg Mason recently filed a registration statement for an ETF based on the QS Low Volatility High Dividend Index, a proprietary benchmark that culls 3,000 domestic stocks for sustainable dividends as well as low earnings and price volatility. The Legg Mason Low Volatility High Dividend ETF is expected to be listed on Nasdaq, but no ticker symbol has yet been assigned. What’s clear from this exercise is that dividends come at a cost. Each high-dividend fund is constructed differently, and each presents a unique combination of risks and rewards. The highest-yielding product may not be the best addition to your portfolio. It’s often better to accept a more modest cash flow than risk hard-earned capital.

Investors May Be Doing The Wrong Thing (Again)

Summary In this article, I delve a little deeper into my recommended Model Stock Portfolio funds to try to get a fresh perspective that cannot be found elsewhere. The snapshot that emerges is intended to further help result-seeking investors judge what might be the best choices going forward within a group of already highly recommended funds. Investors often invest heavily in funds whose holdings are tilted toward previously strongly performing but overvalued stocks, rather than from those with a better chance of showing future strength. It should go without saying that no single or even multiple selection criteria hold the key to which funds you should hold on to and with what emphasis in your portfolio. However, in my Newsletters down through more than 15 years, I have tried to make the case that, while there are numerous good funds (or ETFs) to choose from, the best long-term results are more likely when, even within a list of highly rated funds, one focuses on those composed of stocks that are relatively more undervalued vs. those made up of stocks which have already been “discovered,” and therefore, likely have seen most of their potential run-up in prices already. Expressed a little differently, some funds may have achieved their recent success by their emphasis on holding a preponderance of already recognized “winning” stocks and stock categories and continuing to ride those winners. A simple example is funds that hold a relatively large proportion of what has proven to be an amazing stock, Apple (NASDAQ: AAPL ). The same may be said for funds that have a relatively high proportion of recently high-performing technology stocks as a group. Two such funds I have consistently recommended are the Vanguard Growth Index Fund (MUTF: VIGRX ) (or its equivalent ETF) and Fidelity Contra (MUTF: FCNTX ). The former currently holds 7.5% of the fund in Apple and 26% of the fund in Technology companies. The latter holds about 3.8% in Apple and 29% in technology stocks. Given the excellent performance over recent years of these fund components, the heavy weighting has given a boost to both these funds (and many other similarly categorized Large Growth funds), and been a contributing factor as to why these two funds have beaten the S&P 500 Index on average over many years. But another even more striking example can be cited: funds investing heavily in Health Care, such as PRIMECAP Odyssey Growth (MUTF: POGRX ), Vanguard Health Care (MUTF: VGHCX ) or Vanguard Health Care ETF (NYSEARCA: VHT ). Not surprisingly, the latter two highly narrow-focused funds have nearly all their investments in this one sector, a stock subclass that has on average returned over 20% annualized over the last five years. While, unfortunately, I have never included any of these funds in my Model Stock Portfolios, I have recommended at least one fund with greater than a 20% weighting in Health Care currently, namely T. Rowe Price Value Fund (MUTF: TRVLX ), This fund’s track record against its Large Cap Value category peers has been admirable over the last five years. Beyond this, though, is where things get very murky. As an investor, do you want to stick with funds that invest heavily in stocks and categories that have shown a lot of past momentum in the hopes that this outstanding performance will continue? Or, do you want, perhaps, to trim down your holdings of such funds, and instead for at least the next few years, favor funds more heavily invested in stocks and categories that may show even greater potential for success, namely those choosing the majority of their investments in potentially less overvalued segments of the market? Unfortunately, there is no clear-cut answer to this dilemma. Therefore, it is probably wisest to own funds weighted in both, that is, funds that invest heavily in stocks with strong current momentum, and, those that can potentially become better choices when the former momentum-driven stocks start to lose altitude. Unfortunately too, one of investors’ biggest downfalls happen when the winds of change periodically cause a big shift in the performance of previously winning stocks, categories, and the funds investing heavily in them. While we haven’t seen any such sort of massive shift going back perhaps to the 2007-09 financial crisis, or even before, we know that many investors tend to suffer when outsized bets on previous winners turn into outsized losses. While no one can say with any degree of certainty if and when the next reversal of fortune may befall the current crop of big winners in stocks, what follows is an analysis of which of my recently recommended funds are holding stocks perhaps overloaded with past winning, but now likely overvalued, categories of stocks. And, on the other side of the coin, can I identify which of my recommendations are more oriented toward current ownership in categories that seem to be less likely to underperform, when the next big shift in stock market winners and losers takes hold and impacts fund results for possibly years into the future? A Closer Look at My Model Stock Portfolio Funds In the first list of funds below, I analyze broadly diversified domestic stock funds recommended (or recently so) in my Model Stock Portfolio to examine the above issue. I also include some additional funds that I hold in my own personal investment portfolio. Funds more broadly classified as international stock or narrow-focused sector funds, however, are not included. For each listed fund, I have scored the fund on the extent to which it is currently (based on latest data available) invested in either what appear to be fairly priced categories of stocks, or on the other hand, seemingly overvalued categories, based on my own proprietary research. See the note at the bottom of the list for the meaning of scores. Each fund is listed in a descending order of score, starting with those least likely to be overvalued . Those with greater potential for coming out on top over the next 3 to 5 years, assuming my scoring method proves valid, are listed closer to the top; those that may be strong winners recently, but having a greater potential for underperformance when their current chosen and often overvalued stock selections lose momentum, are found further down the list. Note: If one compares the results shown in the list with the allocations shown in my Oct. ’15 Model Stock Portfolio , the results may not completely agree with the recommendations there because the listing below is based on different data. It should come as no surprise that all of the funds below, because they are diversified mixes of stocks, will have a moderate proportion of their investments in overpriced stock categories, given what we have previously labeled as an overall overvalued market. Therefore, inclusion in this list below in no way ensures that most or all of these funds will prove to be great investments over the next few years. But relatively speaking, we chose these funds, that is, those that are managed, aiming to beat market indices, or at least do well against their similarly classified peers. However, it is very possible, too, that perhaps some of the best investments for the next few years instead may turn out to be in funds that are invested internationally, as generally speaking, these fund categories seem to be relatively more undervalued than U.S. domestic funds are at the present time. Best Model Stock Portfolio Choices (from most highly rated* to less highly rated) Fund Name (Symbol) Score 3 Yr. Return (thru 10-27) (ann.) Category 1. T. Rowe Price Equity Income (MUTF: PRFDX ) 76% 10.6% Large Value 2. Vanguard US Value (MUTF: VUVLX ) 74% 16.5% Large Value 3. Fidelity Large Cap Stock (MUTF: FLCSX ) (tie) 70% 15.5% Large Blend 3. Vanguard Equity-Income (MUTF: VEIPX ) (tie) 70% 13.9% Large Value 3. Vanguard Small Cap Index (MUTF: NAESX ) (tie) 70% 14.7% Small Blend 6. Vanguard Extended Market Idx (MUTF: VEXMX ) 68% 15.0% Mid-Cap Blend 7. T. Rowe Price Value (tie) 65% 16.4% Large Value 7. Vanguard Mid Cap Index Adm (MUTF: VIMAX ) (tie) 65% 17.1% Mid-Cap Blend 9. Vanguard Small Cap Growth Index (MUTF: VISGX ) 64% 13.6% Small Growth 10. Vanguard Windsor II (MUTF: VWNFX ) 63% 13.4% Large Value 11. Vanguard 500 Index (MUTF: VFINX ) 62% 15.8% Large Blend 12. Fidelity Contrafund (tie) 58% 17.1% Large Growth 12. Vanguard Growth Index (tie) 58% 16.9% Large Growth 14. Fidelity Low-Priced Stock (MUTF: FLPSX ) 55% 15.2% Mid-Cap Value 15. AMG Yacktman Service (MUTF: YACKX ) 39% 11.7% Large Blend *Note: Top rating possible is 100%; lowest possible rating is 0%. A score of 70%, for example, means that 70% of the stocks in the fund are judged to be within a class of stocks that is fairly valued while 30% are within a category that my research indicates is overvalued. Of course, funds in the above list that are managed (that is, not index funds) will have the option of switching out of overvalued categories if it is decided to make such a switch. Index funds must stick to their mandated benchmark and typically will not change their composition unless the underlying index changes. Funds with the Most Investor Assets As a basis of comparison with the above funds and to see alternative funds chosen by investors that have currently attracted the most investor assets, it is also informative to look at similarly derived scores of the most popular funds using the same criteria to rate each in terms of my measure of fair vs. overvalued stock portfolio composition. (The first list also includes some of the biggest funds; it also includes a few that mirror some of the most important indices such as the S&P 500, so we won’t show funds that are identical or nearly so to those there. And, I again exclude international and sector funds.) Biggest Funds by Assets (from most highly rated* to less highly rated) Fund Name (Symbol) Score 3 Yr. Return (thru 10-27) (ann.) Category 1. Dodge & Cox Stock (MUTF: DODGX ) 71% 16.1% Large Value 2. Vanguard Value ETF (NYSEARCA: VTV ) 69% 15.0% Large Value 3. American Funds Washington Mutual A (MUTF: AWSHX ) 67% 14.4% Large Value 4. American Funds Invmt Co of Amer A (MUTF: AIVSX ) (tie) 64% 15.0% Large Blend 4. Vanguard Total Stock Mkt Idx Adm (MUTF: VTSAX ) (tie) 64% 15.8% Large Blend 6. American Funds Fundamental Inv A (MUTF: ANCFX ) (tie) 61% 15.3% Large Blend 6. American Funds AMCAP A (MUTF: AMCPX ) (tie) 61% 17.0% Large Growth 8. American Funds Growth Fund of Amer A (MUTF: AGTHX ) 54% 16.8% Large Growth 9. Fidelity Growth Company (MUTF: FDGRX ) 50% 19.6% Large Growth 10. T. Rowe Price Growth Stock (MUTF: PRGFX ) 48% 19.9% Large Growth *Note: See the Note under the first table. If you look carefully over these two lists, you will notice that the majority of funds with the highest, that is, best forward-looking scores, are categorized as Large Value funds. And, almost equally noticeable, most of the funds with a large percentage of already “discovered” stock categories, especially in the second list, are Large Growth funds. What this suggests is that the best opportunities for investors for the next several years would appear to lie in US stock funds that are classified as Large Value. Many Large Growth funds, if this analysis is valid, are likely to perform less strongly than Large Value funds because investors may have already realized most of the performance benefits of this category and are more likely to find both a greater degree of safety in Large Value funds when market conditions are no longer as bright, and a greater degree of return potential due to their less overvalued composition. While there is no way to know for sure how long the current “momentum bias” will continue, as it very well may, investors might always want to keep in mind that over long periods of time, the best way to make money in stocks is to establish and maintain your positions when prices are relatively low. It seems apparent, however, that looking at the second list featuring those funds investors have the most money invested in, they seem to be opting for many funds, including unmanaged index funds, with a relatively greater degree of already “stretched” types of stocks.