Smaller-Cap Emerging-Markets Funds: Fad or Good Idea?

Emerging-markets funds fell off a cliff in 2011. Indeed, after posting gains of 65% or more in 2009 and returns in the high teens in 2010, diversified and regional emerging-markets funds suffered losses of 20% to 25% last year, as concerns about Europe's woes, worries about inflation in China and India, and other fears undermined stocks across the developing world.

But fund companies continued to introduce new emerging-markets funds at a fairly good clip in 2011. After launching a total of 31 diversified and regional emerging-markets funds in 2010, they opened 47 such funds in 2011.

Not too surprisingly, given that the emerging-markets asset class has been well-established and included scores of funds for some time, many of the newer launches are more-specialized offerings. We assessed two trends among the newer launches, emerging markets funds with broad asset-class purviews and ones with exceptionally wide geographic universes, in an article in November. In this column, we will evaluate a third trend among the newer offerings: smaller-cap emerging-markets funds.

The Numbers 
Six funds that focus on small- and mid-cap stocks have been launched in the diversified emerging-markets category since the end of 2009, including Fidelity Emerging Markets Discovery (FEDDX) and William Blair Emerging Markets Small Cap Growth (WESNX). The same number of smaller-cap offerings have opened in the regional emerging-markets categories during the past two years, including broker-sold EP Asia Small Companies (EPASX).

The growth in the number of smaller-cap emerging-markets funds has accelerated over the past couple of years, but the concept is not completely new. A few such funds, such as broker-sold Eaton Vance Asian Small Companies , have been around since the 1990s, in fact, while a few others, such as  Wasatch Emerging Markets Small Cap (WAEMX), opened earlier in the 2000s.  (There are a total of 20 such funds at present.)

The Positives 
These funds have considerable upside potential. The eight smaller-cap emerging-markets funds that were around during the early 2009 to late 2010 worldwide rally posted an average annualized return of 82% during that period. That result was far better than the average annualized returns of foreign large-cap funds, foreign small/mid-cap offerings, diversified emerging-markets funds, and emerging Asia offerings over that span. (The average annualized return for those categories ranged from 43% to 68%.)

Several of the new smaller-cap emerging-markets funds have good pedigrees. For example, broker-sold Columbia Acorn Emerging Markets , which opened in August 2011, is the product of a firm that has been a leader in the field of small- and mid-cap growth investing for decades. It is run by the two lead managers and two of the analysts of a fine foreign small/mid fund,  Columbia Acorn International (LAIAX), that has long invested significant amounts in the developing world. Its four managers are relying on the same stock-selection strategy that they use at that foreign small/mid-growth offering.

Matthews China Small Companies (MCSMX), which was launched in May 2011, has a lot going for it, too. Matthews is an Asia specialist that has delivered superior long-term results at a wide variety of all-cap regional offerings, including  Matthews China (MCHFX). The longtime skipper of that fund and his comanager are applying a similar approach to small firms here, and they work with one of the biggest and best teams of Asia specialists around. 

The Uncertainties 
Columbia Acorn Emerging Markets, Matthews China Small Companies, and the other new smaller-cap emerging-markets funds with good pedigrees remain unproven at this point. Their counterparts with less impressive credentials have even more uncertain futures.

The older smaller-cap emerging-markets funds don't provide a lot of clarity on the long-term prospects of the asset class. Sure, Wasatch Emerging Markets has handily outgained the typical diversified emerging-markets fund since its inception in 2007, while  Matthews Asia Small Companies (MSMLX) has far surpassed the average pan-emerging-Asia offering since its inception in 2008. But the other funds that were launched a few years ago have posted middling to poor results. And none of the funds that opened in the mid 2000s is old enough to have a truly meaningful long-term record. What's more, the very few smaller-cap emerging-markets funds that were launched in the 1990s have mixed long-term records versus their categories.

The Negatives 
These funds are among the most daring open-end offerings available. Smaller-cap stocks come with more risks and experience much more volatility than large-cap names. Likewise, emerging-markets issues in general face more perils and experience far more turbulence than their developed-markets counterparts. Consequently, smaller-cap emerging-markets funds are subject to extreme sell-offs as well as exceptional surges. They are likely to struggle whenever smaller caps lag larger caps and emerging-markets issues trail developed-markets names.

The funds that focus on a particular developing region or a specific country compound these dangers, as do those that employ aggressive stock-selection strategies. Indeed, Oberweis China Opportunities (OBCHX)--which focuses on its target market's fastest-growing domestically oriented firms and readily builds sizable sector over- and underweightings--lost roughly 15 percentage points more than its category's average loss of 24% in 2011.

Smaller-cap emerging-markets funds also tend to be quite pricey. Excluding two DFA funds that can be challenging for individual investors to access outside of all-DFA portfolios, the older offerings have expense ratios of 1.59% to 2.49%. And the newer retail funds have expense ratios of 1.45% to 2.00%.

Final Thoughts 
Interested investors should be sure that they have a long time horizon and a very high tolerance for volatility before they even consider one of these funds. Such investors should also check to see how much exposure to smaller-cap emerging-markets stocks they're getting through their existing holdings. (Nearly all core foreign funds ignore such issues, and most emerging-markets offerings pay only limited attention to such names. But some emerging-markets funds follow all-cap strategies, and most foreign small/mid-cap funds invest 10% to 20% of their assets in the developing world.)

Those intent on investing in these offerings should focus on the older funds that have at least demonstrated the ability to handle tumultuous conditions well so far or on the newer funds with good pedigrees. And they should think carefully about any additional risks their potential picks are taking on beyond the considerable perils that are inherent to all smaller-cap emerging-markets funds.