Most investors agree that there is more inefficiency in small caps – no matter where in the world you find them – and thus more potential for alpha. In EMs, however, where small caps may be especially inefficient, there’s an opportunity that is often overlooked, and not typically part of an allocation plan by any but the largest funds.
A fairly common asset allocation plan for a U.S.-based fund would incorporate a U.S. allocation, an international allocation, and an emerging markets allocation. Historically, a reach for increased alpha in U.S. or international small caps has been more difficult because they don’t move hand-in-hand together with their large cap brethren. In both U.S. and international equities, large and small caps tend to have more independent and less correlated performance relative to large and small caps in EMs. In other words, when large caps are on an extended roll as they have been for many years now, the small caps aren’t necessarily along for the ride. In emerging markets, large caps and small caps have moved much more closely together. Further, the annualized volatility of EM large and small caps has been more similar relative to large and small caps in both U.S. and global equities.
So why does this matter? If allocations to large caps are all about beta, and allocations to small caps are about alpha, then in EMs we believe you have a better chance of getting both at the same time, rather than one or the other.
“Yes, there’s more alpha in small caps everywhere,” says Arup Datta, Head of Global Quantitative Equity at the firm. “But in emerging markets, small caps tend to move similar to large caps – much more in lockstep than in the U.S. or world indexes. In short, there’s typically more alpha in emerging markets, and historically there’s even more alpha yet in emerging markets small caps. In our EM strategies we can go for more alpha, but without taking on much added risk, such as more tracking error or more volatility, in an investor’s return stream.”
