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Emerging Market Small Cap ETFs: Freefall Continues

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Emerging markets have long have been attracting investors from all around the globe due to their high growth potential and rapid pace of industrialization. Fiscal 2010 marked a very good year for the emerging markets as the aftermath of the 2008 crisis seemed to be fading and global growth was back on track.

However, things have been quite different as of late as a series of socio-economic as well as political problems from developed nations have plagued market sentiment. Now, it appears as though the euro zone crisis is spreading, forcing many investors to reconsider deploying assets across the globe but especially in the small cap emerging market space. (read Euro Small Cap ETFs: The Way to Play Europe?)

Exchange Traded Funds (ETFs) make for a cost effective as well as flexible investment avenue for investors to play the growth potential of these attractive markets. However, many products in this space have slumped badly so far this year. Small cap emerging market ETFs were affected more than their mid and large cap counterparts, plunging to start the 2012 period.

Although it is true that small caps ETFs have the potential to fetch higher returns than their large cap counterparts, the flip side also holds true. During the previous year, small caps and emerging markets have proved to be a dangerous combination, best evidenced by the following three ETFs:

Market Vectors Russia Small-Cap ETF (RSXJ - Free Report) , which tracks the Market Vectors Russia Small-Cap Index, has lost an incredible 41.30% in the last one year period. The slump can be primarily attributed to the fact that Russian exports are primarily of the oil variety and prices for this commodity—as well as euro zone demand—have fallen off a cliff to start the year.

Further, RSXJ allocates a solid level of its assets to companies from the energy sector (24.40%) (see Why Russia ETFs Are Not A Debt Crisis Safe Haven). Concentration risk also seems to be a major issue as the ETF presently holds 33 securities in its portfolio and allocates 57.06% of its total assets to the top 10 holdings.

The fund debuted in April last year and since then has managed to accumulate $9.02 million in its asset base. The ETF has below average liquidity in the market as on an average it trades 12,602 shares daily. RSXJ also charges a steep expense ratio of 67 basis points and pays out a paltry yield of 0.51%.

Market Vectors Indonesia Small-Cap ETF has lost almost 13% since its inception this year in March 2012. The ETF charges 61 basis points in fees and expenses and holds 26 securities in its portfolio currently. The ETF is very highly concentrated in its top 10 holdings in which it allocates almost 63%.

Although the ETF is a relatively new addition in this segment, it can be said that the timing of the launch was quite poor amidst global economic crises. While investors somewhat have shown appetite towards the product as indicated by its total assets of $4.31 million and average daily volume of approximately 4700 shares, the ETF has not been able to live up to investor expectations.

The ETF tracks the Market Vectors Indonesia Small-Cap Index and consists of stocks having a market capitalization of less than $1 billion. The ETF relies heavily on financial (39.5%) and industrial (18.3%) sectors.

Given the lack of desire for financial exposure at this time, it shouldn’t be too surprising to see how poorly this fund has fared. While IDXJ doesn’t have much in the way of European debt exposure, the general risk off trade has undoubtedly crushed the fund so far this year.

Market Vectors Brazil Small-Cap ETF (BRF - Free Report) was launched in May of 2009. It tracks the Market Vectors Brazil Small-Cap Index. The index is comprised of small cap stocks publicly traded in the Brazilian markets and with principal business operations within the geographic boundaries of Brazil.

Despite showing an impressive inflow in its asset base, BRF has slumped 35.74% in the last one year period. While Brazil has been one of the favorite destinations for investors targeting the emerging market space, the economy has been countering inflationary problems of its own.

This, along with falling commodity prices, has impacted the Brazilian economy and the small cap space adversely (read Are Investors Abandoning Brazil ETFs?). Small caps being more sensitive to the broader economic scenario were hurt badly and more so than their resilient large cap peers.

BRF charges 59 basis points in fees and expenses and has an asset base of $460.32 million. Approximately 326,109 shares of BRF are traded each day in the markets. The ETF holds 77 securities presently and allocates around 33% of its total assets in the top 10 holdings. The fund relies heavily on the Consumer Defensive, Consumer Cyclical, Industrials and Real Estate sectors.

Learning experience for Investors

Overall, the performance in the space has been downright dreadful to start the year. The value of $1000 invested a year ago in RSXJ would presently be worth $591.41. While in BRF it would be worth $644.90 and an investment in IDJX since its inception in March 2012 would amount to $870.

Emerging markets are generally characterized by high economic growth rate, high inflation and reducing unemployment rate. Many argue that these nations enjoy a superior economic growth rate than their developed counterparts. While this might be true in terms of actual growth percentages, on an absolute growth basis, developed nations tend to grow more than emerging ones.

Thanks to this, as well as the safe haven status of many developed nations, times of economic uncertainty tend to tilt the returns towards developed markets instead of emerging nations. Investors often fail to understand this fact before they take any investment decision and especially when the focus is on other developed markets and not on industrializing nations.

Small cap emerging market ETFs are consequently high risk/return investment avenues. The slippery situation in the Euro zone was responsible for global risk aversion which caused institutional as well as retail investors to withdraw funds from the riskier asset classes.

This also caused many emerging currencies such as the Brazilian real, Mexican peso, Russian rouble, South Korean won, South African rand and Indian rupee to underperform relative to the USD. (see Indian Rupee ETFs: Is The Slide Over?)

While this should have been a favorable proposition for many export oriented emerging markets, instead the trade deficit and the economic growth rate slowed down in the first quarter of 2012 for many of these emerging market economies.

In fact, one of the fastest growing economies in the emerging markets, the Indian economy, grew by a mere 5.3% in the January-March quarter. China and South Korea also witnessed sharp declines in their industrial production. (read Are Korean ETFs In Trouble?)

While it is true that investing in emerging markets can prove to be fruitful for investors, it is prudent to note that it requires a steady appetite for risk and especially during times of a downtrend, when it requires continuous portfolio monitoring and rebalancing (read Guide to Small Cap Emerging Market ETFs).

Moreover, investors would be better off playing individual stocks with good balance sheet and sound fundamentals, rather than a basket approach, at least in the small cap emerging market ETF world at this time.

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