The Impact of Country Tilts on Emerging Market Small-Cap Indexes

Abstract

Many investors invest in emerging market small-capitalization equities to capture the small-cap premium. Investor approach to this investment is greatly influenced by how MSCI, the leading benchmark provider for emerging markets, constructs its small-cap indexes. MSCI’s choice to primarily focus on the smallest stocks in the entire emerging markets investable universe, and not the smallest stocks in each country, has many ramifications. Most importantly, it leads to dramatically different country weights between the MSCI Emerging Markets Small Cap Index and the standard MSCI Emerging Markets Index. This influences the empirical small-cap premium, which is calculated as the difference in performance between the standard and small-cap indexes. In many years, a material portion of this premium is driven by differences in country exposures. Investors need to keep this in mind as they go about allocating their assets to the small-cap segment of emerging markets.