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Investors the world over often have a strong bias for their own home markets and often fail to seek diversification through investments in other countries and markets. However, the world's financial markets seem to be substantially interlinked. The events of 2008 showed that all markets can become highly correlated.

Many popular emerging market ETFs have relatively strong correlations to U.S. markets. However, these ETFs usually consist of larger companies that trade on multiple exchanges or can be purchased as American Depository Receipts (ADRs). For example, iShares MSCI Brazil Capped (NYSEARCA:EWZ) is driven by a few well known stocks. Its top 10 holdings make up 48.7% of its net assets.

However, while some larger capitalization stocks drive the major emerging market ETFs, there are specific ETFs focused on smaller capitalization stocks. While in a previous article, I showed that U.S. small capitalization ETFs do not offer significant diversification benefits from a portfolio volatility reduction perspective, there might be differences with international small-capitalization ETFs. These might offer superior diversification benefits and at least different exposures than their larger-cap counterparts. This article will look at the a series of ETFs in comparison to the benchmark portfolio defined by the SPDR S&P 500 Trust ETF (NYSEARCA:SPY). It is important to note that this analysis is U.S. centric and will not necessarily be beneficial to non-U.S. investors. Non-U.S. investors would have to consider what their benchmark portfolio is and compare that to the various ETFs. A given correlation between SPY and EWZ will not necessarily be the same with say iShares MSCI United Kingdom Index (NYSEARCA:EWU). Furthermore even if EWZ and SPY and EWU and SPY both have high correlations, this does not necessarily mean that EWZ and EWU would have a high correlation. The following ETFs were considered for this analysis:

Select ETFs
TickerNameRecent PriceNet Assets ($ B)*Type
SPYSPDR S&P 500 Trust ETF163.02129.8Large cap
EWZiShares MSCI Brazil Index Fund41.476.1Large cap
BRFMarket Vectors Brazil Small-Cap ETF29.720.5Small cap
EEMiShares MSCI Emerging Markets Index Fund37.3445.6Large cap
EWXSPDR S&P Emerging Markets Small Cap ETF43.580.9Small cap
ILFiShares S&P Latin America 40 Index Fund35.101.5Large cap
LATMMarket Vectors Latin America Small-Cap Index ETF18.5311 millionSmall cap
FXIiShares FTSE/Xinhua China 25 Index Fund32.075.2Large cap
ECNSMSCI China Small Cap Index Fund39.2530 millionSmall cap
HAOGuggenheim/AlphaShares China Small Cap Index ETF21.630.3Small cap
MCHIiShares MSCI China Index39.991.3Large cap

Source: Yahoo!Finance

The first consideration is to compare correlations. I'll look at 24-, 36- and 60-month correlations using monthly data:

TickerTypeCorrelation 24 monthsCorrelation 36 monthsCorrelation 60 months
SPYLarge cap100.0%100.0%100.0%
EWZLarge cap80.8%80.0%80.0%
BRFSmall cap70.3%64.3%NA
EEMLarge cap83.4%82.3%86.5%
EWXSmall cap84.6%79.1%83.9%
ILFLarge cap85.6%84.2%84.9%
LATMSmall cap78.6%72.3%NA
FXILarge cap69.4%67.8%72.2%
MCHILarge cap73.1%NANA
HAOSmall cap70.6%68.1%72.6%
ECNSSmall cap67.1%NANA

Source: Yahoo!Finance for split and dividend adjusted monthly prices, author calculations.

So one can see that the smaller-cap versions often have lower correlations than the larger-cap versions. This is most pronounced in Latin American with BRF versus. EWZ and ILF vs. LATM. It is less true with the broader emerging markets of EEM versus EWX and also for the two sets of Chinese ETFs.

The next question is how they compare in terms of volatility. I would expect the smaller-cap versions to be more volatile than the larger-cap versions. This is often true of domestic ETFs. The following table compares volatility.

TickerTypeMonthly Volatility 24 monthsMonthly Volatility 36 monthsMonthly Volatility 60 months
SPYLarge cap3.8%3.7%5.3%
EWZLarge cap8.4%7.6%10.0%
BRFSmall cap9.8%8.7%NA
EEMLarge cap6.9%6.3%8.3%
EWXSmall cap7.4%6.6%9.0%
ILFLarge cap6.8%6.2%8.6%
LATMSmall cap8.3%7.5%NA
FXILarge cap7.8%6.8%8.4%
MCHILarge cap7.2%NANA
HAOSmall cap8.8%7.8%10.0%
ECNSSmall cap8.8%NANA

Source: Yahoo!Finance for split and dividend adjusted monthly prices, author calculations.

As expected, the smaller-cap versions consistently had higher volatility across all geographies and time frames. The final consideration is to put them together to see if there is a reduction in portfolio volatility. The comparison is between the SPY portfolio and a new portfolio with 50% of SPY and 50% of the given ticker.

Portfolio Impact
TickerCorrelationSecurity VolatilityNew Portfolio VolatilityVolatility Impact

Source: Yahoo!Finance for split and dividend adjusted monthly prices, author calculations.

The above table shows that in all cases the volatility is higher with the addition of these emerging market ETFs. Furthermore, even though the small-cap ETFs had lower correlations, their higher volatility offset that benefit. So the benefits of small-cap emerging market ETFs would have to be around returns and not around volatility reduction.

Disclosure: I am long SPY, EWZ, BRF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Source: Seeking Better Emerging Market Diversification