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Diversification in retirement investing is one of the most important factors for sound portfolio management. Recently, the ETF industry has witnessed tremendous growth: New and more innovative products are introduced continuously, and emerging market small cap ETFs are leading the way.

As an asset class, investing in emerging market ETFs can boost a portfolio's return. For example, the following table shows the performance comparison among four core asset (US Equity (NYSEARCA:VTI), Foreign Equity (NYSEARCA:VEU), Emerging Market (NYSEARCA:VWO) and Fixed Income (NYSEARCA:BND)) strategic and tactical asset allocation portfolios vs. three core asset (without emerging market VWO). It clearly shows the benefit of adding emerging market asset in asset allocation.

Portfolio Performance Comparison

Portfolio/Fund Name 1Yr AR 1Yr Sharpe 3Yr AR 3Yr Sharpe 5Yr AR 5Yr Sharpe
Four Core Asset ETF (EM) Benchmark Strategic Asset Allocation Moderate 20% 161% 2% 11% 6% 24%
Three Core Asset ETF Benchmark Strategic Asset Allocation Moderate 20% 168% 3% 14% 5% 21%
Four Core Asset ETF (EM) Benchmark Tactical Asset Allocation Moderate 4% 43% 5% 50% 9% 57%
Three Core Asset ETF Benchmark Tactical Asset Allocation Moderate 4% 53% 3% 28% 4% 40%
What are small cap shares? The small cap refers to those shares which have relatively small market capitalization, usually ranging between $300 million and $2 billion. The concept of diversification plays a vital role these days; nobody wants to invest their whole amount in one market, industry or country.

Investing in emerging market small cap ETFs enables investors to gain exposure to a high growth segment of emerging markets, which themselves are considered to present more growth opportunities in the coming years. However, as emerging markets are riskier, small cap ETFs in these markets present even greater risk. It is thus important to study these ETFs more carefully before investing. The following table lists three of the most liquid small cap ETFs in this asset class.

Description

Symbol

1 Yr

3 Yr

5 Yr

Avg. Volume(NYSE:K)

1 Yr Sharpe

Wisdomtree Emerging Mkts Small

DGS

41.69%

9.41%

NA

145

205.01%

Guggenheim Frontier Markets

FRN

27.48%

NA

NA

88

149.81%

SPDR S&P Emerging Markets Small

EWX

25.51%

NA

NA

127

143.75%

iShares Emerging Mkt Equity EEM 241% 0 10% 113%

From the above table, clearly DGS is leading the others in terms of longevity and returns of one year. Compared with EEM, its three-year annualized return (9.41%) is way above EEM's annualized return (about 0%). The inception date of the fund is Aug. 1, 2007. 64% of the fund is in small cap shares. In our selection of ETFs, DGS has also the highest daily average volume, 145K.

The following shows the market capitalization breakdown of DGS:

[Click to enlarge]


DGS has also a unique diversification in the emerging market. Please see the following table for its holding percentages among countries as of May 27.

Country Weight

Taiwan

20.78%

South Korea

11.40%

Thailand

9.88%

South Africa

9.33%

Brazil

8.71%

Israel

7.42%

Turkey

7.28%

China

5.36%

Malaysia

5.26%

Chile

4.63%

Philippines

2.95%

Indonesia

2.48%

Mexico

2.06%

India

1.25%

Argentina

0.61%

Poland

0.46%

United States

0.16%

Although the risk can be diversified by investing into these regions, one should also take a cautious note by looking at the pros and cons of small shares:

Pros:

  • Small cap companies are often started by people with great ideas and often initial fast growth is very possible, allowing the investor to make lots of money.
  • One of the biggest advantages of investing in small cap stocks is the opportunity to beat institutional investors. Because mutual funds have restrictions that limit them from buying large portions of any one issuer's outstanding shares, some mutual funds would not be able to give the small cap a meaningful position in the fund. To overcome these limitations, the fund would usually have to file with the SEC, which means tipping its hand and inflating the previously attractive price.

Cons:

  • During market stress or economic crisis, small cap companies usually suffer from greater damage and they present much higher risk, compared with a broadbase emerging market index ETF.
  • Small companies may be acquired by larger companies. The index can be subject to bigger tracking errors. Another source of tracking errors is from small caps' low trading volumes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Emerging Market Small Cap ETFs: Higher Return With Higher Risk