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Over the past few weeks, I’ve been talking about a shift from developed to emerging markets, given slow economic growth and sovereign debt problems in many major developed market countries. Earlier this week, I expanded my view—given recent tremendous market volatility, many of the emerging markets that were viewed as risky or even dangerous a mere 10 years ago now appear to be more attractive than many developed countries, based on their fiscal situations.

Ironically, it may also be true that emerging market small cap stocks—seemingly the poster children for volatility—may be attractive in the current market.

Why? Emerging market small cap stocks tend to be focused on local consumer sectors rather than global sectors. As shown in the chart below, over 30% of the MSCI Emerging Market Small Cap Index is devoted to consumer staples, consumer discretionary or healthcare stocks (compared to just 15% of the large cap index). Higher allocations to these sectors lead me to two notable implications given the current market.

Sector Exposure Differences – EM Small Cap versus EM Large Cap

click to enlarge

Source: MSCI as of June 30, 2011. Indexes shown above are the MSCI Emerging Markets Small Cap Index and the MSCI Emerging Markets Index.

First, because consumer sectors tend to be more closely tied to domestic demand than global sectors such as financials or commodities, emerging market small cap stocks should be better insulated from slowing global growth. Take Brazil, for example. The country’s investable small cap universe offers significantly more exposure to the domestic consumer than the mid- and large cap universe; strong domestic consumption helped the country rebound from the 2008-2009 recession faster than expected. Second, more exposure to consumer stocks means less exposure to financials (and the problems of the globally inter-linked banking system) and cyclical commodities, which are likely to remain under pressure with the weakening of the global economy.

In the long term, it should be noted that consumer sectors are viewed as the key drivers for overall economic growth in the emerging markets, as the emerging market customer comes of age. Countless studies and articles have shown the growing power of the emerging market consumer. One study estimated that more than half the world’s middle class could be in Asia by 2020, and Asian consumers could account for over 40% of global middle class consumption.

While Americans have turned their focus to saving and repairing damaged balance sheets, consumers in emerging markets have begun to spend more, fueled by rising income levels and increased financial security. Just one example—from 2002 to 2007, the number of mobile phone subscribers in developing countries grew by more than 700% to nearly 2.5 billion subscribers. Credit Suisse estimates the number of emerging market mobile phone subscribers to exceed 5 billion by 2014.

The iShares MSCI Emerging Markets Small Cap Index Fund (NYSEARCA:EEMS) is one way to increase exposure to emerging market domestic demand (and potentially the economic power of those estimated 5 billion new cell phone users) in a diversified format.

Source: OECD, January 2010

Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility. Narrowly focused investments and investments in smaller companies typically exhibit higher volatility. Diversification may not protect against market risk.

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Source: The 'Emerging Markets' in Emerging Markets