Adding exposure to exchange-traded funds investing in small-cap emerging market stocks can certainly provide a different slant to a global portfolio. And this year, even a tiny serving of such niche funds is proving quite beneficial.

So far in 2009, the SPDR S&P Emerging Market Small-Cap ETF (NYSEArca: EWX) has gained more than 60%. Putting that into context, consider the ETF has only been trading since May 2008 and has lost more than 20% since inception. (See related story here.)

Last year, the ETF’s underlying index had a 54.62% decline, which closely matched the decline in the large-cap focused MSCI Emerging Markets Index. Yet in 2009, the small-cap index and ETF have had spectacular performances in excess of the large-cap benchmark.

For example, the iShares MSCI Emerging Markets Index ETF (NYSEArca: EEM) is up some 44% in 2009 heading into Wednesday.

The other small-cap ETF focusing on emerging markets is the WisdomTree Emerging Markets SmallCap Dividend Fund (NYSEArca: DGS). It has gained more than 50% so far this year. (See related story here.)

Bullish investors argue that such outsized short-term performance gains are a sign of strong bottom-up progress in developing countries. They point out that smaller companies in emerging markets tend to have more localized businesses and earnings growth. More nimble, it stands to reason that going forward smaller firms can benefit more from economies of scale in labor and production.

Small-cap emerging market companies do represent, however, a great deal of risk—even beyond that of traditional emerging market investments.

Investors need to be mindful of such risks, which will inevitably result in higher-price volatility and illiquidity.

Source: Morningstar 7/24/2009 (Price return only)

General Risks

Let's first consider some of the general red flags involved in this kind of investment. If you decide to add some small-cap emerging markets exposure, do so with eyes wide open. General considerations to take into account include the obvious increased volatility and political instability that comes with the territory. But don't forget about factors such as the often rapid twists in foreign investment flows and currency exchange rates.

Also, as with domestic stocks of smaller companies, emerging market small-caps pose potential issues with liquidity and increased vulnerability to changes in economic winds (both on a micro- and maco-level).

Despite such broad risks, there is potential for above-average returns (and above-average losses) relative to other emerging market ETFs. Such funds can also help to lower a portfolio's overall correlations to stock funds focused on developed countries. This is increasingly being viewed as a significant benefit as economic fortunes around the globe become more interconnected.

Source: Morningstar

Investors looking for lower correlated asset classes may have been dissatisfied with smaller-cap developing country stocks as represented by the S&P Emerging Market Small Cap Index. As shown in the table above, smaller-cap stocks have had a 0.95 correlation with the emerging market stock index over the last 10 years, and only a marginal difference in correlation to the S&P 500 and MSCI EAFE.

The magnitude difference in the risk/reward profile of the small- and large-cap developing country indexes is what makes this category of developing markets unique. In the same way domestic smaller companies generally have a higher standard deviation matched with a higher return, smaller emerging market companies have shown the same relationship.

Source: Morningstar

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