Most institutional equity portfolios hold a small cap sleeve. The rationale is well established: completing exposure to the full equity market, purer exposure to the domestic business cycle, and differentiated sector exposure relative to large cap indices. Yet although emerging market (EM) small caps now constitute a USD 3.5trn universe – comparable in breadth to the Russell 2000 – they remain chronically underrepresented in most institutional asset allocations.

In many cases, the neglect rests on an assumption that EM small caps are the high-risk, exotic cousin of their US or developed market (DM) equivalents. Today, the opposite is closer to the truth. Nearly nine in ten EM small caps (MSCI EM Small Cap Index) are profitable companies. In the Russell 2000, barely more than half are. The EM index trades at half the forward multiple of its US equivalent, on stronger balance sheets. Gains in EM small caps this year (+9%) have been built on earnings, while the US rally (+20%) has been almost entirely a re-rating. The universe is also quite distinct from the standard EM index itself; more domestic, less concentrated, less China.

In this month’s Emerging View, we set out why EM small caps belong back on investors’ radars.