Why EM Small Caps Now: Diversifying China Tech

China’s large-cap technology stocks have come under immense pressure in the last three months—from actions taken against Ant Financial to delay its initial public offering to the latest regulatory actions against the education companies that crippled their ability to earn a profit.

Thus, we believe it may be a good time to review why emerging market small-cap stocks can help diversify some of the risks in the region, as it may seem counterintuitive that small caps can be less risky than large caps.

DGS Has Less China Weight

First, let’s take a look at country exposures in the WisdomTree Emerging Markets SmallCap Dividend Fund (DGS) and the broad MSCI Emerging Markets Index (MSCI EM). 

China’s weight in the MSCI EM Index has grown to more than one-third with the long-term gains in those large tech giants. DGS, by contrast, had less than a 20% exposure in China and Hong Kong stocks. 

For definitions of terms in the table, please visit the glossary.

More Cyclical Reopening Stocks

The sector exposures one gets in DGS are also more tilted to cyclical sectors like Industrials and Materials and away from technology and communication services—further helping diversify portfolios in EM. 

China Tech Still the Big Winner Over Five Years

Despite recent regulation in the Chinese technology sector, China technology stocks still remain top performers over the last five years. In fact, our WisdomTree China ex-State-Owned Enterprises Index has still outperformed the S&P 500 over the last five years, even with the latest fall from grace. 

DGS focuses on dividend-paying stocks—with a rigorous, valuation-based rebalance discipline. When we look at price-to-earnings ratios on estimated forward-looking earnings, we see P/E ratios in single digits at only 9.1x—whereas the broad MSCI EM Index is at 14.5x. 

It is rare to find any market segment with this low of a market multiple—and this is not some narrow basket, as DGS has more than 750 constituents in its portfolio.  

Why Dividend Payers in EM Small Cap

We often describe dividends as a level of corporate governance in emerging markets because companies must have cash to pay dividends, and you can only “fake” a dividend for so long. Dividends have thus served as a measure of quality for these companies, and the data shows this was critical. 

Whereas the cap-weighted MSCI Emerging Markets Small Cap Index had less than 30% of its weight allocated to those top two quintiles, the WisdomTree Emerging Market SmallCap Dividend Index had almost two-thirds of its weight allocated to those top dividend quintiles. 

This attribution analysis shows the long-term outperformance of the WisdomTree Index was driven both by the over-weights to the highest dividend bucket and the under-weights to the zero and lowest-yield segments. 

Cyclical Rotation

During this rotation away from growth, we have seen small caps with a value tilt perform particularly well in 2021 through July with outperformance by significant margins. 

But equally interesting is that small caps have similar volatility as their large-cap brethren. We often think of the Russell 2000 as having significantly more volatility than the S&P 500—partly because there are so many more unprofitable companies in U.S. small caps.

But over the life of DGS, it has displayed volatility levels on par with the broader MSCI EM Index. 

For standardized performance of DGS, please click here.

Factor Diversification

Almost all of WisdomTree’s own Model Portfolios have paired DGS with our Emerging Markets ex-State-Owned Enterprises Fund (XSOE) for some time to achieve factor diversification—pairing the growth-tilted core XSOE with small-cap value stocks in DGS. That pairing worked particularly well in 2021—and the current uncertainty surrounding China technology stocks suggests DGS and small caps could play an ever-larger role in diversifying portfolios from the latest risks to emerging markets.