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SPDR S&P 500 ETF Trust (SPY), iShares MSCI Emerging Markets Indx (ETF) (EEM): The Case for Emerging-Market Small-Cap ETFs

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Emerging markets have materially underperformed their U.S. counterparts in 2013 due to fears about slowing growth and depreciating currencies. The good news is that stocks in those regions are now attractively valued, not only compared to U.S. equities but also based on their own historical valuations. Small-cap ETFs may be the best way to capitalize on the opportunity to invest in emerging markets at a convenient entry price.

Select Sector SPDR

Risks and valuation in emerging markets
The SPDR S&P 500 ETF Trust (NYSEARCA:SPY), which tracks the S&P 500 index, is up by more than 17% this year. But emerging markets have not joined the party. The iShares MSCI Emerging Markets Indx (ETF) (NYSEARCA:EEM), following the MSCI Emerging Markets Index, is down by almost 10% in the same period.

Several factors can be seen as an explanation for this divergence in performance: Countries like Brazil are experiencing disappointing economic growth rates lately, and economists are concerned about the possibility of a hard landing in China among other economic difficulties affecting emerging nations.

Furthermore, the possibility of rising interest rates in the U.S. generates a flow of capital out of emerging countries and into the U.S., so local currencies are under pressure as global investors try to position themselves for higher rates in the U.S. In addition to that, escalating geopolitical problems around the world — like the situation in Syria — tend to generate a flight to safety, and this is another factor affecting emerging-market assets lately.

It’s hard to predict how these variables may evolve in the short term, but on a longer-term basis, emerging markets are looking like a compelling opportunity. While SPY trades at a price-to-prospective-earnings ratio of 14.8, iShares MSCI Emerging Markets Indx (ETF) (NYSEARCA:EEM) carries a much lower valuation with a ratio level of 10.4 based on data from Morningstar. MSCI indexes for China and Brazil are even trading below financial-crisis levels when measured in terms of price-to-book-value ratios.

If emerging-market stocks were to trade in line with U.S. companies, then an ETF like iShares MSCI Emerging Markets Indx (ETF) (NYSEARCA:EEM) would need to outperform SPY by more than 40%. Even if emerging markets are now looking particularly risky, it’s important to keep in mind that these countries traded at a premium versus developed nations not so long ago due to their superior long-term growth prospects.

Uncertainty over the coming months is remarkably high when it comes to evaluating emerging markets’ prospects, so it’s hard to tell whether the current slowdown is just transitory weakness or the beginning of something more serious. On the other hand, this kind of uncertainty is what usually creates buying opportunities for long-term investors, and current valuations certainly seem attractive for those who have the patience and discipline to hold their positions through the short-term volatility.

The smaller the better
The problem when it comes to large companies in some countries is that in many cases they are tilted toward politically sensitive sectors like energy, banks, utilities, or telecommunications. This means that heavy regulation, or even full-blown state ownership, is a distinct possibility, and this can mean bigger risks and smaller returns for investors.

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