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Emerging Markets and Domestic and Foreign Small-Cap for High Beta Trades


Looking beyond "blood in the streets."


Editor's Note: Max Isaacman is the author of "Winning With ETF Strategies: Top Asset Managers Share Their Methods for Beating the Market."

Investors may not have the appetite for investing in high beta sectors now, with the market going sideways to down, and investors flooding out of equities into the "safe-haven" fixed-income asset class. But when the blood stops flowing, often the sectors that have bled the most have the sharpest snapback.

The small-cap stock class is the riskiest and most volatile cap size. But according to history, it has the best upside potential over a longer period of time. The US small-cap sector looks reasonably valued on a price to earnings basis. Investors in this class are figuring that the US economy will continue to recover while the much of the developed world continues to struggle. Small-cap companies, more than mid- and large-cap companies, do more domestic business and they would benefit from a stronger US consumer and increased corporate spending. Small-cap companies can also get a boost from an increasing number of corporate buyouts, which could develop, especially if the economy continues to improve.

There are risks in small caps. If financing gets tight, small-cap companies can suffer, since their access to capital is not as great as big-cap companies. And small cap-companies have a bottom line risk concerning currency exposure, since they do not hedge nearly as much as much as mid- and big-cap companies. The S&P 500 Index companies need to hedge, as they are world-wide companies. According to Howard Silverblatt at Standard and Poor's, the S&P 500 companies receive over 46% of their sales from foreign countries, while companies in the S&P Small-Cap 600 Index get less than 30% from foreign country sales.

Probably the best known small cap ETF is the iShares S&P 600 (IJR). The small-cap index uses the same sectors as the iShares large cap index, which is the S&P 500 Index (IVV), but weights the sectors differently. This is necessary because the availability of tradable securities is different in the two cap sizes. Also the types of companies in IJR are different than the types of companies found in IVV. For instance, in the energy sector of IVV, there are 83% oil and gas companies and 17% equipment and service companies, whereas in IJR, the energy sector has 42% oil and gas companies and 58% equipment and service companies. Also in the IVV financial sector, the big money-center banks comprise most of the weighting, while in the IJR financial sector, REITs, commercial banks, and insurance companies comprise most of the weighting.

Another way to play small caps is to buy an ETF with a different weighting than IJR, which is cap weighted. One alternative is the RevenueShares Small Cap ETF (RWJ), which contains the same stocks as IJR, but is weighted by each company's revenue. RWJ attempts to take advantage of short-term imbalances when price to revenues exceeds a fair level. RWJ rebalances quarterly, increasing the weighting of the lower price/revenue stocks and decreasing weightings of the higher price/revenue stocks, in its attempt to increase the weighting of the stocks that will perform the best going forward and cutting down on those that will perform the worst. As with other alternatively to cap-weighted indexes, RWJ is attempting to undo linking stock price to a company's weight in an index.

Emerging Markets

Many investors are eschewing emerging markets stocks, somewhat caused by forecasts that the region will be facing catastrophe in the future. This view is reflected in the low multiples given emerging markets stocks. But the low valuations may make it time to buy. For instance, China's gross domestic product expanded 7.6% last quarter from the same quarter a year earlier. This is the slowest expansion since 2009, but still is a good growth rate, and if China can continue growing at anywhere near this pace, it is reasonably valued -- not only China, but the emerging markets space is attractive especially if there is any upside GDP surprise.

The World Bank reported that the slowdown in the Chinese economy is due to the weaker global economy. There has been slow growth in Europe and the recovery in the US has been sluggish. The slow US recovery has limited the level of Chinese exports. China has also instituted tighter domestic policies, exacerbating their slowdown. The bank looks for a soft landing, and predicts growth to be higher in 2013.

One way to invest in emerging markets is with an equal-weighted ETF, which takes out some of the concentration that happens with cap-weighted ETFs. Often in emerging markets the larger companies are global in scope and dependent on foreign economies for growth. The equal weighting strategy gives more access to the smaller companies, which give investors more exposure to the dynamics of the local economies. One choice could be the Guggenheim MSCI Emerging Markets Equal-Weighted ETF (EWEM), which has a weighting of 18% China, 14% Taiwan, 12% Korea, 9% Brazil, and 8% India. Generally, equal-weighted indexes hold the same names as their cap-weighted equivalent index. The top ten companies in EWEM comprise 1.08% of the index, whereas the top ten companies in the cap-weighted index, which are the same companies, comprise 15.70%. EWEM paid 3.03% in dividend distributions over the last year. Of course, dividends can and do fluctuate. EWEM sells at about 15 times earnings.

Blood in the streets brings images of rebellions and protests in Greece, Italy, and other European countries. There has been blood in the streets, and the stocks of companies in those countries have been beaten down, sell at low multiples, and at some point could rebound. An ETF that gives exposure to a mixture of emerging markets and developed markets, including Europe, is the RevenueShares ADR ETF (RTR). RTR is weighted by company revenues, and includes companies in the UK, Japan, China, Canada, Brazil, France, and other countries. It pays a 4.35% dividend and sells at about 13 times earnings.
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Clients and Max Isaacman hold shares of RTR, IJR, and may hold shares of EWEM.
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