Emerging-market and small-cap stocks are known for their awesome growth potential and high volatility. So when you put the two together, you have a formula for a super-charged investment with unparalleled growth potential.
Combining emerging-market and small-cap stocks offers investors a unique opportunity to invest in early-stage companies in growing economies, the perfect recipe for long-term gains. But finding and investing in individual stocks in emerging markets is challenging. Not only is there a lack of coverage from the analyst community, but these companies sometimes operate under different standards for compliancy and regulation, making information even more difficult to access.
That's why my favorite way to invest in emerging-market small caps is with exchange-traded funds (ETFs). In the past three years, my favorite fund has handily outperformed the S&P 500, more than doubling with a return of 115%. Take a look at the market-beating gains below.
The instrument in question is the Market Vectors Brazil Small-Cap ETF (NYSE: BRF), an ETF that tracks the performance of the Market Vectors Brazil Small-Cap Index. Although the fund can hold stocks with a market cap of just $150 million, its average holding has a market cap of $1.4 billion, placing it at the higher end of the small-cap range topping out at $2 billion.
The Brazil Small Cap ETF provides investors with direct exposure to Brazil, one of the fastest-growing emerging markets in the world. Brazil's torrid growth trajectory is being fueled by the commodities boom, since the country is one of the major exporters of soybeans, coffee, minerals and energy. The bullish trend in commodities has enriched the country and its middle class, with Brazilian bonds recently being upgraded to investment grade and consumers spending more disposable income on discretionary items that continues to drive gross domestic product growth. These are two long-term trends that have emerging-market economies, like Brazil, in position to grow at a faster pace than developed economies like Japan and the United States in the next 20 years.
But while Brazil is an interesting investment destination in its own right, what makes this fund truly unique is its emphasis on small-cap stocks. Just by simple mathematics, small caps are usually younger companies in the early stages of growth. Some small caps will fail and go out of business, but many will prosper, grow many times over and produce huge returns for early investors.
The Brazil Small-Cap ETF has a relatively narrow investment concentration, with just 73 holdings. In a world of mega mutual funds and ETFs that can hold more than 1,000 stocks, the fund's small portfolio makes this a much focused investment vehicle.
Before it can be included in the fund, a company has to be either traded on a Brazilian exchange or generate more than 50% of its revenue from within Brazil. With $530 million in assets under management, this find continues to gain popularity as more investors shift into international markets. Average daily volume of 237,000 shares provides plenty of liquidity and the tight bid-ask spread of only pennies helps reduce price slippage when executing large orders.
The fund has occasionally been known to trade at a premium to its net asset value (NAV), a price discrepancy that forces investors to pay a premium to the underlying value of shares, so be sure to know what the NAV spreads look like before executing a trade. According to Morningstar, that's not the case right now. The fund's NAV of $40.98 is slightly below the ETF's recent price of $41.
Another added bonus of the fund is that it carries a very healthy dividend yield of nearly 3%. This beats the S&P 500 and 10-year Treasury bonds, so it looks very attractive in a low-yield environment.
In terms of fees, this fund's expense ratio of 0.59% may seem high compared to other ETFs, but it still falls below the category average of 0.84%. Helping on the fee front, Brazil just lifted a temporary 2% tax on international capital inflows in an attempt to attract more investors, but this could also come back sometime down the line, so it's something to keep your eye on.
Risks to Consider: Emerging-market and small-cap stocks are more volatile than developed economies and large caps. Anyone buying small caps in emerging markets should be prepared for big swings in prices.
Action to Take: Using an exchange-traded-fund is a great way to reduce individual company risk and attain instant diversity. The Brazil Small Cap ETF is the best in class and a great way to cash in on Brazil's growing economic power.
Michael Vodicka does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.