Where Small-Caps Can Be Less Risky

Investors typically associate small-cap stocks as having better growth prospects than large-cap equivalents, but the trade off is that smaller stocks are usually more volatile than their larger brethren.

While the Russell 2000 Index and the S&P SmallCap 600 Index have sharply outperformed the S&P 500 since the start of the current bull market, annualized volatility for the two small-cap benchmarks has averaged 21.5 percent over that period compared to 16.2 percent for the S&P 500, according to ETF Replay data.

However, a surprising asset class features some small-caps that are less volatile than their bigger peers: Emerging markets. Of course, that depends on the avenue investors use to access to emerging markets small-caps. The WisdomTree Emerging Markets SmallCap Dividend Fund (NYSE:DGS) reminds investors that in emerging markets, as is the case in the U.S., small-cap dividend payers can help reduce volatility.

Though the relative outperformance is less pronounced than in the U.S., over the last 9.5 years, the MSCI Emerging Markets Small Cap Index was able to outperform the MSCI Emerging Markets Index while increasing annualized volatility by just 1.6 percentage points, said WisdomTree in a recent note. This was a much narrower spread in volatility than was seen when moving down the size spectrum in the U.S., but it did maintain the relationship between large- and small-cap risk, nonetheless.

Since the start of the current bull market for U.S. stocks, a run that has included some bumpy periods for emerging stocks, DGS is up 151.2 percent compared to a gain of just over 97 percent for the MSCI Emerging Markets Index.

DGS's holdings include the 10 percent of the WisdomTree Emerging Markets Dividend Index with the smallest market caps. The ETF's constituents are then weighted by paid dividends, an approach that helps juice yield, and, potentially, returns.

Not only has DGS outperformed the MSCI Emerging Markets Index during this bull market, the ETF has been less volatile. Since March 10, 2009, DGS has sported annualized volatility of 20.6 percent, 330 basis points below the emerging markets benchmark. Narrowing the time frame to three years, investors will see DGS outperformed the MSCI Emerging Markets Index by a 2-to-1 margin will being less volatile.

DGS's small-cap Index has managed to outperform both cap-weighted large- and small-cap indexes by an average of over 250 bps per year while actually reducing annualized volatility relative to cap-weighted EM large caps by more than a percentage point, said WisdomTree. A small-cap index outperforming a large-cap index with less risk may be hard to believe, but we think it all starts with intuitive, intelligent and simple design.

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