For nearly 15 years, Emerging Market (EM) equities have underperformed the MSCI All-Country World Index (ACWI). Since topping out on a relative basis in October 2010, MSCI EM has generated annualized returns of 2.5% through December 31, 2024, while the ACWI has added 9.8% per year, led by the US, where the S&P 500 has generated 14.1% annual returns over this period.

Historically, relative performance cycles between EM and global equities have demonstrated two key features. First, they have been long in duration, with the average relative performance cycle since 1988 lasting nearly nine years. Second, most have been associated with the trajectory of the US dollar, with an 18% change in the value of the broad US dollar index over the duration of an average performance cycle (Exhibit 1).

Exhibit 1. Relative Performance Cycles

Source: Bloomberg

During the current relative performance streak, growth differentials have supported capital flows into the US, reinforcing the strength of the US dollar. However, recent developments point to a potential change in this dynamic.

First, advances by China in artificial intelligence create a potential counterpoint to the investment theme of US exceptionalism. Second, after a period of post-pandemic fiscal largesse, the US has moved toward fiscal consolidation, at the same time Europe has begun spending more on defense and China has signaled fiscal easing to support its economy. Third, recent US tariff announcements may act as a catalyst for capital to flow out of the US. These developments have unfolded against a backdrop in which EM’s weighting within the ACWI shrunk to just over 9% at year-end 2024.

Within EM equities, the small cap segment of the market has represented a source of outperformance amid the relative downturn for the asset class. From EM’s peak relative to the ACWI in 2010 through year-end 2024, EM small caps generated 130 basis points per year of excess returns relative to the broad MSCI EM Index.

The appeal of EM small cap lies in its inefficiency, as this is an under-researched, under-owned segment of the market. Within a universe of over 4,700 companies, an average of three sell side analysts cover each stock, while over one-third have no coverage at all. The weighting of these stocks within the MSCI EM Index is 8.8%, suggesting investors may not be tapping into the alpha opportunities of this segment of the market within a standalone EM equity allocation.

Exhibit 2. Under-Researched Segment of Emerging Markets

Source: Driehaus Capital Management and FactSet Research Systems

In addition to inefficiency, EM small caps offer diversification from a core EM equity allocation, particularly within the country mix. While China represents nearly 30% of the MSCI EM Index, its weighting within MSCI EM Small Cap is far lower at 9.8%. Facing challenging long-term growth prospects, aging demographics, and geopolitical risk, investors may seek to calibrate their China exposure at a lower level than that of the broad benchmark.

Conversely, EM small cap provides higher exposure to India, at 27% versus 19% for the broad index (Exhibit 3). As one of the fastest growing economies within EM, India is amid an investment cycle, with expansions in infrastructure and manufacturing capacity positioning the country to gain market share from China. As the dust settles from recent tariff announcements, India may benefit, as the US seeks a potential 4x increase in bilateral trade with India through 2030.

Exhibit 3. MSCI EM Small Cap Index – Top 5 Country Weights

Source: MSCI

The Driehaus Emerging Markets Small Cap Equity Strategy (Strategy) employs an investment philosophy rooted in behavioral finance, seeking to take advantage of biases held by investors around inflection points and accelerations in corporate earnings. The primary factor that drives our investment decisions is earnings revisions, and we incorporate both fundamental bottom-up factors, as well as macro into our research. The Strategy employs an active sell discipline, harvesting alpha from positive earnings revisions, while quickly exiting ideas where the investment thesis fails to materialize.

Several themes are represented within the Strategy’s current positioning. First, in the wake of recent developments, we continue to emphasize localization. Inherently, small cap securities tend to be domestically driven, and this is reflected in our portfolio, as 75% of revenue is generated in the local market. Amid an uncertain global environment featuring distinct winners and losers, we view domestic demand and localization as important themes.

Second, the Strategy holds overweight positions in India and Brazil, which we expect to be beneficiaries of a changing global trade landscape. Both of these economies maintain relatively low trade exposure, at roughly 30-40% of GDP.

Many of India’s key exports are either services or items that are currently exempt from tariffs. Moreover, India serves as a natural importer of US liquefied natural gas (LNG). As an energy deficient economy, this may lead to greater visibility and lower energy costs for Indian corporates over time. We favor domestic demand themes including the local consumer, along with capital markets companies that benefit from the ongoing financialization of the economy, as domestic savings shift into financial assets.

Brazil represents a potential idiosyncratic source of alpha, with the starting point of high real interest rates. Brazil’s policy rate is currently 14.25%, while inflation is running at 5.5%. Brazil may be poised for political change in 2026, which could alleviate the fiscal concerns that have kept interest rates elevated. At the company level, we find compelling bottom-up ideas in a diverse group of industries, including digital banking, waste treatment, and low-income homebuilding.

EM small cap has been an under-covered, and arguably under-owned, segment of the EM equity market, generating outperformance within the asset class despite a prolonged period of relative underperformance for EM equities. Should the nascent signs of shifting capital flows and questions surrounding the US exceptionalism narrative continue to gain traction, we believe this segment will offer diversification to investors, along with exposure to key themes such as localization and the rise of India.