The Allure of the East

 | Feb 21, 2012 | 1:30 PM EST
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This commentary originally appeared Feb. 21 at 11 a.m. on ETF Profits – to access all the strategies from our team of ETF professionals, click here.

I recently included India on my list of favored country plays for 2012 because I'm attracted to Indian stocks from both a fundamental and technical view.

India is the fifth-largest emerging market and has the world's second-fastest growing economy. Its equity markets, however, have significantly underperformed other emerging markets. India's equity markets, as per the MSCI India Index, were down 37.6% in 2011 in U.S. dollar terms. Once all the rage, the BRIC countries in the emerging markets (Brazil, Russia, India and China) underperformed for two straight years. They have started to rebound in 2012, and I believe the oversold conditions of last year favor India to continue its upward trend.

For aggressive investors in emerging markets, I favor small-cap stocks. I recommend the recently listed iShares MSCI India Small Cap Index Fund (SMIN), which complements the new iShares MSCI India Index Fund (INDA) by focusing on securities from the bottom 14% of equity market capitalization in India. INDA focuses on the top 85% of companies in India's equities market. In addition, SMIN came to market with a competitive edge over competing funds from Van Eck Global and Emerging Global. SMIN has an expense ratio of 0.74%, while its competitors both have expense ratios of 0.85%. The Market Vectors India Small Cap (SCIF) and the EGShares India Small Cap ETF (SCIN) were launched last summer and have gathered $49 million and $23 million in assets, respectively.

I believe the Indian markets are poised to outperform based on continued strong GDP growth and improving inflation. Home to more than one billion people, India is not just the world's largest democracy, it is the second-fastest-growing economy in the world, after China. The Indian economy never experienced much of a downturn due to the global debt crisis. Its GDP grew 9.5% in 2007 and only slowed to 6.8% in 2009. Its GDP growth picked up to 8.9% in 2010 but slowed to 7.3% in 2011 as the government moved to rein in inflation. GDP in India is now expected to grow 6.9% in 2012 and 7.5 % in 2013. India's forecast GDP growth is still the second fastest in the world, just behind China's expected GDP growth of 8.4% for 2012 and 8.7% in 2013.

Inflation has been a concern in India with consumer prices rising at a peak of 12.1% in 2010. However, after years of stimulus, policymakers have begun to gradually withdraw monetary and fiscal policy support and the Consumer Price Index slowed to 9% in 2011 and is now forecast to drop to 6.5% in 2012. The Indian economy changed from policy-driven to private sector-driven growth in 2011, which should continue to drive GDP growth in 2012. Private sector spending is rising quickly and the government tightened fiscal policy in 2011 to manage aggregate demand. Similarly, a continued reversal of monetary policy support is expected.

I am attracted to international, small-cap stocks for many reasons. They are appealing as long-term holdings since they should have superior returns with low correlation to other asset classes, and even though they are volatile, that makes them good trading vehicles.

Many investors have no exposure to international small-cap stocks. A large majority of the assets of exchange-traded funds that invest internationally follow the MSCI indices, which usually focus on the top 85% of each market by market cap. As in the U.S., international small-cap stocks can offer greater long-term returns with much more volatility. They usually have much less analyst coverage and better relative valuations since they may be ignored by large investors seeking global diversification. Many growth stock opportunities exist and when they grow, they will be added to the widely followed, large-cap indices, which can provide incremental returns.

ETFs holding small-cap stocks also tend to have different sector weights than their large-cap counterparts and focus on companies with more exposure to the local economy. India has a large, rapidly growing middle class that is driving consumer spending and health care. Thus, I favor SMIN for its greater exposure to consumer and health care stocks than large-cap ETFs investing in India.

SMIN tracks the free-float market-capitalization-weighted MSCI India Small Cap Index, which rebalances quarterly. The ETF only holds 88 of the underlying index's 236 holdings. SMIN's sector weights are financials (26%); consumer discretionary (17%); industrials (14%); materials (12%): health care (8%); consumer staples (8%); utilities (7%), information technology (6%) and energy (2%).

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