Fund name: Wasatch Emerging Markets Small Cap (WAEMX)

Objective: The fund seeks long-term capital appreciation by investing in small cap companies (for now, a market cap under $3 billion) domiciled in emerging market countries. Wasatch’s investible universe includes both traditional emerging markets and the more-exciting frontier markets encompassed by the Extended Frontier 150 index. Traditional emerging markets are places like Brazil, China and India. Frontier markets include Cote d’Ivoire, Lithuania and Sri Lanka. The manager expects to hold 60-70 stocks.

Adviser: Wasatch Advisors of Salt Lake City, Utah. Wasatch has been around since 1975. It both advises the 14 Wasatch funds and manages money for high net worth individuals and institutions. Across the board, the strength of the company lies in its ability to invest profitably in smaller (micro- to mid-cap) companies. As of June 2007, the firm had $9.2 billion under management.

Managers: Roger Edgley, supported by a team of five international analysts and, more broadly, by the other managers at Wasatch. Edgley manages about a billion dollars in investments for Wasatch, including the International Opportunities and International Growth funds and a couple separate accounts. Before joining Wasatch he was a principal and portfolio manager at Wanger Asset Manager, the long-storied advisor to the Acorn fund. He started at Wanger as the emerging Asia specialist.

Management’s Stake in the Fund: None reported, since the fund began operation just a couple months ago. Mr. Edgley has some hundreds of thousands of dollars invested in his other two charges.

Opening date: October 1, 2007.

Minimum investment: $2,000 for regular accounts, $1,000 for IRAs and Coverdells.

Expense ratio: 2.10% after waivers, which are in effect through January, 2009. Don’t expect much of a price drop. International niche investing is an expensive proposition. The International Growth fund, with over a half billion in assets, still has expenses around 1.8%. The prospect for any substantial reduction is further limited by Wasatch’s entirely-admirable tendency to close its funds while they’re still small enough to pursue their mandates effectively.

Comments: What, you might reasonably ask, am I thinking? In a time of considerable uncertainty and volatility in the financial markets, why would anyone in his right mind be drawn to the smallest companies in the smallest markets in the world?

That’s a good question with a potentially surprising answer. It’s no real surprise that emerging market small cap stocks have substantial returns. The only comparable fund with a five-year record (DFA Emerging Markets Small Cap, DEMSX) has returned a daunting 38% annually for the past five years, which easily exceeds its large-cap focused peer group and index. Since inception (1998), the DFA fund has returned 21% annually while the MSCI Emerging Markets index clocked-in at 14%.

The performance gap exists across all reasonable comparison groups. Templeton reports the cumulative five-year performance of a variety of asset classes, through the end of September 2007:

It might be surprising that EMSC also serve to improve a portfolio’s risk/return profiles. The distinguished emerging markets investors at Nicholas Applegate undertook at ten-year study which compared the broad emerging markets universe with its small- to mid-cap (SMID) subset. Their data ran from 1994 – 2003 and so it predates those markets’ recent hot streak. The NA folks found that the "SMID universe generated superior returns and more attractive correlation benefits than a broad emerging markets mandate." It’s significant that the emerging markets, as a group, declined 29.5% over the decade while the SMID subset lost only 5.3%. While no one celebrates owning a declining asset, the fact that the smaller stocks outperformed in a long period of decline is important. WisdomTree found the same general pattern in modeling their dividend-oriented EMSC fund. Over a ten year period, EMSC stocks were less than 1% riskier but nearly 7% more profitable than larger emerging market stocks.

That same pattern persists in more recent periods. The DFA fund has a lower standard deviation (16.77) and lower beta (0.87) than either the Vanguard Emerging Markets Index fund (1.02) or its MSCI Emerging Markets benchmark index (1.00). In two of the three emerging market declines since 2000, the DFA fund outperformed both its peer group and the Vanguard index.

The key question is, does EMSC make sense within a portfolio? Research from Templeton suggests that it does. Adding a 20% position in EMSCs to an S&P500 portfolio increases risk minimally but increases returns substantially. For the five years through September 2007, an all-S&P portfolio returned 15.45% with a standard deviation of 9.62%. Adding 20% EMSC increased portfolio risk by only 0.14% but boosted annual returns by 4.52%.

Nonetheless, EMSC stocks are largely ignored. At one level, there are very few mutual funds (four, by my count) with substantial EMSC exposure and only two funds (other than Wasatch) with an EMSC mandate. Larger emerging market funds take little notice of such stocks. Vanguard’s index fund invests only 2.2% in small and microcap stocks. The very fine T. Rowe Price Emerging Markets Stock (PRMSX) fund – one of two Morningstar Analyst Picks -- invests under 1% in them. The other Analyst Pick -- American Funds New World A (NEWFX) – has 2.5% of its portfolio in small caps. The five-star Acadian Emerging Markets (AEMGX) commits 3.5%. I’m not sure whether it’s cause or effect, but Nicholas Applegate, Templeton and Wasatch all report that there’s very, very little stock analyst coverage in this area.

As a result, EMSC stocks remain reasonably priced (p/e 14.18) in comparison to the global small cap market (p/e 18.51) or emerging markets in general (p/e 15.67 for Vanguard’s index). Folks committed to investing in this area argue that this represents fundamental mispricing of these stocks, since they enjoin higher growth rates and substantial insulation from global economic turmoil.

Two questions remain: is there reason to believe that Wasatch can profitably invest here? and what are the alternatives to Wasatch?

Wasatch seems capable of pulling this off. Mr. Edgley’s International Opportunities fund, now closed, operates by applying the same investment discipline to international small caps in general. The fund has been a very solid performer in its scant two-year existence (up about 30% per year) and Wasatch closed it with only $50 million under management. Wasatch’s team-oriented investment approach is sensible and has paid off across a broad array of funds. Mr. Edgley has very solid credentials – both here and as a manager for the value-oriented Wanger Asset Management folks and their Acorn Foreign Forty fund. And he has a graduate degree in philosophy, a singularly rigorous field. Edgley notes that members of Wasatch’s research team speak 20 different languages and half have lived abroad. Those are, he argues, "real advantages" when it comes to investing.

Beyond that, the alternatives are durn limited. The most distinguished fund is the semi-passive DFA Emerging Markets Small Cap Portfolio (DEMSX) with an expense ratio of 0.81%. Unfortunately, the DFA funds are not available to retail investors and cannot invest in "frontier" markets. In October 2006, Templeton launched the Emerging Markets Small Cap Fund [TEMMX], run by the legendary Mark Mobius. Assets are around $100 million, but expenses are high at 2.5% and there’s a sales load.

There are two ETFs available. WisdomTree Emerging Markets SmallCap Dividend Fund (DGS), which has an expense ratio of 0.63%. DGS shows a fairly high correlation to the broader small cap universe (the correlation is about .88 for the decade from 1997-2007) and, for better or worse, limits its portfolio options by imposing a dividend requirement. Finally there’s the soon-to-be launched iShares MSCI Emerging Markets Small Cap Fund with an expense ratio of 0.75%.  This ETF, which is not yet released, will track the MSCI EMF Small Cap index. I’m not entirely sure why the iShares ETF isn’t trading, since the prospectus was filed with the SEC in July and the proposed effective date would have been October. Like DFA, both of the ETFs are limited to larger developing markets. 

Bottom Line: I’d take the same approach here that I’d take to considering T. Rowe Price’s Africa and Middle East (TRAMX) fund. It’s an intriguing opportunity to begin investing where few folks have gone before. The sheer lack of competition poses significant challenges (we don’t know what’s going to happen when money starts sloshing around in these markets), as well as significant opportunities (you just know that these markets will be "discovered" soon enough by market-hungry fund firms, which can only boost the value of early investments). If you’re going to go, go carefully and go with a good guide. Price and Wasatch both seem to offer such guides.