Factor investing in emerging markets and small caps: what UK advisers need to know
Emerging markets and small caps are two of the most diverse and under-researched corners of global equities. In the third Factor Academy session with Northern Trust Asset Management, Maarten Smit and Matthew McKendry examined what decades of research say about factor investing in emerging markets and small caps, why share issuance and poor quality have held these segments back, and why implementation so often decides whether a return premium is captured or missed. What follows is a summary of the themes discussed for UK financial advisers. It is illustrative rather than prescriptive, and none of it constitutes advice.
A quick recap: what are factors?
The first two Factor Academy sessions covered factor investing fundamentals and the long-term evidence behind them. In a single sentence, a factor is a specific characteristic of a stock that helps explain its risk and return. The academic literature has identified many, but Maarten focused on the most important ones:
Individual factors can be wrong for long stretches, so the aim is to invest at the intersection of them, improving the odds of ending up on the right side. The second session drew on a simulated 150-year dataset from the US market, which showed the long-term picture remains intact across periods of high and low inflation and interest rates. Simulated and past performance is not a reliable indicator of future results.
Emerging markets: a source of diversification
Emerging markets have been in the spotlight. Earnings expectations have grown strongly, driven in large part by semiconductor businesses such as Taiwan Semiconductor, Samsung Electronics, SK Hynix and MediaTek, which are benefiting from heavy investment in AI computing. Margin expectations, historically below those of the typical US business, have also improved. Maarten was clear that historical trends are not predictive of future results.
The more important point for portfolio construction is how factors behave across regions. Factor returns in developed and emerging markets move together to a degree, but correlations are positive and moderate rather than close to one. Across value, quality, momentum, size, low volatility and dividend yield, Maarten put the average at around 50 to 60 per cent. In other words, the payoffs tend to arrive at different times.
Share issuance: the emerging market malady
A question many advisers will recognise from client conversations: if emerging economies have grown so quickly, why haven't investors seen the returns? Maarten broke equity returns down into revenue growth, changes in valuation, dividends and changes in share count. Over the ten years to March 2024, revenue growth, valuations and dividends together contributed more in emerging markets than in global developed markets. The difference was dilution.
Ten-year annualised gross USD returns, 31 March 2014 to 31 March 2024. Past performance is not a reliable indicator of future results.
When companies issue new shares, the same profits are shared among more shareholders. Buybacks do the opposite, lifting profit per share. Share issuance sits within the quality factor as a measure of management quality, and in emerging markets it is a particularly potent signal. Companies that have issued heavily in the past tend to keep doing so. Maarten called them "repeat offenders".
In Northern Trust's hypothetical analysis of the MSCI Emerging Markets Index from December 2000 to March 2024, companies with the lowest composite share issuance grew a notional 10,000 to roughly twice the ending value of those with the highest, and the high issuers had generated little return for more than a decade. These results are hypothetical, gross of fees and costs, and past performance is not a reliable indicator of future results. In the Q&A, Maarten added nuance: the capital raised did fund real investment, so the debate is not simply "never issue shares". But screening for it is a relatively straightforward way to tilt away from the problem.
Small cap factor investing: why quality matters
Small caps are often the less loved part of the market, with fewer analysts, less news and lower institutional ownership. For a quantitative investor that is an attraction. There are many names, giving breadth to express views independently, and lower attention means factors have tended to pay off slightly better than in large caps. Maarten cautioned that academic figures for small caps are typically equal weighted, long and short, and exclude costs, so they should not be read as an achievable return in a real, long-only portfolio.
The size factor itself has a mixed record. In the US, the average small company beat the average large company until roughly the 1980s. Since then, a winner-takes-all effect in knowledge-based sectors has helped dominant large companies capture more economic profit, and the size factor has been negative over the last ten years. The key insight is why:
The average small company has poor quality. It may have a single business line, less access to credit or a concentrated customer base. In US data from July 1963 to December 2025, the size premium adjusted for market risk was only around half a per cent a year, but it rose meaningfully once the poor average quality of small companies was accounted for. The same pattern appears outside the US, with high quality small caps ahead of low quality small caps in Northern Trust's research:
Source: Northern Trust Quantitative Research. Simulated figures shown for illustration only. Past performance is not a reliable indicator of future results.
Quality also helps with costs. Small caps tend to have wider bid-ask spreads, higher volatility and lower trading volumes, all of which raise implementation costs. Because quality is a stable characteristic, it needs less trading to maintain, making it a relatively efficient way to access the segment.
Implementation determines outcomes
The final part of the session explained how Northern Trust applies these ideas in emerging markets and small caps. Whatever approach a fund selector favours, the principles Maarten described are useful questions to ask of any factor strategy in these segments:
Key takeaways for UK advisers
From the Q&A
How are China weightings decided? Country weights have shifted this year, with Taiwan and Korea rising on semiconductor strength and India falling. Mainland China A shares are around 3 per cent of the index, accessed through Stock Connect, as MSCI applies a partial inclusion factor. Hong Kong listed Chinese stocks are far larger, at around 20 per cent.
My clients already hold emerging markets through a global tracker. Why more, and why factors? First check what the tracker holds: some "world" indices, such as MSCI World, cover developed markets only. How much to allocate is a separate decision. Maarten's view was that the case for factors within an emerging market allocation rests on the historical and live evidence discussed in the session.
Doesn't momentum drive up trading costs? It has the highest turnover of the three main factors. Rather than adding turnover, a modest momentum exposure can be blended within the same turnover budget to help select the right value and quality names.
If small caps haven't consistently beaten large caps, why bother? Maarten suggested flipping the question. Developed large caps are roughly 70 per cent of global market cap, with small caps and emerging markets each around 15 per cent. Start from the whole global market and make the case for leaving segments out, rather than starting from developed large caps and justifying additions.
Further reading
Maarten recommended two Northern Trust research papers: Why Small Caps Are Attractive and Foundations in Factors. Missed the earlier sessions? Factor Academy 1 and 2 are available on demand.
