Emerging markets have kept pace with the US for almost three decades. Value and momentum premiums have been far stronger there than in developed markets. And most of the small cap premium turns out to have been earned in a single month. In our Equity Research Update, Laurentius van den Worm, CFA, Head of Investment Strategy at Timeline, took UK financial advisers through three new research papers informing Timeline's asset allocation review.
Here is what the latest evidence says about investing in emerging markets, factor premiums within emerging markets and how best to capture the small cap premium.
Is the emerging markets premium still real?
The first paper updates Timeline's emerging markets research with data to December 2025. Because around two thirds of a developed world index is now the US, this year's update splits the benchmark into the US and the developed world excluding the US.
How often have emerging markets outperformed?
It depends heavily on the benchmark. Over rolling 20 year periods, emerging markets beat the developed world 72% of the time, the developed world excluding the US 100% of the time, and the US 58% of the time. Over five and 10 years, they trailed the developed world and the US more often than not. As these windows overlap, they represent only a handful of independent market cycles, so the direction is more robust than the exact percentages.
Why the emerging markets premium has narrowed
After the early 2000s, emerging markets led the developed world by up to 12% a year on a rolling 10 year basis, and that period does much of the work in the long run averages. Since around 2017 they have trailed the US heavy developed world index, and their 20 year lead over the developed world excluding the US is now below 1% a year. That does not mean the premium has gone, but it is lumpy rather than steady.
The real risk is when returns turn up
Emerging markets tend to have either very strong or very weak years. Over one year, they lost money 31% of the time against 21% for the developed world. At five years that fell to 3% against 10%, and at 10 years neither had a losing period in the sample. The extra risk is mostly something investors live with over the short to medium term.
On a risk adjusted basis, emerging markets do not come out ahead. Volatility was 18.9% a year against 14.3%, and the developed world had the better Sharpe ratio at one, five and 10 years, with Sortino ratios telling the same story. The worst drawdowns, however, were almost identical at around -45%.
Diversification and concentration
Over 20 year horizons, emerging markets had an average correlation of 69% with the US, 79% with the developed world and 84% with the developed world excluding the US. There is some diversification, mostly against the US, but it is modest.
of an emerging markets index fund sits in its top ten holdings, against 27.5% for a developed world index fund, as at 30 September 2026.
TSMC alone is around 15.1% of the emerging markets index, more than NVIDIA, Apple and Microsoft combined in the developed world index. Both top tens are now dominated by the same AI and semiconductor supply chain, which helps explain the modest diversification benefit.
Companies are shown for illustration only and are not a recommendation to buy or sell any security.
Past performance is not a reliable indicator of future results.
Factor premiums in emerging markets
Portfolios work within a limited risk budget. So the second paper asks whether there is a more efficient way to earn the emerging markets premium than simply holding more of the market, by targeting the parts that have been better rewarded.
Both main explanations for factor premiums point the same way in emerging markets. If premiums are a reward for risk, emerging markets carry more of it: currency and political instability, weaker creditor protection and more cyclical earnings. If premiums come from mispricing, emerging markets have thinner analyst coverage, tighter short selling constraints and far more retail trading, at around 80% to 85% of trading in China A shares. The catch is that these frictions also make premiums more expensive to capture.
Annualised academic long short factor premiums, USD, gross of costs, to May 2026. Quality uses profitability as a proxy.
Value and momentum have been stronger, and independent
The value and momentum premiums were both significantly larger in emerging markets, while quality was positive but slightly lower than in developed markets. Notably, the plain emerging markets equity premium was barely higher than in developed markets, so the advantage comes from the factors rather than the market itself. Emerging markets value was positive in 98% of rolling 10 year periods.
These factors also move largely independently of their developed market equivalents, running on their own cycles. And the higher premiums did not come with proportionately more risk: the worst drawdown for emerging markets value was 19%, against 49% for developed markets value.
What survives in a long-only portfolio?
Academic factors are long-short portfolios, but clients hold long only funds. So the team tested Fama and French's long-only emerging markets indices from July 1991 to June 2026.
Both results were statistically meaningful, though gross of fees and trading costs. Long only value kept about a third of the academic premium and profitability about two-thirds. There is no long-only momentum index, so momentum could not be tested this way.
The two behave differently. Value has paid more but arrived in bursts, adding just 0.6% a year since 2013. Profitability has been steadier, beating the market in 97% of rolling 10-year periods against 80% for value.
Past performance is not a reliable indicator of future results. Returns are shown in US dollars and may increase or decrease as a result of currency fluctuations.
Is the small cap premium a January effect?
Small caps have a long standing place in evidence-based portfolios, since Banz documented the size effect in 1981 and Fama and French built it into their three factor model in 1993. Smaller companies are less liquid and more fragile, so investors demand a higher return to hold them. The third paper does not question that. It asks how best to own small caps, given 40 years of research since.
On its own, size is the weakest major premium. Feng, Lan, Wang and Zhang (2026) put its Sharpe ratio at 0.22 from 1973 to 2021, against 0.57 for quality, and McLean and Pontiff (2016) found it decayed more than most anomalies after publication.
Most of the return arrives in one month
AQR found the size premium is overwhelmingly a January effect. The Timeline team expected to debunk this, so they rebuilt the analysis from 100 years of daily Fama French data.
of the smallest US companies' cumulative return since 1926 was earned in January, a month that makes up 8% of the calendar.
The smallest 10% of US companies averaged 7.13% in January, against 0.85% in other months. The largest showed almost no January effect. Outside January, the size premium was essentially zero. The effect has also faded: since 2000, the January gap for the smallest companies is no longer statistically significant.
Remove January and small caps lose their edge
Using long only indices, the result was starker. January explains the entire small cap premium and a little more, and because the effect is concentrated in the smallest, least liquid stocks, it is also the hardest part to capture after costs. The conclusion is not an argument against investing in small companies. It is an argument against relying on raw size alone.
Past performance is not a reliable indicator of future results. Returns are shown in US dollars and may increase or decrease as a result of currency fluctuations.
A better way to capture the small cap premium
An AQR paper, Size Matters, If You Control Your Junk (Asness et al., 2018), explains why raw size is so weak. Small cap universes are full of unprofitable, unstable, capital hungry businesses that drag the premium down. Control for quality and the size premium becomes larger, steadier and less dependent on January. A market cap weighted small cap index holds all of those businesses by construction.
The extra return did not come from extra risk. Small cap quality returned about 10.4% a year against 6.7% for junk, with lower volatility, and small cap value had the highest return with lower volatility than the small cap universe. Quality or value led in every decade since 1990, although junk has beaten quality since 2020, a reminder that factor premiums can lag for years. Quality held up far better than junk after the dot com bust, but in 2008 everything fell together and quality offered little protection.
The market has already run the experiment
The S&P SmallCap 600, which requires positive earnings, returned 11.77% a year from 1994 to 2020 against 10.49% for the unscreened Russell 2000, with slightly lower volatility. Dimensional's research shows that excluding low profitability small cap growth stocks lifted US small cap returns from 13.95% to 15.17% a year since 1975.
Small cap index or screened fund: the trade offs
The evidence favours screened exposure, but cost and liquidity matter, especially in emerging markets. A screened fund still has to earn its extra cost through genuine factor tilts, sensible tracking error and efficient trading.
Past performance is not a reliable indicator of future results. Returns are shown in US dollars and may increase or decrease as a result of currency fluctuations.
What the research tells us
It comes with more volatility, more concentration and no better risk adjusted return.
Value and momentum premiums have been larger than in developed markets, and profitability has translated more consistently into long only returns.
Raw size has weakened and leans heavily on January. The evidence is much stronger when small caps are combined with quality or value.
This research was originally carried out for Timeline's Investment Committee and has informed the current asset allocation review. Laurentius did not comment on specific portfolio changes, and the outcome will be shared with advisers separately.
Questions from advisers
Is there a stronger case for active managers in emerging markets?
The evidence does not suggest active managers have delivered much stronger outcomes in emerging markets than in developed markets, as emerging markets remain highly liquid and fairly efficient. The research suggests systematic factor exposure has been a more reliable way to harness the inefficiencies that do exist.
Can active funds reduce concentration risk in emerging markets?
They can, but so can an equal weighted index. Reducing one risk usually introduces another, and Laurentius has not seen evidence that active emerging markets portfolios are consistently less concentrated.
Want to go through the research in more detail? Our investment team is always happy to talk it through, or book time with your regional rep for a personalised demo.
Sources and notes: Emerging markets data: Timeline analysis, gross returns in GBP, July 1998 to December 2025, using Morningstar Developed World and Developed World ex US Target Market Exposure indices, Fama/French Emerging Markets dataset and Robert J. Shiller US Stock Market Data. Index concentration: Northern Trust World and EM Equity Index Funds, as at 30 September 2026. Factor premiums: Kenneth French Data Library, May 2026 vintage, USD, gross of costs. Long only EM factor indices: Fama/French via Dimensional, USD, July 1991 to June 2026. Size and January effect: Ken French Data Library, July 1926 to June 2026. Small cap quality and value: Ken French Data Library, July 1990 to May 2026. Index comparison: S&P Dow Jones Indices (2020). Dimensional Fund Advisors research.