Large-cap stocks may have been dominating the U.S. market in 2023, but small-caps are winning in emerging markets. That has put EM investors in a much healthier —and better diversified — position, according to PGIM.

The MSCI Emerging Markets Small Cap Index has returned 17.7 percent for the year-to-date ending in July, significantly outperforming the MSCI Emerging Markets Large Cap Index, which gained 11.4 percent during the same period. Meanwhile, in the U.S., the excitement over artificial intelligence has spurred large-cap stocks to a 22.3 percent gain during the first seven months of the year, outpacing their small-cap peers by 7.3 percentage points.

According to Patrick McDonough, portfolio manager at PGIM Quantitative Solutions, the outperformance of small-caps in emerging markets means those stock markets are in better shape. “In the U.S., you have such a narrow focus on leaders . . . That’s really unhealthy because there’s just no breadth in the market,” he said. “That means there’s no diversification and the capital is being blind and not really being used efficiently.”

In emerging markets, small-cap stocks offer more diversification benefits than their larger peers because they are more sensitive to local economic activities, according to McDonough. “You really get that true emerging market experience in the smaller-cap space,” he said.

Small-cap stocks don't always outperform in emerging markets, McDonough added. For instance, during the onset of the Covid pandemic, large EM companies like Tencent and Alibaba were able to adapt their business models more rapidly than their smaller counterparts. But even during such periods of stress, the concentration in EM large-cap stocks didn't increase as dramatically as the concentration in U.S. large-cap companies has today, he added.

PGIM isn’t alone in being bullish on emerging market stocks. According to Research Affiliates, EM equities are expected to generate an average Sharpe ratio — a measure of risk-adjusted returns — of 0.32 in the next 10 years, significantly higher than the 0.14 ratio generated by developed market stocks. Indonesia and Brazil are projected to generate 10-year Sharpe ratios of 0.43 and 0.4, respectively, leading all other EM economies.

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“It’s getting significantly harder for me to start justifying how we can have these high valuation multiples in U.S. securities,” McDonough said. “I really do think the bulk of opportunities are in emerging markets.”