Earlier this month, the International Monetary Fund (IMF) released its biannual assessment of the global economy and there were few surprises. The IMF‘s economists continue to focus on the deep troubles in Europe, the clear headwinds in place for the U.S. economy and the still-impressive resilience of many emerging market economies. So they updated their economic forecasts to reflect these recent global economic trends: “Relative to our April 2012 forecasts, our forecasts for 2013 growth have been revised from 2.0 percent down to 1.5 percent for advanced economies, and from 6 percent down to 5.6 percent for emerging market and developing economies.”

Of course, 5.6% economic growth would be very welcome on our shores. To put that in context, the U.S. economy has only grown, on average, at a 2.8% pace during the past 40 years.

Yet that has led to a head-scratching conundrum: Even though emerging markets continue to grow at a faster pace than in the United States, this trend hasn’t paid off for investors recently. As I noted back in August, many emerging markets (especially the “BRIC” countries of Brazil, Russia, India and China) have underperformed during the past few years. How could that be?

I may have the answer.

If you dig a little deeper into each emerging market, then you’ll find the largest companies in each market are massive, export-oriented firms that rise and fall on the backs of Europe, the United States and Japan. Together, these three countries still account for the bulk of the world’s economic activity. In effect, an investment in emerging markets is really an indirect proxy for developed markets.

Even large emerging market companies that have greater local exposure are often still tied to global pricing trends. I’m talking about the commodity producers, major banks and basic materials firms.

#-ad_banner-#So if you really want to tap into the dynamic growth that emerging markets offer, then you need to go downstream and seek out the smaller local companies that are more squarely focused on domestic economic activity. Emerging market small caps have shown better results than their bigger peers. In fact, domestically-focused emerging market small caps have outperformed emerging market large caps on a 1-year, 3-year, 5-year and 10-year time frame, according to analysis conducted by S&P Capital IQ. A roughly 15% gain for emerging market small caps thus far in 2012 handily obscures the 10% gain for emerging market large caps.

Another plus for emerging market small caps: They are a better value. Standard &Poor’s analysis found that emerging market small caps trade for around eight times projected 2013 profits on the heels of 16% projected profit growth. Emerging market large caps, on the other hand, trade for 10 times 2013 profits, roughly in line with the projected 10% earnings growth rate.

The best investment route
When it comes to small caps in emerging markets, forget about stock-picking. It’s just too hard to assess small and mid-sized firms that operate in a foreign language halfway around the world. Instead, play this trend with exchange traded funds (ETFs). 

The Guggenheim China Small Cap ETF (NYSE: HAO)’s looks to be the best China play. The ETF invests in consumer stocks (28% of its portfolio), domestically-focused tech and Internet companies (9%), travel and tourism firms (21%), along with more traditional sectors such as real estate and health care. The 0.75% expense ratio is typical for ETFs that must dig deeper than funds focused on blue chips to build a portfolio.

Why would you invest in China right now when the economy looks a bit wobbly? Because the Chinese government has enacted another stimulus effort this year, which is aimed at boosting domestic consumption. This, in turn, plays right into the hands of China’s domestically-focused small caps.

In the August emerging markets article I mentioned earlier, I showed how Brazilian stocks have also underperformed in the past two years. This is largely explained away by two factors: The Brazilian market looked quite frothy in 2010, making profit-taking inevitable. Second, the Brazilian economy, after a very strong growth spurt after the Great Recession, has slowed in 2012, though economists say that within a year or two, this will again be one of the most dynamic economies in the world. 

That’s why the Market Vectors Brazil Small-Cap ETF (NYSE: BRF) makes sense — particularly now (You can buy it for about a third less than what you would have paid in late 2010). The ETF tracks an index that focuses on Brazilian companies in the bottom 10% of the Brazilian market (using $150 million as the minimum threshold). Consumer stocks make up roughly one-third of the portfolio, while financial and real estate stocks have a collective 24% weighting. The remainder is split between domestic manufacturers, utilities and technology firms. The 0.59% expense ratio is in line with the peer group.

The WisdomTree Emerging Markets SmallCap Dividend ETF (NYSE: DGS) is likely to be the safest ETF in this category, simply because it holds a huge amount of stocks (550), all of which have a history of stable dividend payments. Such a broad-based approach has led to lower volatility than other small cap ETFs and to better total returns, according to Morningstar.

Yet this ETF is best suited for taxable investment accounts. That’s because dividend payments can be subject to foreign tax withholding, and you can only recoup those funds through an application for an offsetting tax credit against U.S. taxes — which is ineligible in tax-shielded accounts.

Risks to Consider: If Europe and the United States stumble badly in 2013, then even the emerging markets won’t be immune to the fall. That’s why these are best seen as multi-year investment vehicles.

Action to Take –>  Emerging-market investing will always take a strong stomach thanks to wild price swings. Yet the long-term trends are quite positive for these economies, the BRIC countries in particular, and can help deliver plus-sized returns for the patient investor.