Small Emerging Markets: A New Asset Class

This paper examines whether small low- and middle-income countries offer excess returns and diversification benefits to global investors. Using monthly equity price data from 2015–25, the study pools listed stocks from low- and middle-income countries whose populations fall below a given threshold and construct value-weighted portfolios, sorted by population and land area. It then estimates a two-factor asset-pricing model to evaluate their risk-adjusted performance relative to developed- and emerging-market benchmarks. Portfolios restricted to countries with fewer than 20 million people—or less than 100,000 square kilometers—earn positive and economically meaningful alphas alongside low covariances with global-market returns. Risk-adjusted performance, measured by an adjusted Treynor ratio, peaks in the 15 million to 20 million population range. Once larger low- and middle-income countries enter the portfolio, integration with global markets rises sharply, alphas converge to zero, and diversification benefits vanish. No analogous pattern appears among high-income countries, where even very small markets are fully integrated. These results point to a “small emerging market asset class”: small developing economies remain partially segmented, combining exposure to undiversifiable country-specific risks stemming from structural vulnerability (for example, heightened climate and environmental risk) with limited financial integration, for which investors appear to be compensated. Small low- and middle-income countries thus form a distinct frontier for international portfolio diversification.