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1 Hiding In Plain Sight: The Untapped Potential of Emerging Market Small Caps RBC GAM Fundamental Series RBC Global Asset Management

2 Hiding in Plain Sight: The Untapped Potential of Emerging Market Small Caps 1 Executive Summary Investors have long debated the degree to which the applied skill of active portfolio managers can improve investment returns and generate enough alpha to justify active management fees. Indeed, alpha generation has become more difficult as investors have grown more sophisticated and the pool of unique investment opportunities has contracted. Nevertheless, evidence suggests that there are isolated areas of the market where the potential returns on investment knowledge and skill remain substantial. In this paper, we discuss the alpha-generation potential of one such area of the market, emerging market small cap equity. With nearly ten times as many securities as the emerging market large cap universe, minimal analyst coverage, a general lack of investor interest, and ample relative value opportunities, emerging market small caps offer investors an unusually attractive combination of strong investment performance and relatively low return volatility. We expect to see this compelling but often overlooked asset class among the top performers as information becomes more accessible and growing liquidity attracts more investors.

3 2 Hiding in Plain Sight: The Untapped Potential of Emerging Market Small Caps EXHIBIT 1 Manager Outperformance Is Declining in Frequency and Magnitude Rolling 3-Year Excess Return vs. MSCI World Free Index (USD) Excess Return (Before Fees) 12% 8% 6% 4% 2% 0% -2% -4% -6% 9/95 9/96 9/97 9/98 9/99 9/00 9/01 9/02 9/03 9/04 9/05 9/06 9/07 9/08 9/09 9/10 9/11 9/12 9/13 9/14 Source: Mercer as of Global Equity Universe - Median MSCI World Free Index Global Equity Universe - Upper Quartile Global Equity Universe - Lower Quartile In 1994, the median active global equity manager outperformed the MSCI World Free Index by approximately 400 basis points gross of fees. By 2004, that number had fallen to about 200 basis points. Fast-forward to 2014, and the median manager s performance matched that of the index, before fees. EXHIBIT 2 Active Managers Are Delivering Alpha in EM Small Cap Markets Rolling 3-Year Excess Return vs. MSCI EM Small Cap Index (USD) 12% Seeking Alpha Evidence suggests that in aggregate, it is becoming increasingly difficult for active managers to beat their benchmarks. Moreover, the median excess return of those managers that have outperformed has been declining for the past two decades (Exhibit 1). While this issue is complex, we believe that two important factors have contributed to the structural decline in alpha across most markets: 1) Investors have become smarter. Today s investors are highly educated and more talented than ever before. Approximately 90% of trades on listed stocks are now executed by full-time professionals who are constantly seeking an information advantage (that s up from just fifty years ago). Additionally, trading costs in terms of both brokerage fees and liquidity impacts have fallen and investors have ready access to more robust data, market information and investment research than they could possibly use. The industrialization of the asset management business has generally reduced (if not eliminated) the ability of most asset managers to generate levels of alpha that justify the fees they charge to clients. 2) The investment opportunity set has become smaller. The growth of the asset management industry in terms of both the number of participants and assets under management has caused many investors to focus on larger, highly liquid companies that are already known to the marketplace. With fewer stones unturned and increased competition for alpha, the number of unique investment opportunities has narrowed in most markets and position crowding is now prevalent. Excess Return (Before Fees) 8% 6% 4% 2% 0% -2% 6/08 Source: Mercer as of /09 6/10 EM Small Cap Universe - Median MSCI EM Small Cap Index 6/11 6/12 6/13 6/14 EM Small Cap Universe - Upper Quartile EM Small Cap Universe - Lower Quartile Areas of Interest Though research confirms that alpha levels are diminishing in most markets, it also points to isolated areas where the potential return on investor knowledge and skill is still substantial. Consider emerging market small cap equities, an asset class where the heightened competition and informational efficiencies that prevail in larger cap markets have yet to manifest. The opportunity set within the emerging market small cap investment universe is significantly larger (and manager competition within emerging market small caps is significantly lower) relative to other asset classes. This makes fertile ground for sophisticated investors seeking to capitalize on their intellectual capital and stock picking abilities (Exhibit 2).

4 Hiding in Plain Sight: The Untapped Potential of Emerging Market Small Caps 3 Strength in Numbers Because the emerging market small cap equity universe has considerably more securities than the larger cap emerging market equity universe, it tends to offer a greater number of unique investment opportunities. In fact, the pool of emerging market small cap stocks is approximately 10 times the size of the emerging market large cap universe. Indeed, companies with a market cap below US$5 billion account for more than 90% of the 8,800+ securities that are listed and traded in emerging markets. The MSCI EM Small Cap Index has nearly twice the constituents (1,800+) of the MSCI EM Index, which is dominated by just a handful of very large companies. The 10 largest stocks in the MSCI EM Index comprise more than 16% of its overall market value, while the 10 largest stocks in the MSCI EM Small Cap Index account for only 3.4%. In fact, the market capitalization of the largest stock in the MSCI EM Index, Korean electronics giant, Samsung, has a market cap of more than US$150 billion 8 times the combined market cap of the top 10 stocks in the MSCI EM Small Cap Index. EXHIBIT 3 Emerging Markets Universe Analyst Coverage Stock Coverage as % of Investment Universe 80% 70% 60% 50% 40% 30% 20% 0% 8% 70% Highly Covered (>10) 17% Thinly Covered (6-10) EM Small Caps (Market Capitalization <$5 billion) EM Large Caps (Market Capitalization >$5 billion) 39% 9% Very Thinly Covered (1-5) 44% 4% Not Covered (0) Untapped Alpha Potential Due in part to the sheer size of the investment universe, emerging market small cap equity is a largely unexplored asset class. With minimal coverage from sell side analysts, the existence of high quality, undervalued investments that have yet to be discovered and exploited by active investors is more likely. As of this writing, 70% of emerging market large cap stocks are covered by at least 10 analysts, while nearly 45% of emerging market small cap stocks receive no coverage at all (Exhibit 3). There are also few investment products that are dedicated to emerging market small cap stocks. This lack of institutional investment in the asset class leaves abundant, untouched opportunities to invest in high quality businesses with rapid growth prospects and attractive valuations. In an attempt to quantify this broad-based underinvestment in emerging market small cap companies, we examined the number of emerging market small cap products in the evestment Alliance database ( against the total number of reporting managers in the emerging market equity category. According to evestment, less than 7% of the 486 emerging market products that reported as of March 31, 2014 identified with running small-cap products. Moreover, about 75% of those that did had less than US$500 million in assets under management (Exhibit 4). Given so many opportunities and so few analysts and investors focusing on emerging market small cap stocks, potential alpha capture within the asset class is and will likely remain strong for some time. EXHIBIT 4 Emerging Markets Equity Funds Capitalization Breakdown Degree of Coverage (Avg. # Analysts per Stock) Source: JP Morgan Research, November 2014 EM Large Caps 93% EM Small Caps - 7% AUM under $500 million 5% AUM over $500 million 2% Source: evestment as of

5 4 Hiding in Plain Sight: The Untapped Potential of Emerging Market Small Caps EXHIBIT 5 Global Equity Annual Performance Spreads Spread between Best and Worst Performance Quartiles (basis points) Global Small Cap (<$3 billion) Global Large Cap (>$10 billion) Average Monthly Small Cap Differential (Global) Average Monthly Large Cap Differential (Global) Relative Value Opportunities Historically, the range of returns within small cap equities has been much wider than the range of returns within large cap equities, indicating that the former offers more relative value opportunities (both in number and magnitude). Exhibits 5 and 6 show the annual performance spreads between the best and worst performing stocks in global and emerging market equities, respectively, for small and large cap companies. The average monthly difference between the top- and bottom-performing quintiles shows the magnitude of small and large cap return ranges over a 23 year period. The monthly spread between the top and bottom performers for global and emerging market small cap stocks stood around 125 and 143 basis points, respectively, while the same measure for global and emerging market large caps stands well below those levels at about 82 and 92 basis points, respectively. Source: Bloomberg, Datastream, FactSet, JPMorgan as of EXHIBIT 6 Emerging Market Equity Annual Performance Spreads Spread between Best and Worst Performance Quartiles (basis points) EM Small Cap (<$3 billion) EM Large Cap (>$10 billion) Average Monthly Small Cap Differential (EM) Average Monthly Large Cap Differential (EM) Source: Bloomberg, Datastream, FactSet, JPMorgan as of

6 Hiding in Plain Sight: The Untapped Potential of Emerging Market Small Caps 5 Diversification Benefits Over time, emerging market small cap companies have shown an unusually attractive combination of strong performance and relatively low volatility (Exhibit 7). Smaller company investing also tends to complement larger company investing, thus offering significant diversification benefits. Indeed, the correlation and beta of the MSCI EM Small Cap Index in relation to the MSCI World Index are lower than those of the larger cap MSCI EM Index and the MSCI World Index. While this may seem counterintuitive, recall that in emerging markets, small and large cap share prices behave quite differently. The former are more exposed to emerging market domestic consumer spending and often operate in niche areas that have the potential to deliver strong earnings growth independent of the broader economy. The latter tend to be heavily weighted toward energy, materials and financial sectors, all of which are highly sensitive to global macroeconomic trends and state-owned enterprises. EXHIBIT 7 Diversification Benefits 5-Year Annualized Period Ending MSCI EM Index MSCI EM Small Cap Index MSCI EM Index MSCI EM Small Cap Index MSCI EM Index Standard Deviation 21.2% 20.3% 0% 5% 15% 20% 25% Beta (vs. MSCI World Index) Correlation (vs. MSCI World Index) MSCI EM Small Cap Index Source: FactSet, The MSCI EM Index and the MSCI EM Small Cap Index reported average market capitalizations of $4.6 billion (USD) and $321 million (USD), respectively, as of December 31, 2014.

7 Hiding in Plain Sight: The Untapped Potential of Emerging Market Small Caps 6 Conclusion Emerging market small cap equity is one of the most compelling asset classes available to investors today, but it is also frequently overlooked. Despite its strong performance, improved excess return opportunities and superior diversification potential, most retail and institutional investors have yet to incorporate emerging market small caps into their overall asset allocation strategies. Though coverage of these small emerging market stocks remains light, it is already stronger than it was just a few years ago. With managers and analysts ramping up their research efforts to meet increasing demand for alpha, we doubt that these hidden gems will remain unnoticed for much longer. As informational efficiency and liquidity within the asset class improve, we expect more investors to respond to the diminishing supply of alpha in other markets by exploiting the breadth of unique opportunities that the emerging market small cap equity universe has to offer. For more information, please contact: Paul Williams, Head of EMEA Business Development paul.t.williams@rbc.com Tel: +44 (0) Kelly Walsh, Head of Consutant Relations kelly.walsh@rbc.com Tel: +44 (0) Authored by: Guido Giammattei, Portfolio Manager, Emerging Markets Equity Team RBC Global Asset Management (UK) Limited This document is being provided by RBC Global Asset Management (UK) Limited, part of RBC Global Asset Management. This document may not be reproduced in whole or part, and may not be delivered to any person without the consent of RBC Global Asset Management. This document is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any investment strategy and should not be construed as tax or legal advice. Not all products, services or investments described herein are available in all jurisdictions and some are available on a limited basis only, due to local regulatory and legal requirements. Past performance is not indicative of future results. The information contained in this report has been compiled by RBC Global Asset Management and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. With all investments there is a risk of loss of all or a portion of the amount invested. This document contains the current opinions of RBC Global Asset Management and is not intended to be, and should not be interpreted as, a recommendation of any particular security, strategy or investment product. Unless otherwise indicated, all information and opinions herein are as of the date of this document. All information and opinions herein are subject to change without notice. RBC Global Asset Management is the name used for certain investment advisory subsidiaries of the Royal Bank of Canada. RBC Global Asset Management is the asset management division of Royal Bank of Canada and includes RBC Global Asset Management (U.S.) Inc., RBC Global Asset Management Inc., RBC Global Asset Management (UK) Limited, RBC Alternative Asset Management Inc. and BlueBay Asset Management LLP, which are separate, but affiliated, corporate entities. RBC Global Asset Management (UK) Limited is authorised and regulated by the Financial Conduct Authority. / Trademark(s) of Royal Bank of Canada. Publication date: GUK/15/045/APR16/A