Better performance of non-U.S. small-capitalization stocks has fueled interest in the asset class.
After years of lagging the Morgan Stanley Capital International Europe Australasia Far East Index, an index of small non-U.S. stocks last year through November was leading EAFE by 1.81 percentage points.
Some institutional investors appeared to have been impressed.
In December, the $33.5 billion Pennsylvania Public School Employes' Retirement System, Harrisburg, picked two managers for international small-capitalization stock portfolios - Seligman Henderson Co. and Capital Guardian Trust Co.
The $1.6 billion pension fund of Georgia-Pacific Corp., Atlanta, hired Jacobs Asset Management, Fort Lauderdale, Fla., for a $20 million portfolio that is expected to (but won't have to) emphasize international small-cap stocks and emerging markets.
Duke University, Durham, N.C., is among the institutions that will explore foreign small-cap investing this year, a source said. Officials at Duke could not be reached for confirmation.
A number of tax-exempt institutional investors already invest in international small-cap stocks. They include: Centerior Energy Corp.; the Pennsylvania State Employes' Retirement System; and the San Francisco City & County Employees' Retirement System. BellSouth Corp., Federal Express Corp. and Ameritech also are reported to have allocations, but officials of the latter three funds did not provide confirmation.
But such organizations have been in the minority so far. And performance has been a leading reason.
The question now is whether last year's outperformance by international small-cap stocks will ignite new interest.
Until 1996, returns offered little to cheer about, as evidenced by the Salomon Brothers Extended Market Index of the World excluding the United States. In 1992, the composite index in dollar terms posted a return of -15.14%; in 1993, the index rose 31.1%; in 1994 climbed 8.48%; and in 1995 was up 5.24%. In the 1996 through November, it posted a 9.24% rise.
In comparison, the EAFE outperformed the small-cap index in 1992, with a 12.17% total return; in 1993, with a 32.56% return; and in 1995, an 11.21% advance. But in 1994, and last year through November, the EAFE underperformed Salomon's small-cap non-U.S index by 0.7 percentage points and 1.81 percentage points respectively.
Consultants see growing interest
To some, this year's gains seem to have spurred interest in non-U.S. small caps. Ann Duncan, a senior equity research analyst at Frank Russell Co., Tacoma, Wash., has seen some interest "due both to the increasing number of products being offered and the better performance this year." She said inquiries on this sector typically are coming from larger funds.
So far, though, not much new money has been invested in dedicated international small-cap portfolios, though, Ms. Duncan added.
"So many active international strategies already have exposure to medium-and small-cap stocks; and there is still more interest in emerging markets than in international small cap," she said. "But if outperformance by international small caps continues, (we) expect to see more interest in separate small-cap management."
Charles King, director of international research for consulting firm Evaluation Associates, Norwalk, Conn., saw a "very substantial increase" in interest in international small-cap investing in 1996. The attractions: the pricing "inefficiency" price-earnings ratios that "are relatively attractive vs. those on the large-cap side."
Mr. King said some consultants, including his firm, "made a push" in 1996 for non-U.S. small stocks, and some clients had "followed that suggestion."
From his perspective, foreign small stocks offer diversification both from broad international EAFE portfolios and emerging markets allocations.
He uses Tokyo's market as an example. He said about 25% of the first section of the Tokyo Stock Exchange's index is financial company issues, whereas less than 5% of Japan's over-the counter market consists of those stocks. In contrast, Japan's OTC market has a 23% exposure to "software and other service sector companies, compared with the TSE's 5% exposure to them."
Diversification is a draw
Mr. King believes diversification could lead investors to international small-cap stocks. That's the case for the $17.6 billion Pennsylvania State Employes' fund, which has 20% of its roughly $3.5 billion in international equities in non-U.S. small cap.
Equity analyst David Lee said the fund tries "to maintain a certain exposure to each asset class and each market capitalization." The specific allocation to non-U.S. small stocks comes from "a custom benchmark . . . (that) represents the investible international equities universe."
Mr. Lee's fund has three non-U.S. small-cap managers: Seligman Henderson and two London firms, Mercury Asset Management and Pictet International Management Ltd. Together, they manage about $640 million in international small caps for the fund.
The $7.8 billion San Francisco fund, meanwhile, has about $100 million invested in international small-cap stocks with Capital Guardian and Pictet.
Clare Murphy, executive director, said "diversification was a significant factor" for investing in small-cap international stocks. "The bulk of EAFE represents large-cap stocks."
But the diversification draw might have its limitations. Reza Vishkai, international research director of RogersCasey, Darien, Conn., reports the diversification benefits of non-U.S. small-cap stocks "have not been demonstrated to be as dramatic as they have been with emerging markets."
On a market-by-market basis, returns of small-cap stocks have tended to be highly correlated with those of large caps, he said.
Thus, he sees "very limited" interest in non-U.S. small stock investing.