International small cap a missed opportunity

U.S. consultants and their clients increasingly have moved to embrace global mandates in their search for diversification and return in their equity portfolio. Many of these investors already have built and maintained a sizable position in international equities.

These programs, however, have tended to focus on large-cap stocks in developed countries, overlooking a potentially important source of return and alpha: international small cap. This has happened despite strong performance, better diversification potential, and the opportunity available for active management to deliver strong returns in this asset class.

Exhibit 1, below, shows a rough sketch of the investible equity market, and what tends to be included in the portfolio of a U.S.-based investor.

By far, the most common international equity benchmark for U.S. investors is the MSCI Europe Australasia Far East index. Capturing approximately 85% of the total capitalization of companies in developed European and Asian countries, EAFE has become shorthand for “international equities.”

Most investors recognize it is a developed markets index and does not completely represent the opportunity set outside the U.S. — which is why they have an allocation to emerging markets. However, the focus on the MSCI EAFE as the primary benchmark for “foreign stocks” ignores some other important points about the index. Mainly, that Canada is excluded despite being a $1.5 trillion developed market with some unique attributes as a result of natural resources exposure. Additionally, frontier markets and perhaps most importantly, non-U.S. small-cap stocks are underrepresented.

Many active managers are willing to go outside EAFE's borders and supplement their portfolios with opportunistic allocations to emerging markets — typically with larger companies from those economies. However, strategies indexed to the EAFE index average just a 3% to 4% allocation to small companies, mostly concentrated in only the largest of the small-cap stocks. International strategies oriented toward large-cap stocks outnumber those of small-cap stocks by nearly 10 to 1. Put simply, investors have not given the space the attention it deserves.

By ignoring international small cap, investors are leaving potentially attractive returns on the table. In the past 10 years, even a passive exposure to international small-cap stocks has outpaced a large-cap exposure by more than 300 basis points per year. The active opportunity for skilled investment managers makes the case even more compelling.

The potential for diversification from international equities tends to be overstated.

Large-cap international companies are, for the most part, companies that operate globally, in the same markets as large-cap U.S. companies. By contrast, small international companies tend to have less exposure to markets outside their own local economy. While large-cap companies tend to be closely tied to global economic growth, small-cap companies tend to be more exposed to their own economy.

These characteristics of international small companies help drive the lower correlation with large-cap U.S. equities. International small-cap stocks in the past 17 years had a 0.72 correlation with U.S. large-cap stocks compared with large-cap international, which had a 0.87 correlation. With lower correlation comes a greater benefit for investors seeking diversification.

Because they operate locally and on a smaller scale, small-cap companies are more idiosyncratic than large companies — they tend to behave uniquely. Being more levered to local economies and a smaller basket of products they sell, a small-cap stock's price behavior tends to be harder to explain with a factor model. Stock volatility not explained by a single-factor model increases as you go down the cap spectrum.

The idiosyncrasy of international small-cap stocks can also be seen when measuring stock level correlation by capitalization. By comparing the index return volatility with the average volatility of a stock in the index, we can estimate how similar the behavior is of the stocks within the index. Despite having higher average stock volatility, the small-cap indexes have similar index-level return volatility. The reason is because small-cap stocks have lower correlation with each other — they are more differentiated and behave more uniquely.

International small-cap stocks tend to behave on their own terms and less as a group. If active management and stock selection is be rewarded, we believe the rewards will be greater and more frequent in a place where stocks are behaving more uniquely — namely in international small cap.

While passive exposure to international small cap can benefit institutional investors, we believe the most compelling argument is driven by the superior returns available through active management. One reason for that is most of the companies have yet to be discovered. The average international small-cap company has only five sell-side analysts covering it (compared with 15 for large-cap companies) and more than 20% of the companies have no sell-side coverage at all (Exhibit 2).

This combination of high information inefficiency, high idiosyncratic behavior and low stock-level correlation enables skilled active managers to generate outsized excess returns for investors. Over the past 10 years, the average active international small-cap manager has added nearly 200 basis points over the better performing benchmark, while international large-cap managers have added just more than 50 basis points of value, according to our research.

Of course, along with the limited analyst coverage and inefficiencies in international small cap, there is also lower available liquidity, which drives the limited asset capacity of managers. Many large investment management firms avoid offering strategies in the space because of limited revenue potential, and great investment management teams can fill up their available capacity quickly — often closing international small-cap products somewhere below $1 billion in assets.

While this might make the managers harder to access, it has benefits for early adopters. Managers with smaller products are able to operate nimbly and tend to realize the best performance.

Looking at the performance of the available products segmented by their asset size, it's clear that smaller products outperform larger ones by a significant margin — more than 125 basis points annualized for 10 years.

Investors considering an allocation to international small cap should be mindful that there are challenges as well. These stocks can be less liquid, fees tend to be higher, and individual manager performance can appear volatile when looked at in isolation.

Lastly, perhaps the greatest obstacle to overcome is finding the appropriate capacity with strong investment teams that can take full advantage of the extensive opportunities to add value.

On balance, however, we believe the potential rewards easily outweigh the risks. International small cap now enjoys the same small-cap premium that has existed in the U.S. small-cap market, with perhaps even broader opportunities for skilled active managers to add value, while potentially improving the expected risk/return profile of the overall portfolio.