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.