In many ways, the growth of passive investment strategies has been a game changer for institutional investors. What can be overlooked, however, is that exchange-traded funds and index funds are very often the wrong tool for the right job when it comes to portfolio construction.
The commoditization of international investing through passive funds, for instance, provides an easy and cheap way for U.S. investors to access foreign equities. But if the intent of the allocation is premised on diversification, asset owners might be disappointed to discover that there is far more correlation to domestic equities than they realize or desire. This, coupled with the uncertainty following the landmark vote by the U.K. to leave the European Union, is why so many institutional investors are again exploring actively managed strategies for their international exposures and focusing, in particular, on the small-cap segment as a source for alpha in a low-return environment.
Due to the idiosyncratic risk available through international small-cap stocks, the performance of the segment has more than doubled that of international large caps whether looking over a three-, five-, 10- or 15-year timeframe, through June 2016. On a calendar-year basis, international small caps also beat international large caps in seven of the last 10 years. As modern portfolio theory would predict, because international small-cap stocks are less correlated to U.S. stocks than international large caps, they also provide access to the differentiated return streams that improve overall diversification within a total plan portfolio.
While the Brexit vote drove some panic selling that affected the larger indexes, all the moving pieces and the sometimes-indiscriminate price adjustments in global markets present distinct buying opportunities for value-oriented stock pickers, whose conviction is reflected through a buy-and-hold strategy. And if there is any question regarding where the returns of active international small-cap strategies line up against passive alternatives, over a rolling three-year period since December 2008, the performance of the MSCI All Country World Index ex-U.S. Small Cap index has largely resided below the median when ranked against the comparable eVestment LLC active manager universe, showing a distinct downward trend in which the index’s performance has fallen into the bottom quartile for the past four years.