Commentary: Follow the data for non-U.S. equity allocations

Institutional investors are struggling to cope with a barrage of negativity this year. Inflation at 40-year highs, increasingly hawkish central banks set on quantitative tightening, war in Europe, China's war games in the Taiwan strait, a global energy crisis, plagues, inverted yield curves signaling recession, oil at $100 and elevated valuations create a palpable sense that there's nowhere to hide. Other than burying their heads in the sand, what can investors do to position themselves in the current market environment?

As value investors, we find it helpful to consider valuation in complex situations. U.S. equities, as represented by the S&P 500, lost about 20% in the first half of 2022, but based on earnings, book value, and EBITDA multiples, they are still quite a bit more expensive than non-U.S. equities as shown in the chart below.

But it's not just earnings and book value multiples that are more attractive in non-U.S. equities. Dividend yields, often considered an effective inflation hedge, are considerably higher in foreign stocks than they are in the U.S. And much like American tourists in Europe and Japan who are enjoying the strongest U.S. dollar in decades, U.S. investors can benefit from similar once-in-a-generation purchasing power due to U.S. dollar strength.

It's anyone's guess how the "parade of horribles" referenced earlier plays out; the energy crisis is hitting Europe and Japan harder than it is the U.S., but based on the valuation spread, quite a bit more "bad news" is already being discounted by non-U.S. equities, especially non-U.S. small caps. Timing may be difficult to predict, but history suggests this valuation gap will likely narrow from some combination of earnings normalization, mean reversion of valuation multiples and/or currency flows.

Investors should also avail themselves of one of the best risk management tools available: diversification. Admittedly, diversification arguments have lost some of their potency due to the sustained dominance of the S&P 500 index since the conclusion of the global financial crisis in 2010 and the headline-grabbing performance of "meme" and FAANG stocks. But 2022's year-to-date (through Sept. 30) results could generate renewed interest in uncorrelated assets.

One common approach to diversification is allocating to non-U.S. large caps due to their easy liquidity and perceived "safety." But this may not lead to desired outcomes because, in terms of stock returns, non-U.S. large-cap equities tend have higher correlations to U.S. equities than non-U.S. small caps.

And in terms of economic exposure, non-U.S. large caps get 46% of their sales from foreign sources whereas non-U.S. small caps get about 25% from foreign markets and 75% from local markets. If the goal of investing abroad is to gain exposure to non-correlated assets, non-U.S. small caps provide exposure to a wider variety of macroeconomic conditions and local markets than their non-U.S. large-cap counterparts.

But what's the point of investing in foreign small caps if they also introduce more risk?

Actually, and perhaps surprisingly, historical data suggest that focusing on small-cap vs. large-cap stocks might be a better idea from a risk-adjusted return perspective.

Non-U.S. small caps, especially non-U.S. small cap value equities, have broadly outperformed both non-U.S. large cap and non-U.S. small cap growth/core equities over longer market cycles. This is the classic small-cap premium that many investors recognize.

Perhaps more compelling for institutional investors is that these superior returns are generated with equal or lower risk compared to non-U.S. large caps.

The Sharpe ratio, a measure that incorporates standard deviation and excess return, is instructive here. The Sharpe ratio of developed market small caps is better (higher) than the same measure for developed market large caps on a 10-year horizon. Interestingly, the Sharpe ratio for the MSCI ACWI ex-U.S. Small Cap index, incorporating both developed and emerging markets, exceeds that of MSCI ACWI ex-U.S. Large Cap index over three-, five-, and 10-year time horizons.

In other words, the "riskier" the small cap, the better the relative Sharpe ratio. This is a powerful set of data, in our view.

Given the quantitative evidence in favor of greater non-U.S. small cap exposure, why are institutions seemingly underallocated to the asset class? We believe there are both structural and behavioral reasons.

It is certainly true that for pension funds with a mandate to invest tens or hundreds of billions of dollars, investing in sub-$1 billion market cap companies that often trade less than $1 million in volume per day can be a challenge. And despite a much larger opportunity set, there are only 163 funds investing in non-U.S. small-cap equities, versus 614 funds investing in U.S. small caps, according to eVestment. The implication is that active managers have a greater opportunity to generate returns based on this market inefficiency.

Liquidity is very much a chicken-and-egg problem in our view: Major institutions don't invest in non-U.S. small caps because there's limited liquidity and there's limited liquidity because major institutions don't invest in non-U.S. small caps. With improving technology, homogenization of global securities regulations, increasing global capital flows and prodding from a few pioneering consultants or institutions, non-U.S. small-cap investing could become just as mainstream for the institutional investors of tomorrow as U.S. small-cap investing has become over the last several decades.

Behavioral factors also are likely impacting allocation decisions — allocators are human after all. Home-market bias, the tendency to favor the familiar over the foreign, is very likely a reason why domestic equities, measured as a share of total equities in a pension fund's portfolio, are over 60% and rising for U.S. pension plans, even though the U.S. makes up only about 25% of global gross domestic product. It may very well be the case that U.S. investors also view non-U.S. small caps with the same volatility lens as U.S. small caps and are precluding a larger allocation despite compelling diversification benefits due to the same home-market bias.

Recency bias, the tendency to extrapolate recent events into the future, and confirmation bias, the tendency to favor arguments or data favorable to one's preconceived notions, have also likely helped propel U.S. equities, especially mega-cap tech stocks, to what appear to be unsustainable valuations relative to other global equity asset classes. These emotion-driven tendencies tend not to change with facts or logic and will likely only change when prevailing narratives change.

Recent market turmoil will likely spark lively asset allocation debates in upcoming quarterly performance reviews.

Pension fund investment committees should, in our view, consider rebalancing existing allocations from areas of the market that have significantly outperformed over the past decade and into areas that have significantly underperformed. Taking advantage of the purchasing power afforded by U.S. dollar strength, rotating to non-U.S. small-cap equities is one strategy to diversify, and likely improve overall risk-adjusted returns, when compared to traditional non-U.S. large-cap equity exposure.

Waldemar Mozes is director of investments at Cedar Street Asset Management LLC, a non-U.S. small-cap equities manager, based in Chicago. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.