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.