Putting International Small-Caps on the Map

Putting International Small-Caps on the Map

The case for a strategic allocation to international small cap is well supported by historical data.

A Large Opportunity in International Small-Caps

Considering that less than 1%1 of mutual fund assets in the U.S. are invested in small-caps outside the U.S., we suspect that many asset allocators think of international small-caps (if they think of them at all) as a nearly indistinguishable subset of the large non-U.S. equity universe. If this is correct, international small-caps would seem to be facing an uphill climb toward recognition as an accepted asset class, much like their stateside cousins did more than two decades ago.

However, the facts tell a story that should level that hill. Many asset allocators will be surprised to learn that the total market value of the companies in the MSCI ACWI ex USA Small Cap Index, our proxy for international small-caps, is twice as large as that market capitalization of the Russell 2000 Index.

Compared with U.S. small-caps, there are:

 

Source: FactSet as of 3/31/19. ”U.S. Small-Cap” is represented by the Russell 2000 Index, and “International Small-Cap” by the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Small Cap. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Strong Long-Term Relative and Absolute Performance

By market value alone, international small-caps would seem to merit consideration for inclusion in a globally diversified portfolio. However, their performance record makes an even stronger case for its inclusion as part of an overall equity allocation. (All of the results that follow begin with the first full month of performance for the MSCI ACWI ex USA Index on 5/31/94).

Annualized rolling monthly 10-year returns for the international small-cap index exceeded the MSCI ACWI ex USA Large-Cap Index (our proxy for international large-cap stocks), and nearly matched its domestic counterpart in the Russell 2000. For additional context, we also looked at results for the large-cap Russell 1000 over these same periods.

Beyond this strong relative long-term performance record, international small-caps have additional attractive attributes that might be of particular relevance for asset allocators.

Averages of Monthly Rolling Annualized 10-Year Returns 


Source: FactSet as of 3/31/19. Analysis based from MSCI ACWI Index’s inception (first full month ended 5/31/94) through 3/31/19. U.S. Large-Cap” is represented by the Russell 1000 Index, “International Large-Cap” by Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Large Cap, “U.S. Small-Cap” is represented by the Russell 2000 Index, and “International Small-Cap” by the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Small Cap. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Lower Volatility and Higher Risk-Adjusted Returns

Like their domestic peers, international small-caps have a reputation for high volatility. Even in the context of strong performance, more cautious asset allocators might not consider an investment for fear of taking on an unacceptable level of risk for their clients. The data, however, supports a very different conclusion.

In fact, international small-caps have lower volatility than the U.S. small-caps and only marginally higher volatility than international large-caps, based on rolling 10-year standard deviation.2

When considering the volatility of the international small-cap index, we think it’s useful to recall that it is composed of a globally diverse set of companies in 46 countries that rarely occupy the same place in their respective economic cycles. This geographic diversification helps to dampen the price volatility of any specific security, and in our view, compensates for the lower average market cap for the international small-cap index versus U.S. small-cap index. Also helping to potentially reduce volatility is the prevalence of dividend-paying companies. Approximately 86% of the international small-cap index paid dividends as of 3/31/19.3

 

Attractive Risk/Return Trade-Off

Source: FactSet as of 3/31/19. Analysis based on the average of rolling 10-year periods from the Index Inception (5/31/94) through 3/31/19. U.S. Large-Cap” is represented by the Russell 1000 Index, “International Large-Cap” by Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Large Cap, “U.S. Small-Cap” is represented by the Russell 2000 Index, and “International Small-Cap” by the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Small Cap. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Additionally, over this same rolling 10-year period, international small-caps tied with small-caps for the best risk-adjusted returns, as measured by Sharpe ratio4, of these four asset classes.

 

Monthly Rolling Average Annualized 10-Year Sharpe Ratios

Source: FactSet as of 3/31/19. Analysis based from the Index Inception (5/31/94) through 3/31/19. U.S. Large-Cap” is represented by the Russell 1000 Index, “International Large-Cap” by Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Large Cap, “U.S. Small-Cap” is represented by the Russell 2000 Index, and “International Small-Cap” by the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Small Cap. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Persistence in Beating Large-Caps

Because many investors split their international equity allocation between small- and large-cap stocks, we think it’s important to be aware of the longer-term relative performance history. International small-caps have beaten their large-cap siblings in 71% of rolling three-year periods, 81% of rolling five-year periods, and 94% of rolling 10-year periods.

 

Periods of Outperformance by International Small Cap vs. International Large Cap Stocks

Source: Factset, as of 3/31/19. Analysis based on monthly rolling average annual return periods from the Index Inception (5/31/94) through 3/31/19. International Large-Cap” is represented by the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Large Cap and “International Small-Cap” by the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Small Cap. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

International Small-Cap Results in Different Environments

Analyzing monthly trailing one-year returns from 5/31/94-3/31/19, which consists of 284 periods, we found that while international small-caps outperformed large-caps over most rolling time periods, there were market conditions in which the performance spread was greater than others. We analyzed monthly trailing one-year data from 7/31/96-9/30/18, a span that yielded 255 periods.

We first examined both positive and negative return periods for the international all-cap index to see how non-U.S. small-caps performed versus their large-cap peers. The result was a relative advantage for the international small-cap index in both negative and positive return periods for non-U.S. stocks. We then broadened our scope, examining returns for the international small- and large-cap indexes when the 10-year German Bund yield was rising and falling:

 

International Small-Cap vs International Large-Cap in Different Market Environments

Source: Factset, as of 3/31/19. Analysis based on monthly rolling trailing 1-year periods from the Index Inception (5/31/94) through 3/31/19. International Equity” is represented by the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Investable Market Index, “International Large-Cap” by the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Large Cap and “International Small-Cap” by the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Small Cap. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

International small-caps outperformed their large-cap counterparts in both rising and falling rate environments, but the absolute return level and relative return spread were each significantly different. The best results for U.S. dollar investors came when German Bund Yields were rising, which is possibly due to three overlapping factors: bond yields usually rise when economies are improving, international small-caps have more cyclical exposure than international large-caps, and rising Bund Yields often occur in periods of U.S. dollar weakness, resulting in enhanced gains for U.S. dollar investors.

In each of the four scenarios shown above, the advantage went to international small-cap. We think the results of our research therefore present a strong argument for making a strategic allocation to this asset class.

The Current Opportunity

Among the other compelling reasons to consider allocating to international small-caps is the timeliness of the opportunity. Over the long-term, international small-caps and U.S. small-caps have experienced rotating periods of outperformance with minimal long-term difference between the indexes. However more recently, international small-caps have underperformed which we think has increased the probability for future international outperformance.

It’s worth mentioning that when non-U.S. stocks as a group outpaced their domestic cousins, international small-cap outperformed their large-cap peers 80% of the time—and by an average spread of 6.2%—for all monthly rolling one-year periods from 5/31/94 through 3/31/19.5

The historical data suggests, then, that relatively good periods for international stocks mean relatively better periods for international small-caps. So while there is no guarantee of the course of future returns, we think the long-term performance history of the two small-cap indexes suggests that a multi-year run for international small-caps is possible. In our view, this is especially relevant when evaluating the opportunity in non-U.S. small-caps.

The Case for Active Management in International Small-Caps

Do the attractive attributes of international small-caps also offer the potential for active managers to improve on these results? We believe they do, based on the following:

  • A Large and Diverse Asset Class There are more than twice as many international small-caps as domestic small-caps, providing ample opportunity for active managers to search for mispriced stocks. Further, international small-caps offer access to local, regional, and global businesses hailing from a diverse group of 46 countries.
  • An Inefficient Asset Class More than 30% of the companies in the MSCI ACWI ex USA Small Cap were receiving one or no sell-side analyst coverage versus 15% for those in the Russell 2000 as of 3/31/19.6 This provides an active manager with a potentially sizable analytic advantage.
  • High ROIC6 Companies Historical returns of the international small-cap index’s high-profitability companies, based on ROIC, have markedly exceeded those for the index as a whole. The average annual total return for the top ROIC decile of non-U.S. small-cap stocks was 16.2% from 1/31/03-3/31/19, compared to 10.6% for the overall index over the same period.7 This suggests to us that an active management approach focusing on companies with higher profitability and sustainability can enhance the potential for higher returns.
  • Companies with Earnings Loss-making international small-cap companies have historically lagged. In fact, companies with positive earnings have outperformed the international small-cap index, gaining 12.6% versus 10.6% on an average annual total return basis from 1/31/03-3/31/19.8 A manager who focuses on non-U.S. small-caps with established histories of earnings may therefore also be able to potentially enhance returns.
Conclusion

We think that the combination of strong absolute and relative performance, low correlation to both international large-caps and U.S. small-caps, and strong results in a number of different market environments makes a very strong case for including international small-caps in a globally diversified portfolio. In our view, the timeliness of the opportunity serves to bolster an already compelling case. We suggest that asset allocators consider the potential advantages active management can offer within the asset class based on both the historical strength of certain fundamentals and the overall inefficiency of this large and diverse group of small-cap stocks.


Index definitions:

The MSCI All Country World Ex USA Investable Market Index captures the global equity investment opportunity set across size, style and sector segments in 45 Developed and Emerging Markets, excluding the United States.

The MSCI ACWI ex USA Large Cap Index is an unmanaged, capitalization-weighted index of global large-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income.

The MSCI ACWI ex USA Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income.

The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approxi mately 92% of the total market capitalization of the Russell 3000 Index.

The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.

Footnotes:

1 Source: Morningstar, as of 3/31/19.

2 Standard deviation is a statistic used as a measure of the dispersion or variation in a distribution, or dataset, from its mean, or average; it measures the volatility of an investment’s return over a particular time period; the greater the number, the greater the volatility.

3 There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

4 Sharpe ratio is a risk-adjusted measure of investment return. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.

5 Source: Factset, as of 3/31/19.

6 Return on Invested Capital is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock).

7 January 2003 is the first month which Royce has access to fundamental data on MSCI indexes.

8 Source: FactSet as of 3/31/19.

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