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

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 different story.  Many asset allocators will be surprised to learn that the total market value of the companies in the Russell Global ex-U.S. Small Cap Index is twice as large as that market capitalization of the Russell 2000 Index.

Source: FactSet as of 6/30/18. “U.S. Small-Cap” is represented by the Russell 2000 Index, and “International Small-Cap” by Russell Global ex-U.S. Small Cap Index. 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-cap would seem to merit consideration for inclusion in a globally diversified portfolio, however, the long-term performance record for international small-caps makes an even stronger and more compelling case for its inclusion as part of an overall equity allocation.

Note: The following results use as a starting point the first full month of performance for the Russell Global ex-U.S. Small Cap Index on 7/1/96. 

Annualized rolling monthly 10-year returns for the Russell Global ex-U.S. Small Cap Index versus both its large-cap sibling, the Russell Global ex-U.S. Large Cap Index, and its domestic counterparts in the Russell 2000 Index shows a clear advantage for the Russell Global ex-U.S. Small Cap Index. For additional context, we also looked at results for the large-cap Russell 1000 Index over these same periods.

International small-caps have additional attractive attributes beyond strong absolute and relative long-term performance, features that might be of particular relevance for asset allocators.

 

Averages of Monthly Rolling Annualized 10-Year Returns for Global Small Cap Indexes, 7/1/96 through 6/30/18.
 

Source: Factset.  U.S. large caps represented by the Russell 1000 Index. International large caps represented by the Russell Global ex-U.S. Large Cap Index  U.S. small caps represented by the Russell 2000 Index. International Small-Caps represented by the Russell Global ex-U.S. Small Cap Index.  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 & Higher Risk-Adjusted Returns

Like their domestic peers, international small-caps have a reputation for high volatility. Even in the context of strong performance, then, 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 demonstrated lower volatility than the Russell 2000 and only marginally higher volatility than the Russell Global ex-U.S. Large Cap Index, based on rolling 10-year standard deviation. Additionally, over this same rolling 10-year period, international small-caps also had the best risk-adjusted returns, as measured by Sharpe ratio, of these four asset classes. 

When considering the volatility of the international small cap index, we think it’s useful to recall that the index is composed of a globally diverse set of companies in 44 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 Russell Global ex-U.S. Small Cap versus the Russell 2000. Also helping to potentially reduce volatility is the prevalence of dividend-paying companies. Approximately 85% of the companies in the Russell Global ex-U.S. Small Cap paid dividends as of 6/30/18.

 

Risk/return tradeoff: Average of Monthly Rolling 10-Year Periods, 7/1/96-6/30/18.

Source: Factset.  U.S. large caps represented by the Russell 1000 Index. International large caps represented by the Russell Global ex-U.S. Large Cap Index  U.S. small caps represented by the Russell 2000 Index. International Small-Caps represented by the Russell Global ex-U.S. Small Cap Index.  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.

 

Averages of Monthly Rolling Annualized 10-Year Sharpe Ratio, 7/1/96 through 6/30/18.

Source: Factset.  U.S. large caps represented by the Russell 1000 Index. International large caps represented by the Russell Global ex-U.S. Large Cap Index  U.S. small caps represented by the Russell 2000 Index. International Small-Caps represented by the Russell Global ex-U.S. Small Cap Index.  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 valuable to be aware of the longer-term relative performance history. International small-caps have beaten their large- cap siblings in 76% of rolling three-year periods, 88% of rolling five-year periods, and 97% of rolling 10-year periods.

 

Periods of Outperformance by International Small Cap vs. International Large Cap Stocks, 7/1/96-6/30/18
 

Source: Factset. Analysis based on monthly rolling average annual return periods.  International large caps represented by the Russell Global ex-U.S. Large Cap Index. International Small-Caps represented by the Russell Global ex-U.S. Small Cap Index.  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

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 7/31/96-6/30/18, a span that yielded 252 periods.

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

 

Global Small-Cap vs Global Large Cap. Based on Monthly Rolling Trailing 1-year Periods from 7/1/96 through 6/30/18
 

Source: Factset.   International large caps represented by the Russell Global ex-U.S. Large Cap Index. International Small-Caps represented by the Russell Global ex-U.S. Small Cap Index.  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. This 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 scenarios shown above, the advantage went overwhelmingly to small-cap. We think the results of our research therefore present a strong argument for making a strategic allocation to international small-cap stocks.

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.