When you consider diversifying a portfolio across equities, some areas are more popular than others. Growth and value stocks, large and small companies, and international markets are key categories.
One asset class that is often overlooked — and omitted — is international small-cap stocks.
We think this is a missed opportunity. International small caps offer diversification potential and a category where active managers can shine.
In this brief update, we’ll share two key insights from a recent analysis by our team. We found that international small caps may offer:
- Earnings that are non-correlated with other equity asset classes
- An inefficient universe, with potential for active managers to outperform indexes
Non-correlated earnings can enhance diversification benefits
Building a well-diversified portfolio means combining investments in asset classes that have low correlation. When we make the case for non-U.S. small caps, we can take the low correlation argument a step further by looking at company earnings, not just stock performance.
International small caps offer a different source of potential earnings to a U.S.-based investor. Just as U.S. small caps are more geared to the U.S. economy, international small caps are tied more closely to their local economies. They serve different customers and operate in different macroeconomic environments.
Let’s look at the earnings correlations. We analyze the earnings correlation of four equity asset classes — U.S. large and small caps and non-U.S. large and small caps — over 20 years. Non-U.S. small cap earnings had the lowest correlation to the earnings of every other equity asset class during this timeframe.
An inefficient universe for active managers
At a recent company annual meeting, Charlie Munger, Vice Chairman of Berkshire Hathaway, offered this thought to a group of investors: “The first rule of fishing is to fish where the fish are. Some places have lots of fish, and you don’t have to be a good fisherman to do pretty well. Other places are so heavily fished that no matter how good a fisherman you are, you aren’t going to do very well.”
We believe the international small-cap category offers one of the best ponds for active managers to fish in. It is an inefficient universe, with a median of three sell-side analysts covering each stock, compared with a median of 20 analysts covering U.S. large caps. At the same time, it has a wider variety of opportunities and regions, with thousands more stocks than the S&P 500 Index or the Russell 1000 Index.
It’s time to consider international small caps
We believe that when you build a diversified portfolio, you should consider the possible diversification benefits of non-U.S. small caps. They can help build a more robust portfolio that is less tied to the ups and downs of the U.S. market. Furthermore, this universe is large and inefficient, with thousands of stocks. Active managers who can do research in this universe and follow a careful investment process can find a variety of opportunities to outperform benchmarks.
In our analysis, we use indexes to represent the asset classes: the S&P Developed ex-U.S. Small Cap Index for non-U.S. small-cap equity, the MSCI EAFE Index for non-U.S. large-cap equity, the S&P 500 Index for U.S. large-cap equity, and the Russell 2000 Index for U.S. small-cap equity.
Past performance is not a guarantee of future results. Indexes are not managed and do not incur expenses.
References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, goodfaith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change.
Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
The S&P Developed Ex-U.S. SmallCap Index is an unmanaged index of small-cap stocks from developed countries, excluding the United States.
The S&P 500 Index is an unmanaged index of common stock performance.
The Russell 2000 Index is an unmanaged index comprised of approximately 2,000 of the smallest companies in the Russell 3000 Index as measured by their market capitalization.
The MSCI EAFE Index (ND) is an unmanaged index of equity securities from developed countries in Western Europe, the Far East, and Australasia.
Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company.
You cannot invest directly in an index.
Consider these risks before investing: The value of investments in the fund’s portfolio may fall or fail to rise over extended periods of time for a variety of reasons, including general economic, political, or financial market conditions; investor sentiment and market perceptions; government actions; geopolitical events or changes; and factors related to a specific issuer, geography, industry, or sector. These and other factors may lead to increased volatility and reduced liquidity in the fund’s portfolio holdings. International investing involves currency, economic, and political risks. Emerging-market securities carry illiquidity and volatility risks. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Growth stocks may be more susceptible to earnings disappointments, and value stocks may fail to rebound. Risks associated with derivatives include increased investment exposure (which may be considered leverage) and, in the case of over-the-counter instruments, the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations. Our investment techniques, analyses, and judgments may not produce the outcome we intend. The investments we select for the fund may not perform as well as other securities that we do not select for the fund. We, or the fund’s other service providers, may experience disruptions or operating errors that could have a negative effect on the fund. You can lose money by investing in the fund.