Investment Strategies

International Small Cap Equities: Invest in the Asset Class

International small caps provide diverse exposure to regional economies across the globe. Many portfolios are missing this diversifying asset class. North Square explores its potential advantages.

Contents:
  1. Little Stocks in a Big World
  2. Under Allocation
  3. Two Sides of the Same Coin
  4. Enhanced Portfolio
  5. Actionable Steps

Regardless of where a portfolio is invested, equity portfolios are now global. Many equity portfolios hold companies that operate globally, giving their investors exposure to multiple global regions, across various currencies, and subject to various global economic growth regimes.

The largest and most global of companies, however, are diversified enough such that some of the unique international exposures are not as pronounced. Smaller non-U.S. companies tend to be more reliant on their home markets and thus offer U.S. investors access to a uniquely international return and risk profile. Considering the rapid rise of information, investing in these smaller, foreign-based firms is accessible. As a result, investors now have diversification opportunities through direct, specific exposure to smaller foreign companies.

Based on added value and diversification benefits, we believe that many investors should increase international small cap allocations to 5-10% of their equity portfolios, depending on individual circumstances and risk tolerance.

Little Stocks in a Big World

For purposes of this post, we define international small cap stocks as developed-market, foreign country stocks with a market cap of generally below $6 billion. The most common benchmark used for this universe is the MSCI EAFE Small Cap Index which includes about 2,200 constituents in 20 countries across Europe, Australasia and Far East (EAFE).

With exposure to developed international markets, investors have also recognized the need to invest in emerging markets, although most often through large cap stocks. The MSCI Emerging Markets Index tracks the performance of primarily large and mega cap stocks in developing countries in Asia, Eastern Europe and South America.

While this aim towards diversification abroad is grounded in good practice, it still leaves a hole in many investor portfolios’ allocation to international small cap stocks.

Figure 1

Many investors use the MSCI EAFE Index to guide their primary and perhaps only allocation to international stocks. Whether in the form of ETFs or actively managed strategies based on this index, it misses multiple important asset classes. Left out are international small caps, emerging markets, Canadian stocks and for those looking for true global diversification, frontier or more nascent economies in Africa and Asia (Figure 1). Asset allocations in all U.S. equity mutual funds by broad equity category using Morningstar data, show a striking imbalance.

Figure 2

Total net assets in foreign large cap funds far surpasses foreign small/mid funds, according to Morningstar data (Figure 2). As of 12/31/2018, U.S. open-end foreign large funds had $1.3 trillion in assets, compared to $82 billion in foreign small/mid funds. Total assets in diversified emerging markets funds, again large-cap focused, totaled $335 billion, more than four times international small cap assets. Breaking a portfolio’s foreign allocation into multiple, strategic weightings can diversify returns across time periods and through global market cycles.

Figure 3

Is this under-allocation a missed opportunity?

Portfolios have become more global and therefore affected, even if indirectly, by worldwide market fluctuations. Although the U.S. investable market dominates the globe in terms of market cap value of any single country, developed-market foreign small caps are as large of an investment opportunity as U.S. small caps. The MSCI EAFE Small Cap has a total market value of about $2.1 trillion, while the broad Russell 2000 Index has a market value of $1.8 trillion. There are slightly more constituents in the MSCI EAFE Small Cap than the Russell 2000 as well, about 2,200 compared to about 1,900.

No well-planned and diversified portfolio would be without a U.S. small cap allocation and accordingly, under-allocation to international small caps is a potential risk and missed opportunity.

Two Sides of the Same Coin

The S&P 500 and MSCI EAFE—two large cap indices generally thought of as measures of the U.S. and international markets, respectively—are comprised of globally-operating companies. Over a 10 year period, the correlation between the S&P 500 and MSCI EAFE is around 0.9 which is considered strong. As a small cross-section, the top five companies in each index have similar geographic revenue exposure (Figure 4).

Figure 4

Large multi-national companies that have established far-reaching global operations are often exposed to the same broad global economic cycles, whether they are U.S. headquartered or internationally-based. As we often see in the news, corporate tax schemes and foreign holding companies make this even murkier. To get true international exposure, an allocation to international small cap stocks is important.

Enhanced Portfolio Allocation

In an investment portfolio of these two indices, the MSCI EAFE and MSCI EAFE Small Cap, the historic risk/reward characteristics are apparent over the long-term. Figure 5 shows that over a 10-year period, the various return and standard deviations depending on the allocation between the two indices.

Figure 5

The return comparison over the historical 10-year period for a 50%-50% allocation between the two indices against a 100% large cap MSCI EAFE allocation is resounding. Returns were 33% higher, while the risk as measured by standard deviation increased by just 0.2%.

Figure 6

The same trend can be seen with the Sharpe ratio of the indices over the 3, 5 and 10 year trailing periods (Figure 6).

Actionable Steps

The direct allocation to international small caps in a portfolio takes advantage of the increased investment opportunity outside the U.S. Beyond large global company investments there are smaller, regional and country-based companies that provide unique exposure to growing pockets of the global economy. Active management also provides potential alpha opportunity compared to the index over various historic time periods. Most importantly, broader diversification in a portfolio may add to the risk-adjusted performance through multiple global economic and market cycles.

Figure 7

In Summary
  • Review existing client portfolio allocations to international strategies.
  • Consider re-allocating to international small cap from international large cap or emerging markets, depending on risk tolerance.
  • Contact North Square Investments for more helpful insights.

Important Risks: Equity securities, such as common stocks, are subject to market, economic and business risks that may cause their prices to fluctuate. Investments made in small capitalization companies may be more volatile and less liquid due to limited resources or product lines and more sensitive to economic factors. The Funds may invest in foreign securities which involves certain risks such as currency volatility, political and social instability and reduced market liquidity. Emerging markets may be more volatile and less liquid than more developed markets and therefore may involve greater risks. The Funds may invest in ETFs (Exchange-Traded Funds) and is therefore subject to the same risks as the underlying securities in which the ETF invests as well as entails higher expenses than if invested into the underlying ETF directly.

Before investing, consider the product’s investment objectives, risks, charges and expenses. This and other information is in the prospectus, a copy of which may be obtained by calling 855-551-5521. Please read the prospectus carefully before you invest.

The MSCI EAFE Index measures the performance of large cap international stocks. The MSCI EAFE Small Cap Index measures the performance of small cap international stocks. The MSCI Emerging Market Index captures large and mid cap stocks across emerging market countries.

Distributed by IMST Distributors, LLC.

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