International Small Cap Equity: Put Me in Coach, I’m Ready to Play
Investors have faced the quandary of determining the right mix of U.S. and non-U.S. equity portfolio exposures for decades, leaning on relative valuations, country perspectives and geopolitical crosscurrents as guides. This decision has consistently garnered heightened levels of investor attention given the somewhat cyclical outperformance profiles of both asset classes. Over time, international large cap strategies have mainly been employed by investors seeking developed market exposure outside of the United States. This dynamic has caused non-U.S. small cap equities to largely be overlooked by the investing public, resulting in understated realization of key advantages provided by the asset class. We believe international small cap equities warrant increased portfolio emphasis given a strong history of outperformance versus foreign large caps, historically lower levels of correlation to U.S. stocks, as well as higher levels of active manager outperformance within the space.
Joey Duffy, Director, Investment Specialist, explains why you shouldn’t ignore the International Small Cap asset class.
Non-U.S. economies make up over 75% of global GDP based on IMF 2021 estimates, however U.S. investors have maintained somewhat muted levels of international equity exposure over the last decade. In Figure 1, the chart to the bottom left shows that international equities currently represent only 23% of U.S. investors’ total equity exposure (as of 8/31/2021); this marks the lowest level experienced over the last decade. The chart to the bottom right indicates that within international equity exposures, international small/mid cap strategies have received underwhelming allocations. In fact, the average allocation since 2011 to international small/mid cap equities was only 3.4% of total international equity investment.
Figure 1. Source: Morningstar Direct
Despite generally widespread lack of investor attention, international small cap equities have quietly and consistently outperformed their foreign larger cap brethren. Figure 2 below shows the rolling 3YR excess returns of the MSCI EAFE Small Cap Index relative to the MSCI EAFE benchmark over the last 20 years. With the exception of timing around the global financial crisis (GFC) when investors sought the perceived safety of more mature businesses, international small caps have offered consistent positive excess returns versus the MSCI EAFE. In fact, the MSCI EAFE Small Cap Index has outperformed the MSCI EAFE in 166 of the represented 204 rolling 36-month windows, which equates to 81.4% of the time.
Figure 2. Source: Morningstar Direct
As investors consider non-U.S. equity investments, they often seek to maximize diversification benefits with current U.S. equity positions. International small caps have historically exhibited lower levels of correlation to U.S. stocks versus larger cap non-U.S. equities. The chart in Figure 3 below portrays the rolling 3YR correlations of the MSCI EAFE Small Cap and MSCI EAFE Indexes versus the Russell 3000 Index over the last 20 years. International small caps have exhibited lower levels of correlation to U.S. stocks versus international large caps in 171 of the represented 204 rolling 36-month windows (83.8% of the time).
Figure 3. Source: Morningstar Direct
This added diversification benefit could prove particularly important given the elevated levels of concentration and factor risk present within U.S. broad market indexes such as the S&P 500 and Russell 1000 Growth. In addition, international developed economies are exhibiting slower levels of growth deceleration versus the U.S. International small caps can provide more focused, pure-play exposure to potential stronger post-pandemic recovery dynamics embedded within these foreign markets.
Active managers have faced headwinds in asset classes such as U.S. large cap core equity, where a relatively elevated number of buy and sell side analysts has led to many investors viewing the segment as “too efficient”. International small cap equities tend to be less followed by buy and sell side analysts, which potentially enhances alpha edge within the space. This is exhibited within the chart below, which shows the percentage of active manager outperformance within eVestment’s U.S. Large Cap Core, EAFE Large Cap Core and EAFE Small Cap Equity peer universes over the 3YR, 5YR and 10YR annualized periods as of 6/30/2021. Only a third of active managers within the U.S. Large Cap Core Equity universe have outperformed across the three represented periods. Conversely, 61% of active international small cap managers outperformed over the 3YR and 5YR periods, while a staggering 84% of active international small cap managers registered positive excess returns over the 10YR annualized period. This is the strongest of the represented asset classes, signaling that the segment provides fertile ground for active outperformance.
Figure 4. Source: eVestment Analytics
As investors continue to weigh their U.S. versus international equity exposures, we believe the frequently overlooked international small cap equity space warrants increased attention. Despite only modest allocations across U.S. investor portfolios, international small caps have outperformed their foreign larger cap counterparts while offering generally lower levels of correlation to U.S. stocks. In addition, the space has proven advantageous for active managers in picking winners and evading losers, leading to more impressive levels of active outperformance relative to other asset categories over annualized time periods. Given these advantages, as well as a generally more favorable backdrop for non-U.S. markets, we recommend international small caps be called from the sidelines and considered for an expanded role across investor portfolios.
The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only.
Performance data shown represents past performance and is no guarantee of future results.
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