International equities and domestic small-cap equities are essential parts of an efficient diversified investment strategy, but what about international small-cap equities? In this article we’ll take a look at world small caps as an asset class and offer several reasons for considering their inclusion in your portfolio.
As you weigh up this information, it’s important to remember that small-cap stocks typically carry higher risk than large cap companies and that extra risk is associated with foreign investments. As a result international small caps are best suited to investors with a longer time horizon and higher tolerance for risk.
The sector is large and its long-term relative historical performance has been strong: Over 90% of the world’s companies are considered small cap, and over the long term, MSCI World Small Caps have historically performed better than both domestic and international large caps.
World Small Caps can be an effective diversification tool: Historically, they have had a low correlation to the U.S. large-cap market, and they can offer exposure to areas not typically covered by a non-U.S. equity mandate.
Small-cap stocks tend to be under researched, with significantly less sell-side coverage.
This, along with the asset class’s generally lower liquidity and higher price volatility, can lead to greater inefficiencies in valuations and thus provide potentially better trading opportunities.
What Are International Small Caps?
International small-cap stocks are defined as those companies outside the United States with market capitalization of US$2 billion or less. Over 90% of the world’s companies are considered small cap. The MSCI World Small Cap Index includes over 4,000 stocks.
There are several strong reasons for adding international small caps to your portfolio.
• Historical Long-Term Relative Performance
• Historical Risk vs. Return
• Diversification Potential
• Inefficient Pricing Can Produce Greater Stock picking Opportunities
• Valuations Remain Attractive to Templeton
• Historical Resilience in Weak Economic Environments
Historically International Small Caps Outperform U.S. Small Caps
Over the long term, small caps have outperformed large caps on a global basis. Although historical performance is no guarantee of future results, over the past 17 years, the MSCI World Small Cap Index outperformed the MSCI World Index by 3.02%.
As usual there is a cost for these higher returns, international small caps can and do suffer more volatility than their domestic large cap counterparts. In 2008 the MSCI World Small Cap Index suffered a loss of over 40%. It should be noted however, that international small caps have proven to be much less volatile than their domestic small cap counterparts.
Diversification is what you need
Research shows international small caps have maintained a correlation gap with U.S. broad-market benchmarks over the long term despite the influence of globalization. International small caps tend to be more domestically oriented and, consequently, their correlations to the S&P 500 Index have not yet compressed to the same degree that other assets have in recent years.
Although the short-term correlations of equity assets have generally tightened further during the last several years, international small-cap stocks may continue to offer meaningful diversification opportunities. Please keep in mind that diversification does not guarantee a profit or protect against a loss.
Inefficient Pricing Creates Investment Opportunities
In general, small-cap stocks are under researched, with significantly less coverage than big caps. This factor, along with the asset class’s generally lower liquidity and higher price volatility, can lead to greater inefficiencies in valuations and thus provide potentially better opportunities for identifying mis-pricing. Of all the companies listed on the MSCI World Small Cap Index, 17.6% do not have any analyst coverage at all, whilst 24.2% had three or fewer covering analysts.
In short investing in international small caps could prove to be very lucrative. They have consistently shown strong growth over the past ten years and there is no reason to suggest that isn’t going to be the case going forward.
They’re significantly less volatile than their domestic counterparts, but show around the same level of growth over a ten year period. If you can’t stomach the large ups and downs of the small cap market, you could consider adding international small caps instead. Don’t be fooled into thinking that you won’t receive and volatility though, because you will.
To learn more about trading MSCI world small caps, sign-up for an account over at OptionsHouse, where for a limited time new customers receive 100 free trades. You’ll also receive an exceptional range of tools to help you find the best performing small cap funds over the last ten years.