International Small Cap: A Distinct Asset Class?

Frank Nielsen, CFA
November 01, 2007

Cover photoOver the last five years, the international small-cap category has outperformed the mid- and large-cap segment by 7 percent per year, as measured by the Provisional MSCI EAFE indexes. During the same period, U.S. institutional assets invested in international small-caps have more than tripled.1

International equities have been seen by many investors as a distinct asset class offering diversification benefits combined with attractive risk and return characteristics. However, globalization and more integrated financial markets have led to an increase in correlations across developed markets, reducing the diversification benefits traditionally associated with international investing.2

As U.S. equity owners have begun to allocate higher percentages of their assets into international small-cap—either via explicit small-cap mandates or mandates that opportunistically invest in small-caps—one important question to ask is whether international small-cap should be treated as a separate asset class in the context of the global policy portfolio. This paper attempts to address that question by looking at the differences between international small-cap and mid- and large-cap companies. In particular, we will focus on answering three questions:

1. Have international small-cap stocks exhibited systematically different performance and diversification benefits compared with larger-cap stocks?
2. Does investing in international small-cap suggest a fundamentally different investment process?
3. How should an international small-cap benchmark be constructed?

In the first section, we compare the historical performance and diversification characteristics of the Provisional MSCI Small Cap Indices with the Provisional MSCI Standard Indices.3 Globally, the small-cap segment underperformed during the technology and large-cap boom in the 1990s, but started outperforming the MSCI Standard Indices in 2000. Interestingly, this behavior was observed across regions—an indication of a global size effect. During this period, the risks of the international and regional small-cap indexes were higher than their standard index counterparts. In addition, correlations between the small cap and standard indexes increased outside Asia in recent years, reducing the diversification benefits at the aggregate index level.

In the second section, we evaluate and compare small-cap characteristics in greater detail. The focus is on understanding the relative importance of global sectors versus countries, and analyzing the differences in return dispersion across the two segments. The characteristics are sufficiently dissimilar to consider separating the two size segments and to employ different investment processes. The consistently higher return dispersion of the Provisional MSCI Small Cap Indices, driven by idiosyncratic or company-specific returns within the segment, supports the idea that active management, and in particular fundamental stock picking, may offer more opportunities in international small-cap investing than in the more homogenous large-cap space.

In the third section of this paper, we analyze some implementation challenges of international small-cap mandates and review the question of passive versus active investing in that space. We also review the key methodology elements that need to be present in a small-cap index in order to ensure that the index can serve as a relevant performance benchmark.

Historical Risk And Return Characteristics

Historically, international small-cap stocks have shown attractive correlations for U.S. investors, adding more diversification than investments in other segments within the U.S. equity market. Figure 1 shows the correlation from May 1996 to May 2007 between the Provisional MSCI USA Standard Index and the Provisional MSCI USA Small Cap Index, the average of the provisional small-cap country indexes, and the average of the U.S. sector indexes. Investing in the aggregated U.S. small-cap segment represented by the provisional MSCI USA Small Cap Index would not have added diversification given the correlations between 80 and 90 percent. Correlations with the average U.S. sector index varied over time and recently exhibited similar diversification potential as the average small-cap country index.

Figure 1


1 "Implementation Challenges in International Small Cap," InterSec, February 2006.

2 See "In Search of Global Diversification: Developed and Emerging Markets," Frank Nielsen and Anton V. Puchkov, MSCI Barra Research Insights, Spring 2006.

3 The Provisional MSCI Standard Index consists of the Provisional MSCI Mid plus Provisional MSCI Large Cap indexes.