Robots Leave Money On The Table

September 04, 2014

Opportunity Costs: Lost Puzzle Pieces

My kids, even my teen, get disappointed when they can’t finish a puzzle because pieces have gone missing. They expect, after all that work, to see the whole picture. Yet investors who miss out on returns because of portfolio gaps often don’t see the gaps. But the costs of the missing pieces are real. Global investors who missed out on Canada or non-U.S. small-caps left up to 0.50 percent on the table in each of the past five years.

To measure the opportunity cost of excluding Canada and small-caps, I first compared 10 years of MSCI’s Canada index’s historical returns with those of MSCI’s EAFE, which includes all developed nations except Canada and the U.S. Then I compared the returns of MSCI’s developed ex-U.S. small-caps and MSCI’s emerging market small-caps with their MSCI Standard counterparts, which cover large- and midcaps.

See the opportunity costs table below for the results:

Canada Vs. EAFE Returns 5 Years
Annualized
10 Years
Annualized
MSCI EAFE Standard 10.25% 7.40%
MSCI Canada Standard 9.26% 10.90%
Canada opportunity cost (market weight) -0.09% 0.31%
     
EAFE Small cap vs EAFE Standard returns 5 years 10 years
MSCI EAFE Standard 10.25% 7.40%
MSCI EAFE Small Cap 13.90%  
EAFE Small cap opportunity cost (market weight) 0.51%  
     
Emerging Markets small caps vs Standard 5 years 10 years
MSCI EM Standard 7.82% 12.60%
MSCI EM Small cap 9.49%  
EM Small cap opportunity cost (market weight) 0.23%  

Data: ETF.com as of July 30, 2014

Including Canada at market weights in a developed-market portfolio would have added 0.31 percent to MSCI EAFE’s returns each year over the past decade.

Adding small-caps in proportion to their market weight would have boosted MSCI EAFE Index returns by 0.51 percent/year and MSCI Emerging Markets Index returns by 0.23 percent/year over the past five years.

These performance differentials will surely be different in the future. Indeed, Canada would have been a drag on EAFE performance for the most recent five years. The small-cap premium could fade out or reverse, or even expand. The takeaway here is not that Canada is the investment of the century, but that there is opportunity cost to excluding these exposures.

Clearly, we want to include Canada and the small-caps in our global portfolio. Let’s look again at our puzzle pieces, and rank our choices according to breadth of coverage.

All else equal, our ranked preference would be:

 

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