Small Stocks Offer Greater Diversification
When designing a portfolio, all else equal, we would prefer to add asset classes that have lower correlations. With that in mind, to see which international asset classes provide the greatest diversification benefits, we’ll look at the correlation data for both large and small stocks. The table below shows the annual correlations for the last 20 calendar years, January 1999-December 2018.
As you can see, the benefits of international diversification are greater when investing in small stocks versus large stocks. For example, the correlation of the S&P 500 Index to the EAFE Index was 0.86 versus 0.76 for the EAFE Small Cap Index. We see the same result when looking at the correlation of the S&P 500 Index to the MSCI Emerging Markets Index. For large stocks, it was 0.76 versus 0.70 for small stocks.
Because of their lower correlation and the higher expected returns of international small stocks (and even higher for small value stocks), you should consider including an allocation to them when constructing your portfolio. For example, using Dimensional indices, from 1990 through 2018, while the EAFE Index returned 4.4%, the Dimensional EAFE Small Cap Index returned 6.1% and the Dimensional EAFE Small Value Index returned 7.4%. Too many investors only include an allocation to the EAFE and Emerging Markets Indices.
The bottom line is that if you want to improve the diversification benefits of your international stocks, increase your exposure to small and/or small value stocks, both in developed and emerging markets. That will not only provide the benefits of reduced correlations, but greater exposure to the size and value premiums, which have been just as persistent and pervasive internationally as they have been in the U.S.
You can see the evidence on their returns in “Your Complete Guide to Factor-Based Investing.” Their higher expected returns also allow you to hold less equity risk overall, which historically has reduced the risk of drawdowns. For those interested in how using factor premiums can reduce tail risk, I recommend “Reducing the Risk of Black Swans,” 2018 edition.
We have one more point to cover. When thinking about the benefits of diversification, it’s important to understand that correlations are not the only thing that matters. As long as there’s a dispersion of returns (which there has been every year since 2008), there are diversification benefits.
Dispersion Of Returns
In 2009, we saw wide dispersion of returns. For example, while the S&P 500 was up almost 27%, the MSCI Emerging Markets Index rose 79%. And emerging market small-cap and value stocks produced even higher returns.
In addition, international large value and small value stocks as well as international real estate investment trusts (REITs) outperformed their domestic counterparts by wide margins. Note that while the correlations were positive, as all equity asset classes produced above-average returns, the world didn’t look flat in 2009.