PRICE PERSPECTIVE June 2016 In-depth analysis and insights to inform your decision-making. Global Investing DIVERSIFYING INTERNATIONAL EQUITY ALLOCATIONS WITH SMALL-CAP STOCKS EXECUTIVE SUMMARY International small-cap equities represent a wide, evolving, and generally underinvested opportunity set compared with traditional international equity universes represented by benchmarks such as Morgan Stanley Capital International s Europe, Australasia and the Far East Index (MSCI EAFE) and the MSCI All Country World Index (ACWI) ex USA. Som Priestley, CFA Research Consultant Over longer time periods, international small-cap equities historically have provided superior absolute and risk-adjusted returns relative to other major international equity classes. The asset class also presents additional portfolio diversification opportunities, as it has shown relatively low correlation with other equity markets and features country and sector exposures that differ considerably from traditional international equity benchmarks. The international small-cap space features wider breadth than the traditional international equity benchmarks. The USA Small Cap Index, for example, includes more than 4,300 companies, compared with just 926 in the MSCI EAFE Index. 1 This breadth as well as the relatively idiosyncratic nature of international small-cap returns may provide significant opportunities for active managers to add value through stock selection. Analyst coverage of the international small-cap universe is still relatively limited, and the asset class historically has shown greater variability of regional and economic sector returns compared with traditional international benchmarks. These traits also could potentially enhance the ability of active managers to add value. Our analysis suggests that, over the past 10 years of market history, combining traditional international and international small-cap mandates in a 60/40 mix could have improved both absolute and risk-adjusted returns relative to a traditional international allocation tied to the MSCI EAFE Index. International small-cap stocks represent a large, compelling, but surprisingly underutilized, opportunity set for global equity investors. The MSCI EAFE Small Cap Index includes almost 2,200 stocks available for investment, while the MSCI ACWI ex USA Small Cap Index offers more than 4,300 companies. All told, international small-cap stocks make up almost 70% of the investable international developed equity universe, yet there are only 125 institutional investment strategies active in the international small-cap universe, versus 523 in the international large-cap space. 2 1 2 Based on the combined number of securities in the MSCI EAFE Small Cap Index (2,195) and the MSCI EAFE Index (926) as of December 31, 2015. Product count is based on evestment calculations as of September 30, 2015.
In our view, including international smallcap equities in an institutional portfolio not only has the potential to improve diversification, but also could enhance long-term returns by providing exposure to smaller, more idiosyncratic companies that are more closely tied to the economic environment in their country and/or region. While many global largecap firms generate a significant portion of their revenues internationally, smaller companies are much more reliant on their local economies to generate earnings, and thus may enhance geographic diversification. Figure 1 below compares some of the key characteristics of the major traditional FIGURE 1: Comparison of Selected International Equity Benchmarks All Data as of December 31, 2015 Index MSCI EAFE USA USA Small Cap MSCI Emerging Markets Source: MSCI. Description cap-weighted index designed to measure the performance of developed equity markets excluding the U.S. and Canada. cap-weighted index designed to measure the performance of developed and emerging equity markets excluding the U.S. cap-weighted index designed to measure the performance of developed and emerging small-cap equity markets excluding the U.S. cap-weighted index designed to measure the performance of emerging equity markets. Index Holdings Median Market Cap ($US Millions) Dividend Yield Countries In Index 926 $6,212 3.2% 21 Developed 1,858 3,820 3.2 4,303 371 2.4 22 Developed 23 Emerging 22 Developed 23 Emerging 838 2,098 2.8 23 Emerging FIGURE 2: Selected Equity Index Returns and Standard Deviations Index Annualized Return Standard Deviation International Indexes 1 Year 3 Years 5 Years 10 Years 3 Years 5 Years 10 Years USA -5.2% 1.9% 1.5% 3.4% 12.3% 15.0% 19.1% USA Small Cap 2.6 5.6 2.6 5.0 11.5 14.8 20.6 MSCI Emerging Markets -14.9-6.5-4.6 3.9 14.3 17.8 23.6 US Indexes Russell 3000 0.5 14.7 12.2 7.4 10.7 12.1 15.6 Russell 1000 0.9 15.0 12.4 7.4 10.6 11.9 15.3 Russell 2000-4.4 11.7 9.2 6.8 14.2 15.9 19.8 Sources: MSCI and Russell. Past performance cannot guarantee future results. international benchmarks with the MSCI ACWI ex USA Small Cap Index. 3 ATTRACTIVE RETURNS AND LOW CORRELATIONS Overall, international small-cap stocks, as measured by the USA Small Cap Index, held up relatively well across the previous 10 years. The benchmark outperformed the MSCI ACWI ex USA Index and the MSCI Emerging Markets (EM) Index on both an absolute and risk-adjusted basis over the periods shown in Figure 2 below. Note that the USA Small Cap Index posted higher 3-year, 5-year, and 10-year annualized returns than the MSCI Emerging Markets Index, but with considerably less volatility. It is true that U.S. equity benchmarks, including U.S. small-cap benchmarks, substantially outperformed international small-cap equities over the 3-, 5-, and 10-year periods shown in Figure 2 although with varying degrees of relative risk. However, the relatively low correlations between the international small-cap equity universe and other equity markets, including U.S. equities, still justify including international smallcap stocks in an institutional portfolio, in our view. Evidence of this diversification potential can be found in the fact that over the 10 years ending December 31, 2015, international small-cap equities showed a lower correlation (.85) with U.S. large-cap stocks than did international large-cap stocks (.90). In fact, of the six asset classes shown in Figure 3 (page 3), international small-cap s lowest correlation over that 10-year period was with U.S. small-cap (.79). DIFFERENTIATED COUNTRY AND SECTOR EXPOSURES Another potential diversification opportunity stems from the fact that country and economic sector exposures in the international small-cap asset class 3 We selected the USA Small Cap Index as the primary benchmark for this analysis because of its long track record and broad popularity with investors. 2
vary widely from traditional larger-cap international benchmarks. Figure 4 below, for example, shows relative exposure differentials between the MSCI ACWI ex USA Index and the MSCI ACWI ex USA Small Cap Index across six major non-u.s. equity regions continental Europe, the UK, Asia ex Japan, Japan, Canada, and the emerging markets. FIGURE 3: Index Correlations Ten Years Ended December 31, 2015 Index MSCI ACWI ex USA USA 1.00 MSCI ACWI ex USA Small Cap USA Small Cap 0.97 1.00 MSCI EM MSCI Emerging Markets 0.94 0.93 1.00 Russell 3000 Russell 1000 Russell 2000 Sector exposures within the MSCI ACWI ex USA Small Cap Index also vary considerably from the ACWI ex USA Index (Figure 5, below). As of December 31, 2015, the former provided more exposure to cyclical sectors, such as industrials, consumer discretionary, and information technology, while the latter was more heavily weighted toward defensive sectors such as consumer staples, health care, and utilities. These variations in country and sector exposures have resulted in significantly different performance patterns for each index as was evident in 2015 when the ACWI ex U.S. Small Cap Index returned 2.6%, while the ACWI ex U.S. Index returned -5.2%. A BROADER OPPORTUNITY SET A primary argument for investing in international small-cap equities is the larger opportunity set the asset class provides for active portfolio management, and thus the greater potential it offers for managers to generate excess returns. The theory behind this thinking is formulated in the Fundamental Law of Active Management, which holds that an active manager s information ratio (IR) can be calculated by multiplying his or her information coefficient (a measure of investment skill) by the square root of the number of independent bets that he or she can make in a portfolio. 4 The practical conclusion derived from this formula is that a higher IR can be achieved either through superior investment skill or greater portfolio breadth. While identifying truly skilled Russell 3000 0.89 0.85 0.79 1.00 Russell 1000 0.90 0.85 0.79 1.00 1.00 Russell 2000 0.80 0.79 0.73 0.94 0.92 1.00 Sources: MSCI and Russell. FIGURE 4: Relative Index Country Weights USA Index Minus USA Small Cap Index 8% 6 4 2 0-2 -4-6 -8 Source: MSCI. FIGURE 5: Relative Index Sector Weights Sector MSCI ACWI ex USA USA Small Cap Small-Cap Differential (basis points) Consumer Discretionary 12.2% 17.1% 497 Consumer Staples 10.8 6.8-392 Energy 6.0 3.1-290 Financials 27.1 21.0-608 Health Care 10.0 7.9-170 Industrials and Business Services 11.2 20.4 922 Information Technology 8.3 11.0 273 Materials 6.4 9.3 289 Telecommunication Services 5.2 1.3-382 Utilities 3.5 2.1-137 Source: MSCI. 6.9% Continental Europe Ex US Minus ex US Small Cap -1.2% USA Small Cap Overweights UK 0.0% Asia ex Japan -4.7% Japan USA Overweights 0.1% Canada -1.1% Emerging Markets 4 See: Richard C. Grinold, The Fundamental Law of Active Management, The Journal of Portfolio Management, Vol 15, Spring 1989. 3
active managers is a difficult task, identifying managers who benefit from greater breadth of opportunity is not. Figures 6 and 7 at right provide empirical evidence for the benefits of investment breadth. Over the past 10 years, the median international small-cap manager (who enjoys the greatest breadth) generated both a higher excess return and a higher IR than either the median international developed or the median EM manager. LONG-TERM PERFORMANCE: POTENTIAL BENEFITS AND CONCERNS Figure 8 below demonstrates that adding international small-cap exposure to an international large-cap allocation historically has had the potential to improve both absolute and risk-adjusted returns. This is due to the higher absolute returns posted by international small-cap stocks over time, as well as their previously discussed diversification benefits. However, international small-cap equities historically have been sensitive to the same broad return factors as U.S. small-cap stocks. These sensitivities suggest that international small-cap could underperform international large-cap in the following market and/or economic environments: Poor trading liquidity or worsening credit conditions, Decreased investor appetite for risk, Declining global and/or local economic activity, including a slowdown in merger and acquisition activity or a reduction in initial public offerings, Periods of high market volatility. While these factors generally have been headwinds for international smallcap stocks in the past, each market environment is unique and must be analyzed and understood on its own terms. Investors should also recognize that even under normal conditions, international small-cap equities are FIGURE 6: Equity Manager Information Ratios Ten Years Ended December 31, 2015 International Developed International Small-Cap Emerging Markets High 2.12 1.51 1.21 5th Percentile 1.11 0.97 0.90 25th Percentile 0.61 0.73 0.52 Median 0.33 0.48 0.29 75th Percentile 0.07 0.27-0.04 95th Percentile -0.27-0.13-0.31 Low -0.57-0.57-0.49 Source: evestment Alliance. Data are self-reported by investment management firms. Information ratios are as calculated by evestment Alliance ex-poste. Past performance cannot guarantee future results. FIGURE 7: Equity Manager Excess Returns Ten Years Ended December 31, 2015 International Developed International Small-Cap Emerging Markets High 6.22% 7.81% 6.54% 5th Percentile 4.02 6.01 5.26 25th Percentile 2.22 3.73 2.46 Median 1.04 2.31 1.14 75th Percentile 0.23 1.22-0.11 95th Percentile -1.32-0.47-1.28 Low -2.71-3.43-5.19 Source: evestment Alliance. Data are self-reported by investment management firms. Excess return is the median of the excess returns reported by each manager. Past performance cannot guarantee future results. FIGURE 8: 10-Year Risk and Return Results Annualized Return (%) 8% 7% 6% 5% Russell 1000 Russell 3000 Russell 2000 MSCI EAFE Small Cap 4% 60% EAFE/40% EAFE Small Cap MSCI EAFE MSCI EM 3% 14% 16% 18% 20% 22% 24% 26% Annualized Standard Deviation (%) Sources: MSCI and Russell. 4
subject to market risk, as well as the risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad. CONCLUSIONS International small-cap stocks historically have offered attractive risk-adjusted returns, with relatively low correlations to U.S. equity benchmarks and country and sector exposure weights that differ significantly from larger-cap international benchmarks. The traits suggest that international small-cap allocations offer significant opportunities to improve portfolio diversification. Excess returns and information ratios for active international small-cap managers also suggest that the greater breadth of the international small-cap universe compared with traditional international benchmarks as well as the relatively idiosyncratic, stock-specific nature of international small-cap returns may enhance the ability of active managers to add value through security selection. Despite these potential benefits, institutional investors overall have been relatively slow to include international small-cap allocations in their portfolios, even as other nondeveloped and/or non-large-cap equity assets, such as U.S. small-caps and emerging market stocks, have gained in popularity. For these and the other reasons outlined in this paper, T. Rowe Price suggests that investors consider including a dedicated international small-cap mandate in their non-u.s. equity allocations. 5
T. Rowe Price focuses on delivering investment management excellence that investors can rely on now and over the long term. To learn more, please visit troweprice.com. Important Information This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of June 2016 and may have changed since then. Price Perspectives are provided for informational and educational purposes only and are not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. This Price Perspective provides opinions and commentary that do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision. Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Past performance cannot guarantee future results. Diversification cannot assure a profit or protect against loss in a declining market. All charts and tables are shown for illustrative purposes only. Standard Deviation is a statistical measure of the historic volatility of a mutual fund or portfolio, usually computed using 36 monthly returns. More generally, it is a measure of the extent to which numbers are spread around their average. The wider the dispersions, the larger the standard deviation. The higher the deviation, the greater the volatility. This is an independent measure of volatility; it is not relative to an index. The Russell 3000 Index is a capitalization-weighted stock market index, maintained by the Russell Investment Group, that seeks to be a benchmark of the entire U.S. stock market. It measures the performance of the 3,000 largest publicly held companies incorporated in the U.S. based on market capitalization. The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The Russell 1000 Index is a stock market index that represents the largest 1,000 stocks in the Russell 3000 Index. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell is a trademark of Russell Investment Group. Note: MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. T. Rowe Price Investment Services, Inc., Distributor. C10K8CE0K 2016-US-23321 6/16