Steve Lipper On 5 Things To Know About International Small-Caps
article , video 09-26-2018

Steve Lipper On 5 Things To Know About International Small-Caps

Senior Investment Strategist Steve Lipper provides an introduction to a timely asset class.

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What are some of the advantages of international small company stocks?

As investors look to build exposure to international equities, we’ve uncovered five points of research we think that they would find worthwhile to understand, particularly about international small-caps.

The first is the consistency on a rolling return basis on international small-cap beating international large-cap. So on a three-year rolling basis, actually over three quarters of the time, small beat large. On a five-year basis, about 88% of the time. And on a 10-year basis, international small’s historical record versus international’s large is beating it 97% of the time. Those statistics alone would seem to merit consideration.

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Batting Average of International Small-Cap vs International-Large Cap
Rus Glo ex US SC vs Rus Glo ex US LC Monthly Rolling Average Annual Return Periods from the Index Inception (7/31/96) through 6/30/18

3yr-batting-avg5yr-batting-avg10yr-batting-avg

But let’s bring risk into the equation, and say well, with that outperformance, was it a good return on risk? So the second point is, let’s just zero in on the rolling five year and say, “how did it do on a Sharpe ratio basis?” Well, international small-cap outperformed international large-cap on the Sharpe ratio basis, and emerging markets as well.

On a rolling five-year basis, international small was the highest risk- adjusted return at about .46. Emerging market’s rolling Sharpe ratio was .39. And an international large-cap had not just lower return but also lower risk-adjusted return at a .32.

Sharpe Ratio
Average of Monthly Rolling 5-Year Periods from 7/31/96 through 6/30/18

sharpe-ratio-compare

The Sharpe Ratio is calculated for a specified period by dividing a fund’s annualized excess returns by its annualized standard deviation. The higher the Sharpe ratio, the better the fund’s historical risk-adjusted performance.

A third point to consider for allocators is around diversification or correlation. International equities are added to a portfolio which has U.S. equities, and one of the benefits is to get a lower correlation. Here again, our research finding is international small has some merit. International large-caps’ correlation with the Russell 1000 is about a .85. International small-caps about a .74. So a greater diversification benefit.

Lower Correlation
International small-caps have lower correlation to US large-caps than either international large-caps or US small-caps

correlation-to-largecap

“U.S. Large-Cap” is represented by the Russell 1000, “International Large-Cap” by the Russell Global ex U.S. Large-Cap Index, “U.S. Small-Cap” by Russell 2000, and “International Small-Cap” by the Russell Global ex U.S. Small-Cap Index.

Those are three long-term reasons and distinctions on the asset class, large versus small. But we think that there is also timely reasons to consider international small. For example, one of the drivers to have allocators consider a greater amount of international equity is the anticipation of greater outperformance of international equity versus U.S. Well, let’s look at history and say in those environments, how did international large do versus international small? And we think it’s pretty striking.

When International Has Outperformed U.S.
Int’l Small-Cap Has Historically Outperformed Int’l Large-Cap
Monthly Rolling Trailing 1-year Periods from the Index Inception (7/31/96) through 6/30/18

when-intl-outperformedwhen-intl-outperformed-avg

If you look at rolling one-year periods when international equity beat U.S. equity, international small beat international large over 70% of the time, and by an average of over 600 basis points. So both from a long term and a timely basis, the asset class seems worth of consideration. However, a reaction might be, well that sounds great, why don’t I just do index exposure? Here we have some research findings which suggest international small-cap is very attractive for active managers.

We define light research coverage as one or zero analysts covering a company. So among international large-cap, there’s only about 6% of the companies that have light coverage. And on the international small-cap, actually 36% have one or zero analysts. So that would strike that probably there’s some inefficiency and perhaps some opportunity for the active manager.

% of International Stocks with Little or No Analyst Coverage1
As of 6/30/18

isc-little-analyst-coverage

1 Coverage ≤1
Source: Factset

So in summary, we think these five points are relevant about international small-cap: The consistency of beating international large-cap on rolling three-, five- and 10-year basis; the risk- adjusted return superiority versus international large as well as emerging market; the lower correlation of international small versus international large; the potential timely benefit in that if international beats domestic historically, international small has beaten international large; and the attractive attributes that the international small-cap asset class has potentially for active managers, we think that these five together suggest that international small-cap are worthy of consideration for portfolio allocators. 

Important Disclosure Information

The thoughts and opinions expressed in the video are solely those of the persons speaking as of July 9, 2018 and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

“U.S. Large-Cap” is represented by the Russell 1000, “International Large-Cap” by the Russell Global ex U.S. Large-Cap Index, “U.S. Small-Cap” by Russell 2000, and “International Small-Cap” by the Russell Global ex U.S. Small-Cap Index. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. The Russell Global ex-U.S. Large Cap Index is an index of global large-cap stocks, excluding the United States. The Russell 1000 index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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