Market Insights

International Small-Cap Equities Q&A

Why International Equity?

Growing share of global market capitalization
The US accounts for approximately 46% of the global equity universe,* yet for most US investors, domestic equities comprise a disproportionately larger percentage of their equity portfolios. Having a strong home bias can prevent US investors from achieving the risk and return benefits of a more diversified, global portfolio. Moreover, US equity markets are projected to represent an increasingly smaller share of the total world market cap over the next few decades as global and Growth and Emerging Markets deepen. When considering future equity allocations, we believe investors should increase the degree of globalization in their portfolios to better position themselves to capture this compelling opportunity.

Understanding the international small-cap opportunity
This trend also holds true within the small-cap segment of the developed equity universe. For investors who already access small-caps through the US market, consider the broader picture: small-cap equities comprise 14% of today’s total global market cap. Within small-cap equities, international small-caps represent 55% of the total universe,** yet the average US investor allocates approximately 15% of their small-cap exposure to these stocks.*** We believe that small-cap investors should more broadly diversify and complement their US small-cap market exposure with international small-cap equities in an effort to better reflect globalization and the future growth of non-US equity markets.

Increasing investor focus
Recent search activity substantiates the notion that investors are already increasing their focus on international markets. Over the last five years, while international equity searches have accounted for 38% of the total number of equity searches, the total assets associated with these searches represented 56%. In 2011, international equity search activity surpassed US equity searches in both number of searches and dollars allocated. We believe this trend will continue as investors continue to allocate their portfolios toward non-US markets.

At the same time, the international small-cap asset class has also attracted a significant amount of attention during the recent uptick in international equity searches. International small-cap already accounts for 10% of all global equity searches and has been one of the largest share gainers of search activity over the last two years.

Investors are increasingly focused on non-US equity, a trend we expect to continue as global markets evolve and home country biases moderate. Importantly, the international equity asset class is a collection of diverse opportunity sets; the small-cap segment of this universe can offer a differentiated, compelling solution that we believe warrants more consideration.

*Source: MSCI All Country World Index, by Weight %. As of December 31, 2011.
**FactSet as of December 31, 2011.
***US Based on Morningstar Categories: Small Cap Growth, Small Cap Value, and Small Cap Blend; Non US Based on Morningstar Categories: Foreign Small/SMID Growth and Foreign Small/Mid Blend.
 

 

Why International Small-Cap Equity?

Strong relative performance history
We believe that international small-cap equities can both complement and provide diversification benefits to an investor’s equity allocation. International and US small-caps have historically provided strong returns relative to their large-cap counterparts. Over the last decade, international small-cap equity has outperformed US large-cap equity by almost 100% and international large-cap equity by almost 70% on a cumulative basis.

Importantly, this outperformance has been consistent, with the international small-cap universe outpacing international large-cap equities in eight out of the last eleven calendar years, and US small-caps outpacing US large-caps in seven out of the last eleven years. Diversification of international small-caps has also added value relative to US small-caps over the long term.

On a risk-adjusted basis, international small-cap performance has also been compelling, with a Sharpe ratio double that of US small-cap and international large-cap, and nearly 4X that of the US large-cap universe.

 

Why Active Management?

Broad and inefficient universe presents opportunities
We think small-caps represent an exciting investment opportunity based on the distinct attributes of the asset class and its constituents. The characteristics of the universe are attractive: it is both large and inefficient. The international small-cap universe is comprised of nearly 4,000 stocks, while the large-/mid-cap segment includes approximately 1,200 stocks.* Given the larger scope of the universe and the smaller size of the individual companies, international small-caps also tend to have less research coverage relative to their large-cap counterparts.

On average, large-cap companies are covered by seven research firms, while small-cap companies are covered by only three.** Within the international small-cap equity universe, less research coverage and a greater number of securities offers active managers a wider opportunity set, relative to large-cap equities, from which to exploit market inefficiencies and source investment ideas.

These thousands of diverse companies with varying valuations create a higher dispersion of returns among individual stocks compared to the large-cap universe. This dispersion presents many winners and losers, and thus fertile ground for alpha generation. Skilled active managers can identify true candidates for growth and capitalize on the large dispersion of returns within the small-cap equity universe. With robust research, active managers can uncover early stage opportunities such as small businesses in growing economic segments, players in niche markets with ample room for growth and takeout candidates in consolidating markets, a particularly timely theme with record levels of cash on corporate balance sheets. Additionally, well-managed small-cap companies with exposure to growth markets may also provide compelling upside potential. At the same time, greater variance of returns can pose greater volatility. We believe strong active managers can mitigate the risks of higher stock level dispersion through in-depth analysis and portfolio risk metrics.

*International Small-Caps are represented by the S&P Developed ex US Small Cap Index; International Large-Caps are represented by the S&PDeveloped ex US Large/Mid Cap Index; US Large-Caps are represented by the Russell 1000 Index; US Small-Caps are represented by the Russell
2000 Index. As of December 31, 2011.
**Source: Thomson Reuters, GSAM. Large-cap companies represented by the MSCI World Standard (Large+Mid Cap) Index. Small-cap companies represented by the MSCI World Small Cap Index. As of December 31, 2010. Past performance is not indicative of future results, which may vary_.