(May 4, 2012) — Investors have been warned to not ignore international small-cap equities.
According to a recently published whitepaper by Morgan Stanley Investment Management, international small-caps is a re-emerging asset class. From a valuation standpoint alone, international small cap equities deserve investors’ consideration, but they are often overlooked in favor of emerging markets, the paper, published in January, asserts. “Increasing numbers of small companies are deriving substantial revenues from emerging markets at a time when estimates suggest emerging markets are expected to account for 52% of global growth over the next few years.”
Meanwhile, the average investor’s allocation to international small caps is just 7% compared to a neutral weighting of 12%, the paper said, highlighting that geographically, international small caps offer broader access to many of the smaller developed markets, such as Norway, Hong Kong and New Zealand, where there are few listed large caps.
Morgan Stanley’s paper notes that in relative terms, international small cap equities is twice as cheap as US large caps and 60% cheaper than either US small caps or emerging markets.
The paper continues: “The perception of small caps as a higher beta, high-risk investment belies long-term data that demonstrated outperformance versus large cap stocks, alongside an improved risk-return profile. Notwithstanding performance considerations, in volatile financial markets the distinctive nature of international small caps provided attractive diversification away from large cap stocks, emerging markets and US small cap stocks.”
According to Morgan Stanley, considerable opportunities for international small-cap equities exist through the use of active management.
Similarly, a March whitepaper by MSCI echoed a supportive argument for the asset class, noting that omitting small caps is in fact a significant active decision which many investors may be making unintentionally.
What are the main reasons institutional investors give for excluding global small caps in their equity universe?, the paper by MSCI asked. While some institutional investors believe they achieve sufficient exposure through the opportunistic small cap investments made by their large and mid cap active managers, a second common reason cited for omitting small caps in the institutional portfolio is that small cap investing is more complicated, costly, and resource-intensive.
The paper continues: “For institutions seeking small cap products, a twin problem exists in that there are fewer managers specializing in small caps, and these tend to be from small niche asset management firms…we argue that if there are not sufficient resources to find skilled small cap active managers, institutional investors should implement passive allocations to small caps rather than forgoing their beta return altogether.”