The Case for International Small Cap Investing

The Case for International Small Cap Investing

Harnessing alpha and diversification potential through efficient portfolio construction

Executive summary

While the universe of international, developed-market, small-capitalization companies is extensive, diverse and generally information-inefficient, many investors are under-exposed to this asset class.

Key benefits of international small cap investing include:

  • Expanded opportunity set through exposure to a broader range of companies
  • Demonstrated, historically attractive risk-adjusted returns relative to international developed markets
  • Potential diversification benefits, with low correlation to U.S. equities
  • Less efficient markets with significantly less analyst coverage than larger cap equities, allow for greater potential alpha
  • Allocating to international small caps historically has improved risk-adjusted returns in well-diversified portfolios

Introduction

There isn’t anything small about international small cap investing. The universe of international developed small cap companies exceeds 4,500 securities, over 5,000 if you include emerging markets. If you limit the universe to developed markets, international small cap stocks cover 24 countries, 50% of the world’s listed companies and 77% of internationally listed companies. What’s more, it is an information-inefficient universe, which means there is potential for portfolio managers to add value through rigorous analysis.

The investible universe

A common misperception of international small caps is that they are isolated companies operating within specific countries, with limited global reach and potential. In fact, many international small cap companies are industry leaders with established global reach:

  • Sonova Holding AG, headquartered in Stäfa, Switzerland, is a leading provider of innovative hearing care solutions. Sonova operates in over 100 countries across the globe, has a workforce of more than 14,000 and generated sales of CHF 2.6 billion in the financial year 2020–2021
  • The Adecco Group, based in Zürich, Switzerland, is the world’s second largest human resources provider and temporary staffing firm, and a Fortune Global 500 company. Adecco directly employs 700,000 people a day
  • HelloFresh SE, headquartered in Berlin, Germany, delivers meal kit solutions across the globe, with operations in Australia, Austria, Belgium, Canada, Denmark, Germany, France, Luxembourg, New Zealand, Sweden, Switzerland, The Netherlands, the United Kingdom and the United States

The S&P Developed Ex U.S. Small Cap index represents 15% of the international developed investable universe according to S&P but is only 4% of the assets invested in international equities according to Morningstar. Many investors are missing out on the potential benefits of international small caps.

Return potential

Investing in international small caps may be perceived as risky; however, professional money managers understand that over a full market cycle, international small caps generally outperform international large cap stocks on both total and risk-adjusted return bases.

Figure 1 and the table below compare the total and risk-adjusted returns of two international small cap indexes, the S&P Developed Ex U.S. Small Cap index and the MSCI EAFE Small Cap index. They are compared to two international large cap indexes, the S&P Developed Ex U.S. Large-Mid index and the MSCI EAFE index. Over the past 20 years, the S&P Developed Ex U.S. Small Cap index outperformed its larger counterparts by 3.69% annualized and the MSCI EAFE Small Cap index outperformed them by 2.99% annualized. For the same period, both small cap indexes posted higher risk-adjusted results than the large cap indexes.

Figure 1. International small caps have outperformed large caps over the past 20 years
Figure 1. International small caps have outperformed large caps over the past 20 years

Source: Morningstar Direct data as of 09/30/21; analysis by Voya Investment Management. Past performance is no guarantee of future results.

The S&P Developed Ex U.S. Small Cap index outperformed its large cap counterpart in 16 of the past 20 calendar years. The results are similar on a risk-adjusted basis. Using the Sharpe ratio, the small cap alternatives, despite the higher level of volatility, have risk-adjusted returns that exceed their large cap brethren. The Sharpe ratio of both small cap indexes outperformed the larger caps in 15 of the past 20 years.

Potential diversification benefits

International developed small cap returns are less than perfectly correlated against most asset classes including international large caps, emerging markets, and U.S. fixed income. They also have a lower correlation to U.S. domestic large caps than do U.S. domestic small caps. International developed small caps afford greater diversification potential for investors seeking to optimize a portfolio’s risk-return trade-off.

The goal of an efficient portfolio is to maximize total return potential for a given level of risk. Figure 2 illustrates the rolling correlation of the S&P Developed Ex U.S. Small Cap index and the Russell 2000 index relative to the S&P 500 index for the 20-year period ended 09/30/21. It uses a three-month rolling window with a one-month shift, and highlights that international small caps have a lower rolling correlation to the S&P 500 index than the Russell 2000 index. The lower correlation illustrates that the addition of international small caps to a well-diversified portfolio, in lieu of U.S. domestic small caps, can increase diversification and improve portfolio efficiency.

Figure 2. International small caps offer more diversification potential versus U.S. large caps than do U.S. small caps
Rolling correlations with S&P 500 maximum drawdown
Figure 2. International small caps offer more diversification potential versus U.S. large  caps than do U.S. small caps

Source: Morningstar Direct data as of 09/30/21; analysis by Voya Investment Management. Past performance is no guarantee of future results.

Figure 2 also illustrates the maximum drawdowns, i.e., the peak to trough declines, of the S&P 500 index for the same period. It is often the case that asset classes are less than perfectly correlated in benign environments, only to gravitate toward a correlation of one in periods of stress. Historically, this has not been the case with international small cap stocks. Relative to the S&P 500 index, international small caps’ rolling correlations remained lower than the rolling correlations of U.S. small caps in periods of stress. For example, during the Great Financial Crisis (January 2008 through March 2009), the difference in correlation between international and domestic small cap stocks relative to the S&P 500 index actually increased from a 20-year average of -0.45 to -0.59.

International small cap investing

Building efficient portfolios

Having demonstrated the historical performance and diversification benefits of international small cap stocks, we now turn to adding them into a traditional portfolio, in order to improve potential efficiency and return for a given level of risk. In the hypothetical studies below, we define two series of investment portfolios, each with five models: aggressive, moderately aggressive, moderate, moderately conservative and conservative. Portfolio series 1 (see Figure 3) invests in four asset classes: U.S. large caps, U.S. small caps, U.S. bonds (“Agg”) and international large caps.

Figure 3. Hypothetical portfolio series 1: traditional models
Figure 3. Hypothetical portfolio series 1: traditional models

Source: Bloomberg for data, analysis by Voya Investment Management. U.S. large = S&P 500 index, U.S. small = Russell 2000 index, Agg = Bloomberg U.S. Aggregate index, Int’l = MSCI EAFE index.

Portfolio series 2 (see Figure 4) has the same five portfolios and the four original asset classes, but with the addition of international small caps. By allocating to international small caps, we reduce the positions in U.S. small caps and international large caps. International small caps enhance returns relative to international large caps and enhance diversification relative U.S. small caps through their lower correlations to U.S. large caps.

Figure 4. Hypothetical portfolio series 2: traditional models augmented with international small cap
Figure 4. Hypothetical portfolio series 2: traditional models augmented with international  small cap

Source: Bloomberg for data, analysis by Voya Investment Management. U.S. large = S&P 500 index, U.S. small = Russell 2000 index, Agg = Bloomberg U.S. Aggregate index, Int’l = MSCI EAFE index. Int’l Small = S&P Developed Ex U.S. Small index.

Using annualized returns for the 20 years ended 09/30/21, Figure 5 demonstrates that adding international small caps to a well-diversified portfolio potentially improves the portfolio’s risk-adjusted returns along its efficient frontier.

Figure 5. Adding international small caps enhances a portfolio’s efficient frontier
Figure 5. Adding international small caps enhances a portfolio’s efficient frontier

Source: Bloomberg for data, analysis by Voya Investment Management. U.S. large = S&P 500 index, U.S. small = Russell 2000 index, Agg = Bloomberg U.S. Aggregate index, Int’l = MSCI EAFE index. There can be no guarantee that a diversified portfolio can prevent losses. Past performance is no guarantee of future results.

Figure 6 shows that the more we allocate to international small caps at the expense of U.S. domestic small caps and international large caps, the greater the improvement in the portfolio’s Sharpe ratio. The Sharpe ratio is used to calculate risk-adjusted returns. A higher Share ratio illustrates a better risk-return profile for the portfolio.

Figure 6. Allocating to international small caps potentially improves Sharpe ratio
Figure 6. Allocating to international small caps potentially improves Sharpe ratio

Source: Bloomberg for data, analysis by Voya Investment Management. U.S. large = S&P 500 index, U.S. small = Russell 2000 index, Agg = Bloomberg U.S. Aggregate index, Int’l = MSCI EAFE index. Int’l Small = S&P Developed Ex U.S. Small index There can be no guarantee that a diversified portfolio can prevent losses. Past performance is no guarantee of future results.

Active versus passive strategies

The debate continues as to which is better active or passive management. We believe it depends on the asset class. Since market efficiency varies by asset class, our approach varies. We favor overweighting active management in most fixed income and less efficient equity markets. Price discovery depends on a number of factors including supply and demand, risk tolerance and information flow. U.S. domestic large cap markets are relatively concentrated and highly efficient, incorporating a multitude of factors that make it difficult for most active managers to consistently outperform passive vehicles.

International small cap markets are comprehensive, highly diverse and less efficient. The S&P Developed Ex U.S. Small Cap index includes publicly listed equities in 24 countries with 4,599 constituents. In contrast, the S&P 500 index includes some of the largest, most liquid companies in the world. Only five analysts cover the average international small cap company, compared to 18 analysts for S&P 500 companies. While every company in the S&P 500 has analyst coverage, 224 companies in the MSCI EAFE Small Cap index have no coverage whatsoever and 256 have only one analyst.

As illustrated in Figure 7, the average performance of actively managed funds in the Morningstar Foreign Small/Mid Value, Blend and Growth categories outperformed the average performance of the passively managed funds and exchange-traded funds (ETFs) in the same categories for the one-, three-, five- and ten-year periods ended 09/30/21.

Figure 7. Actively managed international small cap funds historically have outperformed passively managed funds
Figure 7. Actively managed international small cap funds historically have outperformed  passively managed funds

Source: Morningstar Direct, Voya Investment Management. “Active funds” represents the average total return performance of the institutional shares of the actively managed funds and ETFs in the Morningstar Foreign Small/Mid Value, Blend and Growth categories. “Passive funds” represents the average total return performance of the institutional shares of the passively managed funds and ETFs in the Morningstar Foreign Small/Mid Value, Blend and Growth categories. Fund returns are presented net of all fees and expenses. Returns for periods greater than one year are annualized. Past performance is no guarantee of future results.

In contrast, Figure 8 shows the average performance of the actively managed funds in the Morningstar Large Cap Blend Category underperformed the average performance of the passively managed funds and ETFs in the same category for the one-, three-, five- and ten-year periods ended 09/30/21.

Figure 8. Actively managed U.S. domestic large cap funds historically have underperformed passively managed funds
Figure 8. Actively managed U.S. domestic large cap funds historically have  underperformed passively managed funds

Source: Morningstar Direct, Voya Investment Management. “Active funds” represents the average total return performance of the institutional shares of the actively managed funds and ETFs in the Morningstar Large Blend category. “Passive funds” represents the average total return performance of the institutional shares of the passively managed funds and ETFs in the Morningstar Large Blend category. Fund returns are presented net of all fees and expenses. Returns for periods greater than one year are annualized. Past performance is no guarantee of future results.

Compared to other asset classes, international small caps are inefficient, which affords opportunity for investors to benefit by investing in actively managed international small cap funds.

Voya’s multi-disciplined approach to international small caps

International small cap investing can be challenging for a number of reasons. Transaction costs are high, capacity is limited and as noted above, the asset class is broad and diverse. Successfully investing in this asset class requires more than finding a qualified manager ― it requires a flexible and multi-disciplined investment approach (Figure 9). For this asset class, we prefer a multi-manager structure that provides extensive coverage of this diverse asset class, reduces single manager risk and avoids capacity concerns. This allows a fund to be designed with high-conviction managers that have differentiated philosophies and processes and low alpha correlations to each other to achieve consistent and attractive risk-adjusted returns over time.

While implementing a multi-manager framework has many benefits to investors, it can be a challenge to execute successfully. To achieve this, Voya employs a dedicated manager research and selection team that is responsible for due diligence, selection and ongoing monitoring of the underlying managers within this fund. This team has over 15 years of experience working within a multi-manager framework and consists of career research analysts who average nearly 20 years of industry experience. This team has the flexibility to add and replace managers over time, since many factors – such as style headwinds, firmwide issues, manager turnover and capacity constraints – can impact a manager’s ability to outperform over long periods and different market environments. We believe this flexibility is a significant advantage when investing in international small caps.

Figure 9. Voya’s flexible, multi-disciplined approach to international small cap investing
Figure 9. Voya’s flexible, multi-disciplined approach to international small cap investing

Source: Voya Investment Management

IM1898020

The S&P Developed Ex-U.S. SmallCap index is an unmanaged index of small-cap stocks from developed countries, excluding the United States. The index does not reflect fees, brokerage commissions, taxes or other expenses of investing. Investors cannot invest directly in an index.

The MSCI Europe, Australasia and Far East (EAFE) Small Cap index is an unmanaged index which measures the performance of small capitalization equities among developed markets around the world, excluding the United States and Canada. The index does not reflect fees, brokerage commissions, taxes or other expenses of investing. Investors cannot invest directly in an index.

Principal risks: All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield. Investments in small-capitalization companies involve greater risk than is customarily associated with larger, more established companies due to the greater business risks of small size, limited markets and financial resources, narrow product lines and the frequent lack of depth of management. Foreign investments/developing and emerging markets: investing in foreign (non-U.S.) securities may result in the Fund experiencing more rapid and extreme changes in value than a fund that invests exclusively in securities of U.S. companies, due to smaller markets, differing reporting, accounting and auditing standards; and nationalization, expropriation or confiscatory taxation, foreign currency fluctuations, currency blockage, political changes or diplomatic developments. Foreign investment risks typically are greater in developing and emerging markets than in developed markets. Convertible securities are securities that are convertible into or exercisable for common stock at a stated price or rate. Convertible securities are subject to the usual risks associated with debt securities, such as interest rate and credit risk. In addition, because convertible securities react to changes in the value of the stocks into which they convert, they are subject to market risk. Currency: to the extent that the Fund invests directly in foreign currencies or in securities denominated in or that trade in foreign (non-U.S.) currencies, it is subject to the risk that those currencies will decline in value relative to the U.S. dollar or, in the case of hedging positions, that the U.S. dollar will decline in value relative to the currency being hedged. Derivative instruments are subject to a number of risks, including the risk of changes in the market price of the underlying securities, credit risk with respect to the counterparty, risk of loss due to changes in interest rates and liquidity risk. The use of certain derivatives may also have a leveraging effect which may increase the volatility of the Fund and reduce its returns. Growth investing: prices of growth stocks typically reflect high expectations for future company growth, and may fall quickly and significantly if investors suspect that actual growth may be less than expected. Growth companies typically lack any dividends that might cushion price declines. Growth stocks tend to be more volatile than value stocks, and may underperform the market as a whole over any given time period. Value investing: securities that appear to be undervalued may never appreciate to the extent expected. Further, because the prices of value-oriented securities tend to correlate more closely with economic cycles than growth-oriented securities, they generally are more sensitive to changing economic conditions, such as changes in interest rates, corporate earnings and industrial production. Other risks of the Fund include, but are not limited to: Investment by other funds, investment model risk, market risk, stock risk, other investment companies and securities lending. Investors should consult the Fund’s prospectus and statement of additional information for a more detailed discussion of the Fund’s risks.

An investment in the Fund is not a bank deposit and is not insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board or any other government agency.

This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities. Past performance is no guarantee of future results.

The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Portfolio holdings are fluid and are subject to daily change based on market conditions and other factors.

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