Many institutional investors invest in broad international or global mandates to access non-U.S. small caps in their portfolios. However, we have often seen that these broader investment mandates either underrepresent or exclude non-U.S. small caps completely. This leaves many institutions underexposed to this important market segment.
We offer quantitative research that has a different insight — we believe that non-U.S. small caps are an attractive long-term allocation and ripe for active managers (A case for active non-U.S. small-cap equity). By breaking down the sources of returns, we also reveal the timeliness of making an allocation in the current environment, given relative equity valuations and interest-rate levels.
In this brief update, we will share two key insights from our research study. International small caps may offer:
- Earnings that are non-correlated with other equity asset classes
- An inefficient universe, with potential for active managers to outperform indexes
Non-correlated earnings can enhance diversification benefits
Building a well-diversified portfolio means combining investments in asset classes that have low correlation. When we make the case for non-U.S. small caps, we can take the low correlation argument a step further by looking at company earnings, not just stock performance.
International small caps offer a different source of potential earnings to a U.S.-based investor. Just as U.S. small caps are more geared to the U.S. economy, international small caps are tied more closely to their local economies. They serve different customers and operate in different macroeconomic environments.
Our research analyzed the earnings correlation of four equity asset classes — U.S. large and small caps and non-U.S. large and small caps — over 20 years. Non-U.S. small cap earnings had the lowest correlation to the earnings of every other equity asset class during this timeframe.
An inefficient universe for active managers
At a recent company annual meeting, Charlie Munger, Vice Chairman of Berkshire Hathaway, offered this thought to a group of investors: “The first rule of fishing is to fish where the fish are. Some places have lots of fish, and you don’t have to be a good fisherman to do pretty well. Other places are so heavily fished that no matter how good a fisherman you are, you aren’t going to do very well.”
We believe the international small-cap category offers one of the best ponds for active managers to fish in. It is an inefficient universe, with a median of three sell-side analysts covering each stock, compared with a median of 20 analysts covering U.S. large caps. At the same time, it has a wider variety of opportunities and regions, with thousands more stocks than the S&P 500 Index or the Russell 1000 Index.
It's time to consider international small capsWe believe it is important to recognize the possible diversification benefits of non-U.S. small caps. They can offer a potential source of returns that can make a portfolio more resilient and less driven by the ups and downs of the U.S. market. Furthermore, the non-U.S. small-cap universe is large and inefficient, with thousands of stocks — a market we believe is rich with opportunity for active managers to add value.
A case for active non-U.S. small-cap equity
For more on our research, read "A case for active non-U.S. small-cap equity." (PDF)Download white paper (PDF)
You can continue exploring this theme and why we believe conditions in 2021 may be potentially attractive for introducing an allocation by reading A case for active non-U.S. small-cap equity. You can also explore Putnam’s institutional capability in this asset class.
In our analysis, we use indexes to represent the asset classes: the S&P Developed ex-U.S. Small Cap Index for non-U.S. small-cap equity, the MSCI EAFE Index for non-U.S. large-cap equity, the S&P 500 Index for U.S. large-cap equity, and the Russell 2000 Index for U.S. small-cap equity.
Past performance is not a guarantee of future results. Indexes are not managed and do not incur expenses.
For informational purposes only. Not an investment recommendation.
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Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.
Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. You can lose money by investing in a mutual fund.
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