Four Reasons to Consider an Allocation to International Small Cap Equities

Investors first fell in love with American small cap stocks in the late 1970s when small companies became recognized as more nimble, fast growing, and more able to adapt to changes to technology than their bloated, plodding large competitors. Since their first great boom, US small caps have proven to have ups and downs, but continue to be the source of the great success stories in corporate America and have proven one of the most successful asset classes for active management to add value.1

So with this history, why have investors shunned allocations to international small cap stocks? While US small cap, international large cap, and even emerging markets have all attracted significant assets, international small cap in developed non-US markets remains largely uncharted territory. We believe there are a number of reasons that investors should consider an allocation to international small cap stocks, including:

  • The size of the international small cap equity universe, which is largely untapped by active managers
  • International small cap offers diversification to mainstream equity classes
  • Exposure to non-dollar assets offers additional diversification especially if U.S. dollar weakens
  • Inefficiency of international small cap market offers alpha potential for active managers

Reason 1: The Size of the International Small Cap Market

From a sheer size standpoint, we believe the non-U.S. small cap equity market is large enough to warrant interest by US investors. The table shown in Exhibit A below clearly demonstrates the dominance of the large cap US and international companies in terms of market capitalization. The combined market cap (by weight) of US and international large cap companies is about 65% of the entire universe, yet when measured as a percent of total number of companies, the large cap universes account for less than 10% of the total count.

International small and mid-cap companies represent over 40% of the number of companies around the globe and about 14% of the total capitalization of world equity markets. From a percent of market cap basis, they are larger than the emerging markets.

But more importantly – there are not many active managers focused on international small cap companies – we believe this offers some potential to exploit inefficiencies. The total assets under management (AUM) in the eVestment Alliance database for international small cap is approximately $98 billion (as of 12/31/2015), representing just 5% of the $1.9 trillion international small cap universe. Compare that to the US small cap market where eVestment Alliance indicates that $602 billion of AUM – almost a third of the available market cap ($2.0 trillion) - is being actively managed.2

The combination of these two factors: the size of the universe and the fact that only approximately 5% of the universe is covered by active managers suggests there are some opportunities to benefit from both inefficiencies and additional investment capital moving into this space. We explore the inefficiency argument more thoroughly under Reason 4.