Feast or Famine

Should you add small-cap international equities to your broader global equity asset allocation?

This article examines the risk-reward trade-off of adding a satellite weighting of small-cap international equities to a broader global equity asset allocation.

Our analysis is based on the S&P/Citigroup Small Cap World ex-U.S index, a leading benchmark that tracks international stocks with less than $2 billion in market capitalization. Our research indicates the returns of small-cap international equities are inherently more volatile than those of other global equity asset classes.

From 1991 to 2007, the annualized standard deviation of the S&P/Citigroup Small Cap World ex-U.S index was 19.62 vs. only 16.5 for the S&P 500 index and 16.81 for the MSCI EAFE index of foreign stocks.

While overseas small caps have provided greater upside during bull markets, they have fallen more in bear markets. Indeed, this pattern has been borne out in the current market cycle. The asset class’ gains during the five-year bull market ended in October 2007 far exceeded those of both U.S. stocks and large-cap international equities. Since then, its decline has also been the largest.

S&P Equity Research believes the ability of an asset class to add diversification to a portfolio should be a central part of deciding whether its inclusion is merited. The less correlated it is with other heavily weighted asset classes in the portfolio, the greater its potential to smooth out returns over time.

International small caps’ 0.68 correlation with the S&P 500 index is significantly lower than the 0.83 of the MSCI EAFE index (see table on page 9). Although its correlation to mid- and small-cap U.S. equities is only slightly lower than that of EAFE, we believe the smaller mid- and small-cap weightings in most U.S. investor portfolios make this less relevant than its low correlation to large caps.

While we believe the above-average return potential and lower correlation of international small caps makes their portfolio inclusion a logical choice for risk tolerant, long-term U.S. investors, the asset class’ higher standard deviation implies a satellite rather than core portfolio weighting, in our opinion.

Exotic asset classes tend to have higher expense ratios, making low-cost index funds and ETFs an attractive alternative, in our view. The SPDR S&P International Small Cap exchange-traded fund (GWX) tracks the S&P/Citigroup World ex-U.S. index. Its expense ratio of 0.6% is roughly one-third the category average. Japan, Canada, the U.K., Australia, and Germany comprise roughly 73% of this ETF’s holdings.

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