Redrawing the equity map with global small caps
The earth is flat . . . or so it was believed, until sometime after 500 B.C.1 Until then, explorers dared not venture too far, for fear of reaching the physical limits of the planet and . . . falling off. It’s easy to imagine how constrained the world must have seemed to those who held this view. Equity indexing, too, has had its own “flat earth” period, when the global opportunity set seemed to be limited to the largest stocks from a select number of large countries. Fortunately, with the FTSE Global Small Cap Index, FTSE Russell has pushed past this narrow view to capture a vastly expanded equity universe that includes global small caps (hereinafter “small caps”), which are generally defined as companies with market capitalization of less than $5 billion. In an earlier paper, we showed that although small caps comprise only about 10% of the world’s equities by market value, they make up approximately 70% of the world’s investment opportunities by numbers of stocks.2 The characteristics of these stocks often differ from those of their large cap counterparts, so that when small caps are added to traditional large cap allocations, they can diversify the total portfolio and offer the potential for enhanced returns. In this brief research note, we explore small caps and the potential benefits of “rounding out” an equity portfolio by adding this asset class.
Nowadays, most investors understand the need to diversify their equity portfolios beyond stocks from their home country. But in so doing, their focus has primarily been on large cap stocks from the largest markets, like those found in the FTSE All-World Index.3 Global large cap companies such as Apple, Nestlé, Toyota and Samsung all have highly recognizable brands whose familiarity provides a degree of comfort to investors moving outside their home markets.4 But many of these large companies are increasingly interconnected after having expanded their businesses globally, meaning that a common set of factors could explain much of their collective performance. Small caps, on the other hand, can be more dependent on their local economies, and therefore may offer an alternative pattern of performance and characteristics when mixed into a portfolio of global equities.5 Throughout this paper, we will use the FTSE All-World Index and the FTSE Global Small Cap Index to contrast global large cap with global small cap stocks, as well as a hypothetical 90:10 weighted blend of these two indexes (90% FTSE All-World, 10% FTSE Global Small Cap) in order to demonstrate the historical diversification effects of adding small caps to the traditional large cap allocation.6
The performance of small caps tends to lead when markets have directional strength, either up or down. This leadership offers investors the opportunity to participate more in up-trending markets, but also carries the risk of more downside exposure when market sentiment turns negative. Figure 1 illustrates the performance tendencies of small caps in both up and down markets. Shaking off the effects of the early 2000s global slowdown, the FTSE Global Small Cap Index outperformed the FTSE All-World Index by more than 15% in 2003, and this leadership continued each year through 2006. As the storm clouds gathered over equity markets in 2007, the FTSE Global Small Cap Index still managed a respectable 11.8% calendar year return, but fell behind the FTSE All-World Index on a relative basis. When the global financial crisis unfolded in 2008, small caps had their worst year of the period evaluated7 – the FTSE Global Small Cap Index fell by nearly 46%, compared to the FTSE All-World Index, which fell by nearly 42%. But at the beginning of the global recovery, the FTSE Global Small Cap Index once again outperformed the FTSE All-World Index, by 11.8% in 2009 and 13.6% in 2010.
As expected, based on these indexes’ individual performances, our hypothetical allocation to a 90:10 blend of the stocks contained in the FTSE All-World and FTSE Global Small Cap indexes would have performed better than a 100% allocation to global large caps in the FTSE All-World Index in nine of the thirteen yearly periods evaluated.
On a cumulative basis, the FTSE Global Small Cap Index has outperformed the FTSE All-World Index since 2003. While one cannot invest directly in an index, passive products such as ETFs that replicate an underlying benchmark’s return have grown highly popular among investors for their low costs and ease of use. As an example of this type of index-based investment, a hypothetical $1,000 investment in a passive product that tracked the FTSE Global Small Cap Index, made in 2003 and held through June 2015, would have grown to approximately $4,294, before fees and other tracking error. This compares favorably to a hypothetical investment in a passive product based on the FTSE All-World Index, which would have grown to approximately $3,121, before fees and other tracking error. We would note, however, that tracking error and management fees would generally be lower for a product following an easier to track global large cap benchmark (like the FTSE All-World Index) than the fees required to manage a more difficult to track global small cap benchmark containing more securities that may be less liquid.8,9 Our blended 90:10 portfolio, which would have included a mix of both index-based products, would have grown to approximately $3,227 before fees.
As the global financial crisis gripped equity markets in 2008, the return patterns among many asset groupings including stocks, industries, countries, etc., converged. Whether assets were perceived as being risky (stocks, mortgage-related instruments) or non-risky (cash, certain fixed income instruments) was all that mattered. As a result, correlations between many asset classes touched historic highs, near 1.0 – meaning they were all moving in a similar direction and at roughly the same rates of change. The global small cap index became more highly correlated with the global large cap index during this time period, although they were never perfectly correlated. As shown in Figure 3, more recent correlations between the global small cap index and the global large cap index have declined to levels not observed since data for both the FTSE All-World Index and the FTSE Global Small Cap Index became available in 2003. The recent fall in correlations may reflect a return to global trends driving large caps and local trends driving small caps. If a lower-correlation environment continues, small caps should again provide an enhanced level of performance diversification for the traditional large cap portfolio.
In addition to their potential for diversifying traditional large cap portfolios, small caps have also historically provided industry exposures that differ from those of large caps. While small cap is often thought of as the realm of cutting-edge technology start-ups, in fact many small cap companies worldwide exist to serve larger companies. Suppliers to the airline, auto and other manufacturing industries make up a substantial portion of the asset class, as is observable in the concentration in the Industrials sector of the FTSE Global Small Cap Index. Figure 4 shows the differences in ICB industry composition of the FTSE Global Small Cap Index and the FTSE All-World Index. The Industrials, Consumer Services, Financials and Basic Materials sectors make up 62.5% of the FTSE Global Small Cap Index, a combined overweight of 11.6% against the same sectors in the FTSE All-World Index – with most of that difference coming from Industrials. Technology in the small cap index is, perhaps surprisingly, underweight relative to large cap by approximately 1.1%.
Small caps come from every corner of the world, including both developed and emerging countries. While countries like the U.S., UK and Japan spring to mind as having well-developed equity markets with companies of all sizes, others, like South Korea, China and India, offer a diversity of small cap companies. These can be important components of any broad-based global small cap index. Relative to the FTSE All-World Index, the FTSE Global Small Cap Index is underweight some of the largest developed markets, e.g., the UK, Japan and Germany; but it offers larger exposures to emerging markets like Taiwan and South Korea (Figure 5). Perhaps most importantly, allocating to small caps allows an investor to gain complete exposure to a country’s equity market. Our hypothetical blended portfolio would smooth out the distribution of country weights, potentially better aligning desired exposures to those achieved within an investor’s portfolio.
Volatility, valuations and other fundamental considerations Volatility and risk
Small caps have historically been more volatile than their large cap counterparts, which comes as no surprise. As shown in Table 1, the returns of the FTSE Global Small Cap Index have an annualized standard deviation of 21.0%, as compared to 17.8% for the FTSE All-World Index. But the true test is whether investors can be sufficiently rewarded for the additional risk of small caps – and we find evidence that historically, investors would have been compensated for bearing the extra risk. Over the entire period January 2003 to June 2015, the Sharpe ratio (risk-adjusted return) for the FTSE Global Small Cap Index was 0.86, and for the FTSE All-World Index, 0.76. Our hypothetical 90:10 Blend shows the Sharpe ratio improving slightly, to 0.77. So while small caps are generally more volatile, over the long term they have the potential to increase the risk-adjusted returns of a global equity portfolio.
The valuation of small caps, referred to herein by using price-to-earnings (P/E) with one-year I/B/E/S forecasted earnings, has historically been higher than for global large caps, particularly during times of market stress. The FTSE Global Small Cap Index experienced sharp increases in valuations around the beginning of the Great Recession in 2008, and valuations remained high until 2010. These increases, shown in Figure 6, followed the combined effects of stock prices rebounding from their 2008–2009 lows and forecasted earnings falling during the same time span. Setting aside this extraordinary event, small cap valuations have generally remained directionally consistent with large caps. Over the entire period evaluated in Figure 6, the median one-year P/E for the FTSE Global Small Cap Index was 15.2, as compared to 14.6 for the FTSE All-World Index. After a sustained market recovery and expansion, small cap valuations are again nearing their pre–Great Recession peak of 2007. As the global economy continues to show improvement, it is unclear whether generally positive market sentiment will support new valuation highs going forward.
Just as the earth doesn’t stop at a flat edge, the world’s equity universe doesn’t end with large companies. There are large numbers of small cap stocks worldwide, and a great many products exposed to this asset class, that can be used to improve the diversity of an equity portfolio. Small cap companies hail from countries in all regions of the world, both developed and emerging, and tend to be more closely tied to their local economies than large caps. There is the occasional tech start-up, but more often it’s a parts manufacturer that made a piece of the airplane you fly, the car you drive, or the smart phone you can’t leave home without. The mix of characteristics and opportunities for growth that small caps may offer should put them squarely on a global investor’s equity map for further exploration.