The Case For Global Small-Cap

Coverage of the 2012 Global Investment Conference

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small fishAs an asset class, global small-cap equities offer several unique benefits. First, the opportunity set is expansive. With more than 4,500 stocks, the current global small-cap universe has more than twice as many stocks as the nearly 1,900 in the large- and mid-cap universes that make up the Standard MSCI GIMI World Index.

The asset class is less efficiently researched because it is covered by fewer equity analysts. This lower level of coverage results in greater market inefficiencies, and hence greater scope for finding undervalued stocks. There is also greater valuation dispersion in small caps than in large caps which can result in stronger performance in selecting outperforming companies.

Global small-cap equities have historically delivered strong absolute and risk-adjusted returns relative to global large caps and other asset classes. The strong returns offered by global small-cap equities have translated into rising demand, as institutional investors continually seek exposure to asset classes with high absolute and risk-adjusted returns to meet their investment objectives.

The global small cap asset class offers significant diversification benefits when combined with large-cap global equities and other major asset classes. When global small caps are held at a market weight in an index such as the MSCI World Index (i.e. moving to the MSCI IMI Index), both return, and risk-adjusted returns are enhanced. Although global small caps are riskier than large caps, they are less risky than emerging market stocks, and historically have provided marginally higher risk-adjusted returns when added to a developed global large cap portfolio. In addition, due to the inefficiences of the small cap marketplace, median manager alpha has historically been significant, and well above that of large cap global managers.

The diversification benefit of global small-cap investing has become more important as the trend toward globalization has increased correlations between national stock markets, thus eroding the diversification benefits of large-cap global investing. Small-cap stocks, which are less affected by global investment trends and tend to be driven more by idiosyncratic local market factors, we believe, are better diversifiers than large-cap stocks.

Over the 22 year history of the S&P Indices (and the 17 year history of the MSCI global indices), small-caps outperformed large/mid-caps about half the time. However, in those years where small-caps outperformed, they exhibited stronger upside than downside.  The data are consistent with our experience and intuition that large market selloffs are often associated with significant risk aversion, which can potentially create substantial opportunities in niche asset classes such as global small-cap stocks.

Global investments are a large and growing part of most institutional investors’ strategic asset allocation as confirmed by a 2010 Pyramis Global Advisors survey of chief investment officers, treasurers, and executive directors at corporate and public defined benefit (DB) pension plans in the US, Canada, and several European countries. Additionally, some institutional investors have added global small-cap mandates following the May 2008 introduction of the MSCI GIMI, which includes a 15% allocation to small-cap stocks.

We believe that the prospects for global small-cap equities are bright and that institutional investors will continue to increase their allocation to this asset class as its benefits become more widely understood.  Global small-cap investing, which has been on the rise in the institutional marketplace, is likely to accelerate, given the renewed focus on the asset class. Because investing in the widest liquid universe of securities is a central tenet of modern portfolio theory, we anticipate that institutional investors will continue to increase their exposure to global small-cap equities. Global small-cap returns should enjoy a “tailwind” as many institutional investors close their “small-cap gap” and increase their allocation to this asset class.

Chris Steward is Institutional Portfolio Manager, Pyramis Global Advisors

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