The Allocators’ Conundrum

With bond yields below their historic averages and equity valuations above theirs, asset allocators face the daunting prospect of lower than average returns while still needing to meet the growing challenge of required performance goals. These required rates of return are driven by either mandatory withdrawal rates, in the case of retirees, endowments, and foundations, or portfolio growth rates for investors still in the accumulation stage. The question this paper seeks to answer is, can global small caps help allocators square this circle by providing the opportunity for increased returns without a commensurate increase in risk? Our research suggests that the answer to that question is a resounding “yes.” This paper examines how we arrived at this view, which also shows that global small caps are a ‘Goldilocks’ asset class—one with attractive absolute and relative long-term returns that’s demonstrated far less relative risk, we believe, than one may expect.

Why Allocate to Global Small-Cap Stocks?

Our primary goal is to introduce the global small-cap asset class by detailing its attributes in terms of performance, multiple risk measures, and its relative results in varying economic regimes. We also detail why it offers fertile ground for active management. We frame this analysis by comparing global small cap’s performance with that of global large cap and emerging markets—the two asset classes most commonly used for public market equity investments.

Those allocators already familiar with global large caps may be pleasantly surprised by the similarity in the risk profiles of global large and small caps. Given this comparable risk profile, we think allocators may also be surprised by the regular frequency with which global small caps have historically delivered higher returns than their larger peers.

The comment we receive most regularly from prospective investors more conversant with emerging markets is, “Why would I consider global small caps when I can just invest in EM for a beta play on global equities?” We detail the reasons below but offer a summary answer here: emerging market equities have a much higher risk profile than global small caps, and so EM is a more questionable allocation from a risk-budgeting perspective. Of particular relevance for active managers is the fact that the opportunity set—that is, the number of companies—is more than twice as large in global small caps compared to emerging markets.

The first section compares rolling returns and the frequency of outperformance, risk metrics, and risk-adjusted returns, along with down market and recovery periods, for global small cap and global large cap before looking at global small caps versus emerging markets on the same parameters.¹ We also present regime studies that reveal the environments that are more and less favorable for each of the three asset classes, comparing them during periods of rising and falling interest rates, increasing and decreasing cyclical activity, narrowing and widening credit spreads, and higher and lower levels of nominal GDP growth. We then show the potential performance benefits of adding global small caps to a portfolio of global large caps and to a portfolio of both global large caps and emerging markets.

We wish to emphasize four key points that make global small caps worthy of allocators’ attention.

The asset class has historically enjoyed:

1) A superior return profile to global large caps despite a comparable risk profile;
2) A meaningfully lower risk profile than emerging market stocks, despite a somewhat better long-term return profile;
3) A performance record that suggests portfolios could improve their returns without increasing their risk by including global small caps; and
4) Attributes which indicate the asset class may be a fruitful area for active management.

¹ Throughout this paper, we used the MSCI ACWI Small Cap Index as our proxy for global small-caps, the MSCI ACWI Large Cap Index as our proxy for global large-cap stocks, and the MSCI Emerging Markets Index as our proxy for emerging markets for the data in this paper.
Past performance is no guarantee of future results.

An Undiscovered Country

It seems fair to say that the majority of asset allocators do not evaluate or consider global small caps, preferring instead to limit their global equity allocation to large caps and/or emerging market equities. For example, less than 1% of UCITs fund assets are invested in global small cap portfolios according to Morningstar data—which strikes us as a missed opportunity. Global small caps are an attractively large asset class—$9.7 trillion in market cap as of 6/30/21—featuring significantly more companies—more than 6,200—than the global large cap (1,429) and emerging markets (1,412) indexes combined.

Strong Long-Term Performance and Consistent Outperformance Versus Global Large Caps

In order to merit inclusion in a globally diversified portfolio, any asset class needs to first pass the performance threshold by exceeding the returns for the asset class it aims to displace. Global small caps pass this first performance test handily. Based on rolling monthly annualized 5- and 10-year returns since the index’s inception, global small caps posted a significantly higher return than global large caps averaging 8.2% versus 6.1% for the rolling five-year periods and an even more impressive 8.5% versus 5.5% for the 10-year periods.

More impressive than the rolling monthly average outperformance was the consistency of global small cap’s relative advantage. As shown in the chart below, global small caps outperformed global large caps in 91% of all 10-year periods and 74% of all five-year periods.

% of Outperformance Periods for MSCI ACWI Small Cap vs MSCI ACWI Large Cap
Monthly Rolling Average Annual Return Periods from Index Inception (5/31/94) through 6/30/21

Past performance is no guarantee of future results. The above chart is shown for illustrative purposes only and does not reflect the past performance, or project the future performance, of any investment. The performance of an index, such as those used above, does not represent any particular investment as you can not invest in an index. Source: Bloomberg.

Lower-Than-Expected Volatility and Higher Risk Adjusted Returns Versus Global Large Caps

Responsible allocators must always bear risk in mind, and the attractive long-term performance record for global small caps would mean less if this advantage came with a markedly higher risk profile. Fortunately, global small-caps’ incremental volatility compared with global large caps is lower than many might think. Global small caps have higher volatility based on average five- and 10-year rolling monthly average standard deviation, but only modestly so. Moreover, the relatively low incremental volatility of global small caps is complemented by the relatively large return spread versus global large caps, a combination that has produced a superior risk/return trade-off as illustrated by the scatterplot.

Average of Monthly Rolling 5- and 10-Year Periods
From 5/31/94–6/30/21

The above chart is shown for illustrative purposes only and does not reflect the past performance, or project the future performance, of any investment. The performance of an index, such as those used above, does not represent any particular investment as you can not invest in an index. Past performance is no guarantee of future results. Source: Bloomberg.

As might be expected given this favorable risk/return profile, global small caps have consistently delivered appreciably better risk-adjusted returns than global large caps, as measured by Sharpe ratio, as well as an admirably high percentage of outperformance periods.

Relative Risk Adjusted Returns for Global Small Cap vs. Global Large Cap
Monthly Rolling Sharpe Ratios from 5/31/94-6/30/21

 

• 	PERIODS GLOBAL SMALL BEAT GLOBAL LARGE		MSCI ACWI SMALL AVG*	MSCI ACWI LARGE AVG*
  Five-Year	193/266 PERIODS	73%	0.47%	0.39%
  10-Year	184/206 PERIODS	89%	0.44%	0.30%

  *Average of monthly rolling sharpe ratios over the specified periods.
  Past performance is no guarantee of future results. Source: Bloomberg.

  Alternative Risk Metrics

  While volatility is the most common way of measuring risk, we use two additional measures that are helpful in understanding the potential risks of investing in global small caps. First, one intuitive definition of risk is the probability of a capital loss. While that probability cannot be known with certainty about a future investment, we suspect that most allocators would be surprised by the percentage of multi-year holding periods when global small caps experienced a loss, compared with the loss experienced by global large caps.

  Global small caps had fewer periods of negative or flat returns than global large caps over rolling 5-year periods. Notably, global small caps had no negative return experiences over 10-year holding periods, while global large caps had 17, or 8% of the time.

  Global small caps had no negative return experiences over 10-year holding periods, while global large caps had 17, or 8% of the time.

  % of Positive Monthly Rolling Return Periods
  MSCI ACWI Small Cap vs MSCI ACWI Large Cap from 5/31/94–6/30/21

  
  
  Number of periods where MSCI ACWI SC has a positive return: 5-Year, 247 /266, 10-Year, 206 / 206.
  Number of periods where MSCI ACWI LC has a positive return: 5-Year, 207 /266, 10-Year, 189 / 206.
  Past performance is no guarantee of future results. Source: Bloomberg.

  Another useful risk metric is the depth of down market declines. On this measure, global small caps had deeper declines than global large caps, as shown by the prior six declines since the index’s inception.

  Down Market Performance Comparison of Global Small Cap vs. Global Large Cap
  From 5/31/94 through 6/30/21 (%)

  

  Past performance is no guarantee of future results. Source: Bloomberg.

  However, global small caps also experienced stronger recoveries than global large caps, averaging 64.3% one year after market troughs, compared with 47.8% for global large caps. Putting the decline and first year of recovery together shows that global small caps declined further and bounced back stronger to lead over the entire period.

  Subsequent 1-Year Periods after Down Market Performance Comparison
  From 5/31/94 through 6/30/21 (%)

  

  Past performance is no guarantee of future results. Source: Bloomberg.

  Global Small Cap’s Superiority to Global Large Cap

  To summarize: global small caps have historically delivered higher average returns than global large caps over multiple time periods, have enjoyed a notably high frequency of beating their larger siblings, and delivered superior risk-adjusted results—more than compensating for the modest increase in volatility. The asset class accomplished all of this while also experiencing fewer multi-year periods of losses, in large part by recovering quickly after market declines. This impressive collection of positive attributes would seem to merit, in our view, the addition or increase of a global small cap allocation.

  A Surprising Performance Advantage Over Emerging Market Equities

  Our conversations with investors have revealed two fundamental misunderstandings about global small caps compared with emerging market equities. First, many are surprised that global small caps own the long-term historical performance edge over the MSCI Emerging Markets Index—based on rolling monthly five- and 10-year periods since the inception of the global small cap index in May 1994. Global small caps also outperformed emerging market equities for a majority of the rolling periods—in 64% of all five-year periods and 54% of all 10-year periods.

  The performance spread for global small caps is narrower versus emerging market equities than it is versus global large caps, though we have found that any performance advantage for global small caps tends to come as a surprise, particularly to emerging market equity investors.

  % of Outperformance Periods for MSCI ACWI Small Index vs MSCI EM Index
  Monthly Rolling Average Annual Return Periods from Index Inception (5/31/94) through 6/30/21

  

  Past performance is no guarantee of future results. The above chart is shown for illustrative purposes only and does not reflect the past performance, or project the future performance, of any investment. The performance of an index, such as those used above, does not represent any particular investment as you can not invest in an index. Source: Bloomberg.

  Significantly Lower Volatility and Attractive Risk-Adjusted Returns Versus Emerging Markets

  The second misperception relates to the degree of difference in the volatility between the two asset classes. Emerging market equity investors often contend that the two asset classes must have comparable risk profiles. Yet, their return histories show that emerging market equity has a meaningfully higher volatility profile than global small caps. We think that the higher returns and lower volatility of global small caps versus emerging market equities create an attractive risk/reward profile for the former, as shown in the scatterplot.

  We think that the higher returns and lower volatility of global small caps versus emerging market equities create an attractive risk/reward profile for the former.

  Average of Monthly Rolling 5- and 10-Year Periods
  From 5/31/94 – 6/30/21

  

  Past performance is no guarantee of future results. The above chart is shown for illustrative purposes only and does not reflect the past performance, or project the future performance, of any investment. The performance of an index, such as those used above, does not represent any particular investment as you cannot invest in an index. Source: Bloomberg.

  In light of both its strong relative performance history and lower volatility, it comes as no surprise that global small caps have a record of consistently higher risk-adjusted returns than emerging markets.

  Relative Risk Adjusted Returns for Global Small Caps vs. Emerging Markets
  Monthly Rolling Sharpe Ratios from 5/31/94-6/30/21

  	PERIODS GLOBAL SMALL BEAT EMERGING MARKETS		MSCI ACWI SMALL AVG*	MSCI EM AVG*
  Five-Year	170/266 PERIODS	64%	0.47	0.31
  10-Year	131/206 PERIODS	64%	0.44	0.34

  *Average of monthly rolling sharpe ratios over the specified periods. Past performance is no guarantee of future results. Source: Bloomberg.

  Frequency of Loss and Down Market Comparisons Versus Emerging Markets

  Extending our risk analysis of the two asset classes to additional risk measures confirms our earlier observations. Global small caps had fewer periods when they experienced a loss than emerging market equities over rolling 5- and 10-year periods, while posting higher average returns. The disparities are startling. Over five-year rolling monthly return periods, the MSCI ACWI Small Cap had 19 negative return periods--while the MSCI EM Index had 74. The global small-cap index had no negative monthly 10-year rolling return periods; emerging markets had seven.

  Global small caps also experienced less severe declines than emerging market equities, beating them in five of the six major downturns of 20% or more since the inception of the global small cap index on 5/31/94.

  Down Market Performance Comparison
  From 5/31/94 through 6/30/21 (%)

  
  
  Past performance is no guarantee of future results. Source: Bloomberg.

  Recovery periods were equally favorable for global small caps, which had an average return in the subsequent recoveries, averaging 64.3% (as mentioned above) one year after the market trough, compared to 58.9% for emerging markets. Putting the decline and first year of recovery together shows a decided performance advantage for global small cap stocks.

  Subsequent 1-Year Periods after Down Market Performance Comparison
  From 5/31/94 through 6/30/21 (%)

  

  Past performance is no guarantee of future results. Source: Bloomberg.

  Global Small-Cap Results in Different Environments

  To further examine the superior performance record for global small caps versus global large caps and emerging market equities, we analyzed different economic regimes based on four indicators to see which led to the most favorable and unfavorable returns for each of the three asset classes. The four regime conditions were: interest rates, using the 10-year U.S. Treasury yield; cyclical activity, using the U.S. ISM Manufacturing Index; credit spreads, using U.S. high yield spreads; and the level of economic activity, using nominal U.S. GDP growth. For two of the four indicators, we calculated rolling one-year returns from 5/31/94 and compared the results. (We note that data for high-yield spreads only goes back to 12/31/96.)

  Looking at interest rates, we found a positive correlation for all three asset classes with rising interest rates, perhaps a surprising result for some. All three asset classes had average one-year returns in rising rate periods that exceeded their overall average one-year returns. Global small caps outperformed global large caps in 72% of the observations by an average of 555 basis points. Emerging market equities, however, outperformed global small caps by 69 basis points and had a higher return in 56% of the periods. When the 10-year Treasury yield was falling, global large caps fared best, with an average gain of 2.5% while small caps rose 1.5% on average, and emerging markets had negative results, declining 1.1% on average. It seems likely that the three asset classes did not advance solely because interest rates are rising but instead because other positive factors, such as economic acceleration, were coincident.

  Interest Rate Environments
  Monthly Rolling Trailing 1-year Periods from 5/31/94 through 6/30/21

  

• Past performance is no guarantee of future results. Global SC is the MSCI ACWI SC Index, Global Large Cap is the MSCI ACWI LC Index, and EM is the MSCI EM Index. Source: Bloomberg

  Looking next to cyclical activity, the return patterns were similar—all three asset classes had average returns that exceeded their overall average one-year returns for periods with rising U.S. ISM readings. Global small caps outperformed global large caps in 67% of the observations by an average of 420 basis points, while once again, the results versus emerging market equities were the opposite, as global small caps underperformed emerging market equities by 188 basis points and had a higher return in 60% of the periods. During periods of falling ISM measures, global large caps beat both global small caps and emerging markets the majority of the time, with an average gain of 3.3% versus an average gain of 1.9% for global small caps and a loss of 2.7% for emerging markets.

  ISM Environments
  Monthly Rolling Trailing 1-year Periods from 5/31/94 through 6/30/21

  

  Past performance is no guarantee of future results. Global SC is the MSCI ACWI SC Index, Global Large Cap is the MSCI ACWI LC Index, and Emerging Markets is the MSCI Emerging Market Index. Source: Bloomberg

  Our next test was to see the results for periods in which credit spreads were widening. Global large caps beat global small caps in 43% of widening credit spread periods—in which each averaged a negative return—by an average of 201 bps. However, global small caps beat emerging market stocks by an average of 281 bps in 60% of the periods.

  Credit Spread Environments
  Monthly Rolling Trailing 1-year Periods from 12/31/96-6/30/21

   

   

• Past performance is no guarantee of future results. Global SC is the MSCI ACWI SC Index, Global Large Cap is the MSCI ACWI LC Index, and EM is the MSCI EM Index. Source: Bloomberg

•  

  Global small caps outperformed global large caps in periods when credit spreads were narrowing, outperforming by an average of 665 bps over 79% of the periods—advancing on average 24.3% versus 17.7% for global large caps. However, emerging market equities had an edge over global small caps in periods of tightening spreads, leading by an average of 91 bps and 59% of the periods.

  We also looked at performance in the context of nominal U.S. GDP growth. Previous research showed better correlations of small cap returns with nominal, rather than real, U.S. GDP growth, as small caps tend to benefit from both increased inflation and increased real economic growth. We constructed this study looking at periods of 3-5% nominal U.S. GDP growth compared with periods that grew 5%-plus. The return gap was notable in that global small caps beat global large caps 63% of the time by an average of 185 basis points when nominal GDP growth was in the 3-5% range. However, global small caps trounced global large caps by an average of 747 basis points in 80% of the periods when nominal GDP growth was 5% or greater. As might be expected, emerging markets outpaced global small caps during these more robust, 5%-plus periods, beating global small caps 70% of the time, with an average return of 30.3% versus 25.3% for global small caps.

  Nominal U.S. GDP Environments
  Quarterly Rolling Trailing 1-year Periods from 6/30/01-6/30/21

  

  Past performance is no guarantee of future results. Global SC is the MSCI ACWI SC Index, Global Large Cap is the MSCI ACWI LC Index, and EM is the MSCI EM Index. Source: Bloomberg

  There seem to be clear patterns of relative performance advantages among the three asset classes through different environments. A simplified way to show the same diverse tendencies is to look at returns in each of the past 25 calendar years for the three asset classes, sorted by best return.

  The graphic below shows the number of years in which each index finished first or last:

  

  Past performance is no guarantee of future results. Global Small Cap is the MSCI ACWI SC Index, Global Large Cap is the MSCI ACWI LC Index, and Emerging Market is the MSCI Emerging Market Index. Source: Bloomberg.

  These varying results suggest that it might be productive to include these asset classes together in a portfolio, but we think the more salient point is that global small cap enjoyed significantly fewer years with the lowest return of the three asset classes. We think this offers a major support for our argument that global small caps are the ‘Goldilocks’ asset class among the three.

  Portfolio Examples

  Returning to the original challenge for the global allocator—how to best structure a portfolio for attractive returns without assuming undue risk, we analyzed two simplified comparisons designed to highlight the benefits of adding global small caps to a multi-asset portfolio. For each portfolio, we calculated hypothetical results (based on an initial $100 million portfolio), standard deviation, and Sharpe ratio. In the first comparison, we calculated returns for a 60/40 Global Large Cap/Global Fixed Income portfolio compared to a 40% Global Large Cap, 20% Global Small Cap, and 40% Global Fixed Income portfolio. Both portfolios were rebalanced quarterly and encompassed the same time period, 5/31/94-6/30/21.

  While both portfolios showed strong standard and risk-adjusted performance, the portfolio with the global small-cap allocation had higher absolute and risk-adjusted returns as well as comparable volatility.

  Four Hypothetical Growth of $100,000,000 by Portfolio Allocations
  Quarterly Rebalanced from 5/31/94-6/30/21 (Monthly Data)

  

  Past performance is no guarantee of future results. The charts above are shown for illustrative purposes only are hypothetical and do not reflect the past performance, or project the future performance, of any actual investment. The performance of an index, such as those used above, does not represent any particular investment as you cannot invest in an index. “Global Small-Cap” is represented by the MSCI ACWI x USA SC, “Global Large-Cap” is represented by the MSCI ACWI LC, “Global Fixed Income” is represented by the Bloomberg Barclays Global Aggregate Bond Index and “Emerging Markets” is represented by the MSCI EM. Source: Bloomberg.

  In the second comparison, we calculated returns for a portfolio consisting of 40% Global Large Cap, 20% Emerging Market, and 40% Global Fixed Income and compared it to a portfolio with 30% Global Large Cap, 20% Global Small Cap, 10% Emerging Market and 40% Global Fixed Income portfolio. As with the first hypothetical, both portfolios were rebalanced quarterly and encompassed the same 5/31/94-6/30/21 time period. Once again, while both multi-asset hypothetical portfolios showed strong standard and risk-adjusted performance, the portfolio with the global small-cap allocation had higher absolute and risk-adjusted returns as well as lower volatility, with the portfolio that allocated to global small cap posting a 7.1% average annual total return, both with and without an allocations to emerging markets.

  We think these results make a strong argument in favor of allocating to global small cap stocks. As mid-1994 was an especially challenging year for emerging markets, we also opted to calculate at these same hypotheticals over the last 20 years. This two-decade look gives a fairer picture of the positive effect of allocating to both global small caps and emerging markets. In fact, because each is a highly differentiated asset class with different performance patterns, we think an allocation that includes both makes the most sense. This is borne out by the data. The average annual total return for an allocation to global small cap, 7.2%, or emerging markets, 7.3%, was better than the 6.5% average annual total return for the portfolio that included only global large cap in its equity exposure. However, the highest return was for the portfolio that held both global small cap and emerging markets, which had an average annual total return of 7.6%. We think these hypothetical portfolio allocations therefore makes a very convincing case for allocating across all three global asset classes.

  Four Hypothetical Growth of $1,000,0000 by Portfolio Allocations Last 20 Years
  Quarterly Rebalanced from 6/30/01-6/30/21 (Monthly Data)

  

  Past performance is no guarantee of future results. The charts above are shown for illustrative purposes only are hypothetical and do not reflect the past performance, or project the future performance, of any actual investment. The performance of an index, such as those used above, does not represent any particular investment as you cannot invest in an index. “Global Small-Cap” is represented by the MSCI ACWI x USA SC, “Global Large-Cap” is represented by the MSCI ACWI LC, “Global Fixed Income” is represented by the Bloomberg Barclays Global Aggregate Bond Index and “Emerging Markets” is represented by the MSCI EM. Source: Bloomberg.

  The Case for Active Management in Global Small Caps

  Do the attractive attributes of global small caps also offer the potential for active managers to improve on these results? We believe they do, based on the following observations.

  A Large and Inefficient Asset Class

  As we have noted previously, global small caps are a large opportunity set with more than 6,200 stocks in the MSCI ACWI Small Cap Index—which is more than four times as many companies as in the MSCI ACWI Large Cap Index and four times as many companies as in the MSCI EM Index.

  A Large Opportunity Set
  Number of global small cap vs. large cap companies as of 6/30/21
  

  

• Source: FactSet

  More important for active managers, the research coverage of global small caps is much less extensive than it is for global large caps, with 22% of global small cap companies (roughly 1,400) having one—or no—analyst coverage, compared with only 4% of global large caps with similarly scant coverage. This observation indicates, at least to us, that global small caps are a very attractive hunting ground for active managers.

  We believe global small caps offer a very attractive hunting ground for active managers.

  An Inefficient Asset Class
  % of global stocks with coverage from <1 analyst as of 6/30/21

  

  Source: FactSet

  High ROIC Companies

  Additional support for the case for active management derives from showing that some filters active managers can use have produced historically superior results. For example, the subset of companies within global small caps with high profitability, based on ROIC (return on invested capital), have delivered returns that markedly exceeded those for the index as a whole. The average annual total return for the top ROIC decile of global small-cap stocks was 14.8% from 3/31/03-6/30/21, compared to 12.3% for the overall index over the same period. This suggests to us that an active management approach focusing on companies with higher profitability can enhance the potential for higher returns.

  Conclusion

  Our goal in this paper was to introduce the global small-cap asset class and present research findings which support the idea that global allocators should consider adding the asset class to their multi-asset portfolios. In our view, global small cap’s combination of strong absolute and relative performance, lower-than-expected volatility, relatively strong down market results, and strong results in several different market environments makes a very strong case for including this asset class in a globally diversified portfolio. A meaningful weighting in global small caps can also improve both the standard and risk-adjusted returns of a global large cap portfolio. Allocators who have solely used global large caps and emerging market equities have the opportunity to consider the potential benefits of adding an allocation to global small caps.

  We suggest that global allocators also consider the potential advantages active management can offer within this asset class based on both the historical strength of certain filters and the overall inefficiency of this large opportunity set of global small-cap stocks.

 

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