Small companies beneficial for international equity portfolio allocations

21 Jan 2019

The inclusion of international small companies in a broader international equities portfolio significantly enhances an investor’s return profile, with no material detraction from a risk perspective, according to Zenith. Furthermore, due to the inefficiencies apparent in international smaller companies, Zenith believes an active investment approach should produce a superior outcome relative to a passive approach.

According to MSCI, international smaller companies are defined as listed stocks with market capitalisations of between $US 200 million and $US 1.5 billion. The international small cap benchmark consists of over 4,300 stocks, which offers greater levels of diversification and broader investment opportunities versus the MSCI World Index (1,600 stocks) that represents larger companies.

Zenith compared the performance of both indices over more than 17 years. A passive investment of $100 made on 1 October 2001 in international smaller companies would be worth approximately $328 on 31 December 2018, compared to approximately $197 for broader international equities.

While international smaller companies can provide investors with an opportunity to generate greater returns, Zenith notes that this outperformance comes at the cost of higher volatility. Over the assessed period the smaller companies index recorded a standard deviation of 13.4% p.a., compared with 11.6% p.a. for the broader index.

Although the volatility of international smaller companies has historically been higher than that of its large cap counterpart, Zenith notes that this difference has narrowed significantly in recent times. The synchronised subdued market volatility can be attributable, in part, to the current low interest rate environment that has resulted in a heighted degree of investor risk tolerance.

Quan Nguyen, Zenith Head of Equities said “While international small caps have the potential to provide investors with high levels of returns, the elevated volatility levels of this asset class can make it difficult to achieve superior returns over the long-term when measured on a risk-adjusted basis. However, Zenith believes this should not deter investors from seeking an international small cap exposure.”

Part of the benefit of including international small companies is the outperformance potential of active fund managers in this space, which arise from the apparent inefficiencies and comparative lack of research in the small cap segment of the market.

Nguyen said, “Active international small cap fund managers are better placed to generate excess return than their large cap counterparts, and we believe an active investment approach should produce a superior outcome relative to a passive approach”.

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