Does your plan have a global small-cap “gap”?

April, 2012 Print



Although global small-cap equities have historically offered attractive returns and diversification properties to most investors, there has been a sharp increase in interest in the global small-cap asset class over the past few years, due in part to a search for diversification, and in part to changes to the Morgan Stanley Capital International (MSCI) global equity indices. In May 2008, MSCI Barra launched the MSCI Global Investable Market Indices (MSCI GIMI), which implemented a more robust small-cap index within its popular MSCI global equity indices. As a result, many investors now include global smallcap stocks on their “report card.” We believe that global small-cap stocks are a compelling asset class that has a place in every institutional investor’s portfolio.

Global small-cap investing
The case for global investing is grounded in modern portfolio theory, beginning with the Markowitz models of the 1950s, which were based on the diversification benefits of investing in the broadest possible global portfolio. However, when most investors add companies from outside their domestic market to their portfolios, they generally add large-cap names – in part due to their liquidity. This common large-cap bias also derives from the fact that most stock indices are capitalisation-weighted, and from the name recognition and comfort level that come from holding wellknown multinational companies.

As 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 largeand mid-cap universes that make up the standard MSCI GIMI World Index.

Second, the asset class is less efficiently researched because it is covered by fewer equity analysts. For example, the average number of analysts per stock in the MSCI World Standard Index is 17.3, compared with only 7.4 for the World Small Cap Index.1 This lower level of coverage results in greater market inefficiencies, and hence greater scope for finding undervalued stocks. Third, global small-cap equities have historically delivered strong absolute and risk-adjusted returns relative to global large-caps and other asset classes. And lastly, the asset class offers significant diversification benefits when combined with largecap global equities and other major asset classes.

Many institutional investors have global small-cap mandates due to the attractiveness of the asset class itself, given the historical performance and diversification benefits offered by global small-cap stocks. Some institutional investors added global small-cap mandates following the May 2008 introduction of the MSCI GIMI, which includes a 15% allocation to small-cap stocks. This article looks at the role of global equities within the asset allocation policies of institutional investors, reviews the historical risk-and- return characteristics of the global small-cap asset class, addresses the differences between the MSCI GIMI group of indices and previous versions of the MSCI global equity indices, and explores the ways in which institutional investors might choose to add small-cap global stocks to their strategic asset allocation.

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 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 466 corporate and public defined benefit (DB) pension plans in the US, Canada, the UK and 10 northern European countries. These survey respondents manage more than $2 trillion (USD) in pension assets, or approximately 12% of the global DB plan market. When asked if they intend to diversify their global equity portfolios into different capitalisation ranges, such as large and small cap, 25% of DB plan sponsors in the US, 28% of UK plan sponsors and 38% of plan sponsors in Europe (ex-UK) indicated that they did intend to diversify.

As the MSCI GIMI index includes a 15% allocation to small-cap stocks, this implies that there will be a significant increase in demand for international small-cap stocks, even if only a small proportion of institutional investors decide to move from the old MSCI Standard international equity indices to the MSCI GIMI family of indices.

Global small-cap equities – historical performance
The historical case for global small-cap investing is a strong one and becomes evident with a closer look at four demonstrable historical characteristics of this asset class:
• Strong absolute returns
• Consistent value added from active management
• Diversification benefits
• High risk-adjusted returns

Strong absolute returns

Historically, global small-cap equities have been able to deliver stronger returns than global large caps over longer-term time horizons, as shown in Figure 1. Similarly, longer-term studies of US small-cap equity returns relative to US large-cap equity returns have demonstrated that the higher risk premium associated with small-cap stocks translates into larger returns. This same high risk premium effect may also help explain the higher returns provided by global small-cap stocks. In any case, 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.

Long-term returns for global small-cap stocks versus global large-cap stocks have been strong; however, their relative performance can vary substantially from period to period. Figure 2 (below) shows that small-cap stocks lagged the larger MSCI World Standard Index from 1995 through 1999, but have outperformed the World Standard Index in eight out of the last 11 calendar years since 2000. Although these periods of small-cap stock over- and underperformance relative to large- and mid-cap stocks seem to persist for several years, the diversification benefits of global small- cap stocks make a strong case for maintaining a strategic allocation to global small-cap equities throughout the market cycle.

Consistent value added from active management

Although most academic studies of the benefits of global investing are from a US investor’s perspective, historically, they have shown that returns to US investors for actively managed international small-cap stocks have been higher than for international largecap stocks, in part because fewer equity analysts follow these stocks. Figure 3 (below) shows rolling three-year quarterly returns for the median international small-cap manager relative to the benchmark. The average threeyear alpha for the median international small-cap manager has been a strong 2.8%, a full percentage point higher than the alpha for the median international large-cap manager.

Diversification benefits

The diversification benefit of global small-cap investing has become more important as the trend toward globalisation 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. Figure 4 (below) shows that while the correlation of global small-cap stocks with most major country and regional market indices has tended to move in the same direction as correlations with global large-cap stocks, in most markets, the correlation of the small-cap stocks has consistently been much lower. Against most major indices, global small-cap stocks provide significant or better diversification than emerging market stocks.

High risk-adjusted returns

The high absolute returns of global small-cap stocks combined with the diversification benefits lead to strong risk-adjusted returns, as shown in Figure 5 (below). Again, in most market environments, small-cap stocks have higher risk-adjusted returns than large-cap and global mid-cap stocks. Therefore, within a multi-asset-class portfolio, the global small-cap allocation may be included not only for the absolute return expectations but also for their historical risk adjusted returns.

Implementation considerations

The foregoing discussion provides strong arguments to support the consideration of global small-cap equities as a separate asset class and demonstrates that they have historically provided attractive risk-and-return properties within a diversified portfolio. However, many institutional investors might still be wondering what changes, if any, they should consider making to their investment portfolios reflecting the changes to the MSCI global equity indices and, if so, how they might best implement them.

We believe that institutional investors have three main options available when considering the addition of global smallcap equities to their investment plan. These options, with their respective advantages and disadvantages, are to:

• Maintain the status quo
• Extend existing mandates
• Add a separate small-cap mandate

Maintain the status quo

Many institutional investors may decide that they do not need to change their strategic asset allocation to include global small-cap and will choose to stay with the MSCI Global Standard Index. Maintaining the status quo may represent the path of least resistance in that no new mandates need be added, thus avoiding the board approval process and the accompanying complications of adding a new portfolio to the asset allocation policy. However, the drawback of this approach is that it ignores the potential diversification and return offered by global small-cap stocks, and runs counter to the principles of modern portfolio theory that provide the intellectual underpinning for the majority of diversified investment plans.

Extend existing mandates

An approach that is only slightly more burdensome than maintaining the status quo is to adopt the all-cap MSCI World IMI benchmark and extend the mandate of the existing global managers to include global small-cap stocks. One appeal of this approach is that it minimises the administrative burden of setting up new accounts and overseeing new managers. However, it has some drawbacks as well. A shift from the MSCI World Standard Index to the World IMI adds about 4,400 names to the benchmark, essentially trebling the number of stocks to follow. Many investment managers may lack the expertise or familiarity with this asset class needed to provide the diversification and return that a specialist small-cap manager can provide. Large-cap managers might be tempted to invest in only a representative sample of the small-cap equity universe or to vary the small-cap allocation opportunistically; both strategies can reduce diversification and return. Lastly, global small-cap stocks are driven by local factors and have less market liquidity, where a higher degree of local knowledge and trading expertise can be immensely beneficial. To extract the greatest benefit from both idea generation and execution in global small-cap investing requires regionally based small-cap equity research and analysis and a specialised trading staff.

Add a separate small-cap mandate

Lastly, many institutional investors will decide to add a separate global small-cap mandate with a proven track record. This approach benefits from the specialist global small-cap expertise of the manager and the advantage of trading expertise in the more liquidityconstrained markets for smaller-cap stocks. A stand-alone global small-cap portfolio also enables the establishment of more specific portfolio-level risk-andreturn targets. For example, an institutional investor might wish to allocate a higher risk target to the global small-cap portfolio, given the greater inefficiency of the asset class and its smaller weight within the overall plan. The downside to this approach is that it requires additional administrative effort in the search for, hiring, and ongoing oversight of the global small-cap investment manager. In addition, given the liquidity constraints within the global small-cap segment, many of the best small-cap equity investment managers are either closed or have limited capacity.


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, due at least in part to changes in the MSCI global equity indices. The potential benefits of investing in global small-cap stocks have been well documented. Global small-cap equities present a large investment universe of securities that, as they are covered by fewer research analysts than large- and mid-cap stocks, have historically provided consistently strong riskadjusted returns in addition to powerful portfolio diversification benefits. 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.




Robert Feldman
Portfolio Manager
Pyramis Global Advisors

Lance McInerney
Institutional Portfolio Manager
Pyramis Global Advisors

Chris Steward
Institutional Portfolio Manager
Pyramis Global Advisors



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