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Finding hidden gems in global small caps

They're less expensive than their U.S. counterparts and can lower portfolio volatility

Jun 2, 2015 @ 12:01 am

By Darek Wojnar

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As advisers consider where they can source potential growth for clients' portfolios, one overlooked asset class is global small-cap equities.

Despite U.S. investors' being very comfortable with international investing, small-cap companies (market cap of $300 million-$2 billion) outside the United States have generally flown under the radar. Yet upon closer review, they stand out for several attractive reasons.

For starters, of the more than 6,000 publicly traded global small-cap stocks, only about 2,000 are domiciled in the U.S., while two-thirds are based abroad. And a large proportion of those companies are in developed and emerging countries with established markets and liquidity. This represents an extremely large and deep pool of companies that many U.S. investment portfolios simply aren't exposed to.

(More: Small cap stocks go large on dividend payouts)

And while many investors with diversified holdings have at least some portion of their portfolio invested in small-cap equities via exchange-traded funds, mutual funds or directly, the majority of that allocation is likely in the U.S., where small caps currently appear expensive when compared to other markets. Today, U.S. small-cap equities trade at 45 times trailing P/E, whereas international and emerging-markets small caps are nearly half as expensive at 23 times and 21 times, respectively. Of course, investing internationally involves additional risks, so some investors view this valuation premium as justified. Others looking deep into markets see many companies' being overlooked by most investors but have potentially attractive valuations.

OVERCONCENTRATION

And consider this: U.S. small caps are also trading more than two times higher than U.S. large caps, so not only are most investors concentrating too much, if not all, of their small-cap exposure in the U.S., but that allocation currently looks a bit overheated and might be poised for a pullback. Advisers take note: There are potential dark clouds hanging over the U.S. economy and if the markets head south or even just flatten, U.S. small caps will be vulnerable.

International small caps, while generally considered riskier than the other parts of equity markets, also exhibit lower correlations to other asset classes, including to their U.S. counterparts. This may be viewed as both an attractive and particularly timely characteristic that can help U.S. investors prepare for the inevitable rise in interest rates and the potential resulting market turbulence, provided they're willing to look beyond the U.S. and take advantage of the opportunities globally.

(More: Wirehouses raise clients' exposure to alternatives, but reps still just dabbling)

One explanation for the lack of U.S. investors' exposure to this asset class is the idea of “home bias.” Though investors today have thoroughly embraced international and emerging-markets investing, it's a somewhat recent development. In the mid-1990s, for example, most individual investors in the U.S. had little to no international exposure. By the early 2000s, the target allocation recommended by many institutional managers had significant allocation to international equities, but most individual investors had minimal exposure, if any. Today, most portfolio strategists recommend a meaningful allocation to international equity investments within a long-term equity portfolio; however, the vast majority of this allocation is in large-cap stocks.

FAR FROM RISK-FREE

I'm by no means recommending that investors abandon U.S. small caps altogether. As with all investments, global small caps are far from risk-free. But considering a strategy that incorporates international developed and emerging markets along with U.S. exposure seems to make sense. What we find intriguing is the idea that combining U.S. small caps with international small caps may actually decrease volatility.

(More: Smaller economies offering bigger returns in the emerging markets sector)

In total, global small-cap equities may represent one of the last asset classes that U.S. investors have yet to embrace. Advisers would be wise to analyze this space to determine whether it makes sense for their clients' overall investment goals.

Darek Wojnar is a managing director at Lattice Strategies, a San Francisco-based investment management firmfirm and ETF sponsor.

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