ManagersINSIGHT. The Case for Investing in International Small Cap. Chart 1

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1 Managers INVESTM ENT GROUP Mutual Funds Separate Accounts Investment Solutions ManagersINSIGHT AUGUST 2011 Managers Investment Group Research and Analysis by Michael Zinkand, CFA The Case for Investing in International Small Cap Most investors would agree that investing in domestic small-cap stock has become an essential element to building a well-diversified investment program. Over time, small-cap stocks have provided exposure to a segment of the equity market that typically offers faster growth, good risk-adjusted returns, and relatively low correlation with larger-cap stocks and other asset classes. Yet, when investors make an allocation to the international markets, they have tended to ignore the substantial universe of smaller-cap stocks that are available overseas, quite possibly thinking they are getting significant small-cap exposure by investing in emerging markets. We believe investors are missing an opportunity to further add value and increase diversification by ignoring this large segment of the international equity market. In this analysis, we show that international small-cap stocks provide the same benefits that U.S. small-cap stocks offer, along with some additional benefits. They: Substantially increase the investment opportunity set and potential for adding alpha Complete the cap range of an international portfolio, as emerging market benchmarks 1 only derive approximately 15% of their weighting from companies with a market capitalizations less than $5 Billion Demonstrate added diversification benefits Historically have provided good absolute and risk-adjusted returns, allowing investors the opportunity to enhance their portfolio return without additional uncompensated risk As a result, we believe investors should reassess their allocation to international small-cap stocks, with the goal of increasing their weighting to a target of 5%-10% of their total equity allocation 2. THE GLOBAL SMALL CAP MARKET International benchmarks and investors do not have a uniform capitalization definition of small-cap stock. Some consider $2 Billion as 1 MSCI, Factset the cutoff, while others prefer $3 or $5 Billion. One of the most popular index providers, Morgan Stanley Capital International ( MSCI ), defines small-cap stock as those stocks that represent the bottom 10% 15% of global market capitalization. Using recent MSCI data, small-cap stock represented 14% of the global equity market, evenly split between domestic and non-u.s. stocks (as of June 30, 2011). (Chart 1) Chart 1 Domestic Small Cap GLOBAL INVESTABLE UNIVERSE Total World Equity Market Cap $34.0 Trillion 7% Source: MSCI & Factset 06/30/11 International Large Cap 49% 37% 7% Domestic Large Cap The global small-cap stock universe as measured by the MSCI All Country World Index ex U.S. Small Cap Index (MSCI ACWIxUS SC) contains approximately 6,500 stocks, with roughly 4,500 of those outside the United States. This universe represents a sizable pool of stocks for active international managers to choose from one that has more than twice as many stocks as the U.S. small-cap market. (Table 1) Table 1 - Characteristics as of 06/30/11 International Small Cap CHARACTERISTIC MSCI ACWIxUS SC Russell 2000 Wtd-avg Mkt Cap $1,209 M $1,131 M # of Securities 4,663 1,985 # of Countries 44 1 MI Investors should consider their particular circumstances and/or speak with their advisors to determine the specific allocation that is appropriate for them. continued on page 2 PAGE 1

2 Even though the non-u.s. small-cap stock universe is large and represents 7% of the global marketplace, international small-cap stock is substantially underweighted in investors portfolios. According to Morningstar, international small-cap stocks represent only 1.4% of equity mutual fund assets (Chart 2) and 1.3% of separate account equity assets (Chart 3), signifying investors are underweight a meaningful portion of the global capital markets. Chart 2 ALLOCATIONS IN EQUITY MUTUAL FUNDS International SC Equity International LC Equity U.S. LC Equity U.S. Small Cap Emerging Markets 7.8% 5.3% 22.0% 1.4% 63.5% The underweight to international small-cap stock is likely attributable to one or more of the following factors: Most non-u.s. exposure is concentrated in products that are benchmarked against broad international indexes, such as the MSCI EAFE Index and the MSCI ACWIxUS Index. These indices each have less than a 5% weighting in small-cap stocks. Investors may believe they are achieving small-cap exposure by allocating assets to emerging markets. In reality, the MSCI Emerging Markets Index has less than a 3% weighting to stock with market capitalizations below $2 Billion and less than a 15% weighting to stock with a market capitalization below $5 Billion. Investors may be unaware of the opportunity or the significance of the opportunity. Investors may perceive that international small-cap stock is too risky and/or does not offer compelling diversification benefits, although history does not support this perception (particularly compared with the experience of U.S. small-cap stock). Source: Morningstar Chart 3 ALLOCATIONS IN EQUITY SEPARATE ACCOUNTS International SC Equity International LC Equity U.S. LC Equity U.S. Small Cap Emerging Markets Source: Morningstar 8.6% 27.3% 7.8% 1.3% 55.0% DOMESTIC AND INTERNATIONAL SMALL-CAP STOCKS HAVE SIMILAR ATTRIBUTES Good Absolute Return Potential For the last few decades, U.S. investors have been attracted to domestic small-cap stocks because of their strong returns. Since its inception in early-1979, the Russell 2000 Index (U.S. Small Cap) has earned an annualized return of 11.8%. Moreover, U.S. small-cap stocks have returned an annualized 6.3% over the last ten years, substantially outperforming larger-cap stocks. (Table 2) International small-cap stocks, however, have performed even better over the last ten years the MSCI ACWIxUS Small Cap Index produced an annualized return of 12.0%. This compares favorably with the return of the Russell 2000 Index (+6.3%), the MSCI ACWIxUS Index (+7.5%) and the Russell 1000 Index (+3.2%). We believe these returns are partly attributable to the stronger growth potential international small-cap stocks offer. (Table 2) continued on page 3 Managers INVESTM ENT GROUP PAGE 2

3 Table 2 Annualized Returns for Periods Ending 06/30/11 INDEX 1 Year 3 Year 5 Year 10 Year MSCI ACWIxUS SC 34.2% 5.6% 5.9% 12.0% MSCI ACWIxUS 29.7% -0.4% 3.7% 7.5% Russell % 7.8% 4.1% 6.3% Russell % 3.7% 3.3% 3.2% Good Risk-Adjusted Returns Not only do non-u.s. small-cap stocks offer good absolute return potential, like U.S. small-cap stocks, they historically have offered good risk-adjusted returns even better than those of their largecap international counterpart over all time periods shown in Table 3. Table 3 highlights Sharpe ratios (a measure of risk-adjusted return that compares excess return above a risk-free rate to standard deviation) for these same indices. Table 3 Sharpe Ratios for Periods Ending 06/30/11 INDEX 3 Year 5 Year 10 Year MSCI ACWIxUS SC MSCI ACWIxUS Russell Russell Another interesting characteristic of the small-cap stock universe, is that neither the Russell 2000 Index nor the MSCI ACWIxUS SC have generated a negative 10-year return since their respective inception dates. Conversely, the Russell 1000 has done so 8% of the time since This is an important distinction given the negative attention U.S. large-cap stocks have received for their low returns over the last decade. Attractive Alpha Potential for Active Managers As we ve seen, the global small-cap stock universe includes approximately 6,600 stocks, dwarfing the large-cap market, which consists of approximately 3,000 stocks. As a result, active managers have the opportunity to construct unique investment portfolios that may differ significantly from the index. The investment universe of 4,600 non-u.s. small-cap stocks should allow active small-cap international 3 Factset managers greater diversification potential and flexibility in portfolio construction. Small-cap stock also offers investment managers an opportunity to exploit a less-covered segment of the capital markets. Since largecap stocks have significant Wall Street coverage and have become increasingly efficient, the ability to add value in this space is restricted. In the small-cap universe, however, only five analysts, on average, cover each MSCI ACWIxUS SC stock even fewer than the average of six analysts covering each Russell 2000 stock. This compares with an average of 14 analysts for MSCI ACWIxUS stocks and 15 analysts for the stocks in the Russell 1000 Index 3. This dearth of coverage provides active small-cap managers an opportunity to exploit mispricings before they are recognized by others. Comparable Correlation Benefits In addition to good historical returns and strong alpha potential, international small-cap stock also provides good diversification when paired with other broad market indexes. Since the inception of the MSCI ACWIxUS SC Index in June 1994 through June 30, 2011, it has produced a correlation coefficient of with the Russell 1000 Index, with the Russell 2000 Index, and with the BC U.S. Aggregate Bond Index. Over the same time period, the Russell 2000 Index produced a correlation of with Russell 1000 Index and with the BC U.S. Aggregate Bond Index. Similar Risk Profile Some investors may perceive international small-cap stocks to be more risky than their U.S. small-cap counterparts. Certainly, this segment shares the same types of risks, such as currency and political, with all the international markets. International small-cap stocks may be somewhat more vulnerable to political risk, because their performance is often more closely aligned with the economy of their home country than is the performance of large multinational corporations. Nevertheless, some political risk is associated with all non-u.s. investments. Some would argue that, given the challenges the U.S. currently faces, U.S. stocks are also subject to political risk. We continued on page 4 Managers INVESTM ENT GROUP PAGE 3

4 believe diversification and proven management skill are the best ways to manage political risk. Liquidity is another perceived risk. As is the case when investing in U.S. small-cap equities, investors need to be proactive in managing liquidity and capacity. This makes it imperative that active portfolio managers diligently oversee their investment portfolios to ensure adequate liquidity. Another perception is that international small-cap stocks have significantly higher volatility than other segments. This is partly true because non-u.s. small-cap stocks do have higher standard deviations than large cap stocks (both U.S. and non-u.s.). Their standard deviation, however, is comparable to that of U.S. small-cap stock, particularly over longer time periods. (Table 4) Table 4 Standard Deviation for Periods Ending 06/30/11 INDEX 3 Year 5 Year 10 Year MSCI ACWIxUS SC MSCI ACWIxUS Russell Russell Some also consider non-u.s. small-cap stock to be a low-quality segment of the global equity markets. As a result, it is perceived to be inherently more risky. The reality is that international small-cap stock has BETTER quality statistics and forward growth expectations than domestic small-cap stock (Table 5). Table 5 Characteristics as of 06/30/11 CHARACTERISTIC MSCI ACWIxUS SC Russell 2000 Forward EPS Growth ROE ROA LT Debt / Capital Whether viewing forward growth, ROE, ROA or debt ratios, non-u.s. small-cap equities look very attractive when compared with U.S. smallcap equities. THE ADVANTAGES OF INTERNATIONAL SMALL CAP OVER U.S. SMALL CAP Faster Growth Potential U.S. and international small-cap stocks have many positive similarities that can benefit investors. However, international smallcap stock has several distinct advantages over U.S. small-cap stock. First, international small-cap stock offers exposure to faster growth outside the U.S. Over the coming years, many analysts are anticipating that non-u.s. economic growth will exceed U.S. economic growth. The International Monetary Fund predicts U.S. GDP will grow at an annualized rate of 2.7% over the next five years 4. Conversely, the 44 countries represented in the MSCI ACWIxUS SC Index have an average expected GDP growth rate of 3.6%, with 64% expected to generate higher growth than the U.S. over the next five years. More Opportunity for Active Managers to Outperform Another advantage that international small-cap stock has over U.S. small-cap stock is the size and diversity of the universe, and the ability of active managers to take advantage of this breadth. The international small-cap investment universe is much larger than the U.S. small-cap space. It includes approximately 4,600 stocks across 44 countries, while the U.S. small-cap segment only includes approximately 2,000 stocks all located in one country. While the correlations at the index level show some diversification potential relative to other equity segments, when viewed country-bycountry, the correlations provide an even more compelling opportunity for an active manager. While the MSCI ACWIxUS SC Index s correlation to the Russell 1000 is for the 16-year period ending June 30, 2011, the average correlation coefficient for the underlying 44 countries is just Because of the scope of the international market, active managers have a great opportunity to differentiate their portfolio from an index and emphasize the most attractive countries. Investors can thus gain exposure to markets that move somewhat differentially than the U.S., increasing the diversification benefit of international smallcap investing. 4 International Monetary Fund World Economic Outlook April, 2011 continued on page 5 Managers INVESTM ENT GROUP PAGE 4

5 Exposure to Emerging Markets Another benefit of international small-cap stock is that it can provide a path to gain exposure to emerging markets. All 21 emerging market countries are expected to achieve greater growth than the U.S. in the coming years. Moreover, emerging markets have generated strong absolute returns over the last few years and many don t have the debt burdens found in many developed countries. Since emerging markets represent an approximate 25% weight within the MSCI ACWIxUS SC Index, an active international small-cap manager has the latitude to make a significant allocation to attractive emerging market equities. INCORPORATING INTERNATIONAL SMALL-CAP STOCK INTO A PORTFOLIO U.S. investors would have benefited from international small-cap exposure in recent years. Chart 4 highlights the hypothetical return and standard deviation of three equity portfolios with varying allocations to international small-cap stock. All three have a typical 60/40 breakdown between U.S. equity and non-u.s. equity. The first does not allocate to international small-cap stock, the second allocates 5% to international small-cap stock and the third has a 10% allocation. Chart 4 Annualized Standard Deviation Vs Annualized Return Annualized Return Annualized Standard Deviation Russell 1000 Russell 2000 MSCI EAFE MSCI EME MSCI ACWIxUS SC 50% 10% 35% 5% 0% 50% 10% 30% 5% 5% 50% 10% 25% 5% 10% Investors could have increased the 10-year annualized return of their equity sleeve by 32 bps (0.32%) by including only a 5% allocation to small-cap international stock. Gaining 32 bps with only a 5% allocation shows the return potential international small-cap stock offers investors. Greater allocations to international small-cap stock would have produced commensurately greater returns, as a 10% allocation would have increased the annualized return by 63 bps (0.63%). These increases are significant given the low annualized returns generated in certain areas of the market during this time period and the forecast for low returns over the coming years. The annualized standard deviation also increased as investors allocated more to international small-cap stock. However, investors would have been appropriately rewarded for taking the slightly greater risk associated with international small-cap stock. The portfolio without international small-cap stock would have had a Sharpe ratio of over the last ten years. The one with a 5% allocation would have had a Sharpe ratio of and the 10% allocation would have had a Sharpe ratio. Admittedly, the differential is not huge. However, it does confirm the added risk is fairly compensated with greater return. In uncertain times like now, with lower forward return expectations, international small-cap stock may help investors meet their target return without additional uncompensated risk. SUMMARY International small-cap stock can provide a meaningful enhancement to an already diversified global equity portfolio. An allocation to international small-cap stock offers: Good historical risk-adjusted returns Exposure to faster growth outside the U.S. Potentially enhanced diversification Considerable alpha potential for active managers to capture Characteristics similar to domestic small-cap stocks Investors should reexamine their current allocation to determine how much international small-cap stock exposure they have truly gained via their other international equity holdings. Industry data continued on page 6 Managers INVESTM ENT GROUP PAGE 5

6 would suggest that most investors currently have a six percentage point underweight to international small-cap stock relative to the percentage international small cap stock represents in the global equity market. A reasonable objective is to allocate 5% 10% of your total equity portfolio to international small-cap stocks. Investors may even find that they can participate in emerging markets to a significant extent by investing in international small-cap stock, though the converse is not necessarily true. If you already invest in U.S. small-cap stock, then you are likely comfortable with the risks associated with international small-cap stock and allocating to international small-cap stock is a logical next step. An allocation to international small-cap stock offers investors the potential to generate higher absolute and risk-adjusted returns. DISCLOSURES Past performance is no guarantee of future results. Any sectors, industries, or securities discussed should not be perceived as investment recommendations. The views expressed represent the opinions of Managers Investment Group and are not intended as a forecast or guarantee of future results. There is no guarantee that these investment strategies will work under all market conditions, and investors should evaluate their ability to invest for a long term, especially during periods of downturns in the market. The investment return and the principal value of an investment will fluctuate so that an investor s shares, when redeemed, may be worth more or less than their original cost. Asset allocation does not protect against the risk of fluctuating prices and uncertain returns. The MSCI All Country World Index ex-us Small Cap Index covers all investable small-cap securities with a market capitalization below that of the companies in the MSCI Standard Indices (excluding USA), and targets approximately 14% of each market s free-float adjusted market capitalization. The MSCI All Country World ex-us Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The index consisted of 44 country indices comprising 23 developed and 21 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. The emerging market country indices included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. All MSCI data is provided as is. The products described herein are not sponsored or endorsed and have not been reviewed or passed on by MSCI. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data or the products described herein. Copying or redistributing the MSCI data is strictly prohibited. The Russell 2000 Index is composed of the 2000 smallest stocks in the Russell 3000 Index and is widely regarded in the industry as the premier measure of small-cap stock performance. The Russell 1000 Index measures the performance of approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market. The Russell 2000 and 1000 Indices are trademarks of Russell Investments. Russell is a trademark of Russell Investments. The Barclays Capital U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds. Indices are unmanaged, are not available for investment, and do not incur expenses. Investment advisory services are offered by Managers Investment Group LLC, an investment adviser registered with the U.S. Securities and Exchange Commission. Managers Investment Group LLC is an independently managed subsidiary of Affiliated Managers Group, Inc. (NYSE: AMG). Managers Distributors, Inc. is a wholly owned subsidiary of Managers Investment Group LLC. Information has been obtained from sources believed to be reliable, but its accuracy, completeness, and interpretation are not guaranteed. Each of us at Managers Investment Group LLC appreciates the continuing opportunity to assist you with your investing needs. If you have any questions, please call Managers Investment Group LLC. All Rights Reserved. Managers INVESTM ENT GROUP Managers INVESTM ENT GROUP PAGE 6