Global Total Market Investing: Does Your Plan Have a Global Small-Cap Gap?

leadership series INVESTMENT INSIGHTS August 2013 Global Total Market Investing: Does Your Plan Have a Global Small-Cap Gap? This is for Institutional/Investment Professional Use Only Interest in global small-cap equities has grown in the past several years, due in part to the attractive returns and diversification properties the asset class can offer. Also, the introduction of the Morgan Stanley Capital International (MSCI) Global Investable Market Index (GIMI) methodology in 2008 included a more robust small-cap index than the prior benchmark, putting global small-cap stocks on many investor report cards. This paper looks at the role of global equities within the asset allocation policies of institutional investors. It also reviews the historical risk-return characteristics of global small-cap stocks, examines the differences between the MSCI GIMI indices and previous versions of MSCI s global indices, and explores ways in which institutional investors might wish to add small-cap global stocks to their strategic asset allocation. Fidelity Worldwide Investment has been retained to distribute Pyramis Global Advisors (PGA) products outside of North America. This document has been written by members of PGA s investment team. 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 investors include companies from outside their domestic market to their portfolios, they often add large-cap names, in part due to their liquidity. This large-cap bias also derives from the fact that most stock indices are capitalization weighted, as well as from the name recognition and comfort level that come from holding well-known multinational companies. As an asset class, global small-cap equities offer several benefits relative to large-cap stocks. First, the opportunity set is expansive. With more than 4,200 stocks, the global small-cap universe has more than twice as many stocks as the 1,600 in the large- and mid-cap universes that make up the MSCI GIMI World Standard Index. Second, because fewer equity analysts cover the small-cap asset class, it is less efficiently researched. For example, the average number of analysts per stock in the MSCI World Standard Index is 17.2, compared with only 7.0 for the World Small Cap Index.1 This lower level of coverage results in greater market inefficiencies and, thus, greater scope for finding undervalued stocks. Third, global small-cap equities have historically delivered strong absolute and risk-adjusted returns relative to global large-cap equities, which we will discuss in much greater detail later in this article. Additionally, small-caps can provide significant diversification benefits when combined with large-cap global equities and other major asset classes. Given the historical performance and diversification offered by global small-cap stocks, many institutional investors have already initiated global small-cap mandates. 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. We believe the prospects for global small-cap equities are bright: PGA s own 2012 Pyramis Global Institutional Investor Survey indicates that institutional investors will continue to increase their allocation to this asset class as its benefits become more widely understood. KEY TAKEAWAYS Many institutional investors have initiated global smallcap mandates due to the asset class s strong historical performance, diversification benefits, and attractive riskadjusted returns. Modern portfolio theory advocates investing in the widest liquid universe of securities; however, many institutional investors have limited exposure to the global small-cap asset class. Adding a separate global small-cap mandate with a proven track record may benefit investment managers more than simply extending an existing mandate across the market-cap spectrum. Robert Feldman, CFA Portfolio Manager, PGA Nick Horn, CFA Institutional Portfolio Manager, PGA Chris Steward, CFA Institutional Portfolio Manager, PGA 1

Institutions historical approach to global investing Global investments are a large, growing part of many institutional investors strategic asset allocations, as shown in a 2012 Pyramis survey of chief investment officers, treasurers, and executive directors at 632 corporate and public defined benefit (DB) pension plans in the U.S., U.K., Canada, seven northern European countries, and six Asian countries. The respondents manage more than $5 trillion (USD) in pension assets, or about 20% of the global DB market. When asked if they would consider adding more-aggressive sub asset classes (e.g., global small-caps) in their investment mix to increase returns, 29% of DB plan sponsors globally said they are likely to or definitely will (see Exhibit 1, below). When asked specifically about investing in global small-caps, 16% said they intended to do so over the next 1-2 years. The MSCI GIMI index includes a 15% allocation to small-cap stocks, implying a significant potential increase in demand for international small-caps, even if only a small proportion of U.S. institutional investors moves from the old MSCI Standard international equity indices to the MSCI GIMI indices. MSCI benchmark changes The MSCI GIMI indices cover the large-, mid-, and small-cap spectrum, and growth and value styles, across a variety of regional benchmarks, such as the EAFE Index. The MSCI Global/Regional Standard indices include both large- and mid-cap stocks, which together comprise nearly 85% of each country s market cap. The corresponding small-cap indices cover companies in the bottom 15% of capitalization above a minimum size ranging from around $150 million to $400 million (USD) of free-float-adjusted market capitalization and meet certain liquidity thresholds. In the past, the World Standard and World Small Cap indices overlapped to a degree as seen in Exhibit 2 (below), but the current World Small Cap Index provides more comprehensive coverage and eliminates the overlap. Because the GIMI targets up to 99% of the free-float-adjusted market cap in each country, the benchmark change sharply increased the number of stocks in the index. The current MSCI World Small Cap Index contains more than 4,200 companies as of June 30, 2013, compared with 1,900 companies before the new methodology transition in 2008. Global small-cap equities historical performance The historical case for global small-cap investing is a strong one and becomes more pronounced with a closer look at four distinct historical characteristics of this asset class: Strong absolute returns Consistent value added from active management Diversification benefits High risk-adjusted returns 2

Strong absolute returns Historically, global small-cap stocks have delivered higher returns than global large caps over a longer time horizon (see Exhibit 3, above). Similarly, longer-term studies of U.S. small-cap returns relative to U.S. large-caps have demonstrated that the higher risk premium associated with small-cap stocks translates into stronger returns. This higher risk premium effect may help explain the higher returns provided by global small-cap stocks. In any case, the strong returns offered by global small-caps has led to 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-caps relative to large-caps have been strong, but their relative performance can vary considerably from period to period. Small-caps lagged the larger MSCI World Standard Index from 1995 to 1999, but beat the index in nine of 13 calendar years from 2000 to 2012 (see Exhibit 4, above right). Periods of small-cap over- or underperformance relative to larger-caps seem to persist for several years. Regardless, the diversification benefits of global small-caps build a strong case for maintaining a strategic allocation to them throughout the market cycle. Consistent value added from active management While many academic studies of the benefits of global investing are from a U.S. investor s perspective, they have shown that returns to U.S. investors for actively managed international small-cap stocks have historically been higher than for international large-caps, partly because fewer equity analysts follow small-caps. Exhibit 5 (page 4) shows rolling three-year quarterly returns for the median international small-cap manager relative to the benchmark. The average three-year alpha for the median international small-cap manager has been a strong 3.3%, more than twice that of the median EAFE Large/Mid Cap manager. The consistency of excess returns to active management in global small-caps can be explained by using the Barra Integrated Model. In this model, asset returns are attributed to common global factors, common local (country-specific) factors, or idiosyncratic (stock-specific) returns. A 2012 MSCI Research Insight paper2 showed that stock-specific volatility for the ACWI Small Cap Index is considerably higher than the ACWI Standard Index. This indicates that since company-specific fundamentals more often drive small-cap stock returns, the potential return to active management and fundamental research is higher in the small-cap space. In fact, the same paper noted: Because information on small caps is less widely available, in theory, analyst research can 3

Historically, the correlation of global small-cap stocks with most major country and regional market indices has been much lower than that of global large-caps in most markets (see Exhibit 6, below). Additionally, in many markets global small-caps provide meaningful, or sometimes better, diversification than emergingmarket stocks. High risk-adjusted returns One reason why institutional investors have underinvested in global small-cap equities may be due to their higher perceived risk. However, when global small-cap stocks are added to create an all-cap global equity portfolio, their high absolute returns combined with their diversification benefits can actually improve the risk-adjusted returns of the total portfolio. For an investor benchmarked to the MSCI World Index, Exhibit 7 (page 5) shows the change in return relative to the standard deviation of return over the past 10 years by adding a benchmark-weight allocation to either global small caps (moving to the World IMI Index) or emerging markets (moving to the ACWI Index), or to both asset classes (moving to the ACWI IMI). Adding small-cap or emerging-market stocks added 35-45 basis points to returns across a variety of base currencies, while adding both asset classes generated close to 80 basis points in additional return. Since both small-cap and emerging-market stocks are riskier asset classes, moving from the MSCI World Index to the generate more value-added insights. Similarly, small-cap stocks are more heavily impacted by company-specific characteristics, favouring a bottom-up stock picking investment process. Thus, it is reasonable to assume that the higher returns to active management in the small-cap portfolio may be sustainable and translate into higher risk-adjusted returns in an all-cap global equity portfolio. Diversification benefits Global small-cap investing can have compelling advantages. In the study International Diversification with Large- and Small-Cap Stocks, Cheol S. Eun, Wei Huang, and Sandy Lai, write: Our simulations indeed show that a fully diversified international large-cap stock portfolio is about 9.2% as risky (measured by the portfolio variance) as a typical individual stock, but a fully diversified international large- and small-cap stock portfolio can further reduce the risk by about two-thirds. This result suggests that small-cap stocks can play an effective and unique role in global risk diversification. 3 As the world has become more global, correlations have increased between national stock markets, thus eroding the diversification benefits of large-cap global investing. Therefore, the diversification benefits of global small-caps have become more important. We believe that small-cap stocks, which are less affected by global investment trends and tend to be driven more by idiosyncratic local market factors, are better diversifiers than large-cap stocks. 4

Implementation considerations The preceding 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 they should consider making to their investment portfolio reflecting the changes to the MSCI global equity indices, and how they might best implement them. As small-cap stocks have historically enhanced returns without increasing portfolio risk, at least a full market weight of 15% of a plan s equity allocation is recommended. Regardless of the amount of the allocation, those institutional investors deciding to add small-caps to their investment portfolio need to consider how to best implement this change. They might choose to extend their existing mandates down the market-cap spectrum, or they might pursue a separate small-cap mandate. Both options are explored in more detail below. World IMI, ACWI, or ACWI IMI indexes generally increases overall risk as expressed by standard deviation. However, the additional risk from investing in global small-caps or emerging markets has been well rewarded over time. As Exhibit 7 (above) illustrates, the ratio of index returns to index standard deviation rises when small-cap stocks, or emerging-market stocks, or both asset classes, are added to the index in every major currency. Although many institutional investors have included a strategic allocation to emerging markets for a decade or more, it is worth noting that the mean/variance argument for including global small-cap stocks is even stronger than the case for emerging markets during this time period. A strong argument for global small-cap investing can also be made within a risk-budgeting framework. Although many institutional investors subscribe to the theory that small-cap equities should earn a risk premium over their large-cap brethren, these same investors often have limited small-cap exposure, even within their home markets. According to the 2012 MSCI study referenced earlier, investors not fully participating in the broadest possible universe (represented by the MSCI World IMI index) are unintentionally but effectively taking a significant active underweight position in global small-caps. The study concludes that, within a risk-budgeting framework, avoiding small-cap exposure can consume a substantial part of the overall risk budget; perhaps as much as 50% to 75% of the total risk budget. Extend existing mandates This approach, while attractive because of its ease of implementation, is sub-optimal and only slightly better than ignoring an allocation to small-cap stocks altogether. Any asset class that merits a strategic allocation in an institutional investor s portfolio should also merit a dedicated portfolio. While this approach minimizes the administrative burden of setting up new accounts and overseeing new managers, it has drawbacks. A shift from the MSCI World Standard Index to the World IMI adds about 5,800 names to the benchmark, essentially tripling the number of stocks to follow. Many investment managers may lack the knowledge or familiarity with this asset class that is needed in order to provide the diversification and return that a specialist small-cap manager is able to provide. Large-cap managers might be tempted to invest in only a representative sample of the small-cap equity universe or to alter the small-cap allocation opportunistically, but both strategies can reduce diversification and return and are inefficient from a risk-budgeting perspective. Lastly, global small-cap stocks have less market liquidity and are driven by local factors, where a higher degree of local knowledge and trading expertise can be immensely beneficial. Extracting the greatest benefit from both idea generation and execution in global small-cap investing requires a regionally based small-cap equity research and analysis team and a specialized trading staff. Add a separate small-cap mandate Adding a separate global small-cap mandate with a proven track record has several advantages. This approach benefits from the global small-cap expertise of the manager and the advantage of trading expertise in the more liquidity-constrained markets for smaller-cap stocks. A standalone global small-cap portfolio also enables the establishment of more specific portfolio-level risk and return targets. For example, an institutional investor might wish to 5

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. This approach, however, does require additional administrative effort in the search for, hiring, and ongoing oversight of the global small-cap investment manager. Conclusion Global small-cap investing, which has been on the rise in the institutional marketplace, is likely to increase given the renewed focus on the asset class. The potential benefits of investing in global small-cap stocks have been well documented. Global smallcap equities present a large investment universe of securities that, as they are covered by fewer research analysts than larger stocks, have historically provided consistently strong risk-adjusted returns in addition to powerful portfolio diversification benefits. Since investing in the widest liquid universe of securities is a central tenet of modern portfolio theory, we expect institutional investors to continue to expand their exposure to global small-cap equities. This was further confirmed by a 2012 Pyramis Global Investor Survey 4 that indicated many institutional investors intend to increase their allocation to this asset class. Therefore, global small-cap returns may enjoy a tailwind as many institutional investors close their small-cap gap and increase their allocation to this asset class. Authors Robert Feldman, CFA Portfolio Manager Robert Feldman is a vice president and portfolio manager at Pyramis Global Advisors, an FMR Co company. In this role, he is responsible for managing international and global small-cap portfolios on behalf of institutional investors. Mr. Feldman joined FMR Co in 2000. Chris Steward, CFA Institutional Portfolio Manager Chris Steward is an institutional portfolio manager at Pyramis Global Advisors, an FMR Co company. He is a member of the portfolio management teams for the Pyramis International Growth and Select International Small-Cap strategies. Mr. Steward joined Pyramis in 2006. Nick Horn, CFA Institutional Portfolio Manager Nick Horn is an institutional portfolio manager at Pyramis Global Advisors, an FMR Co company. He is a member of the portfolio management team covering International/Global Small- Cap Equity strategies. Mr. Horn joined FMR Co in 2006. 6

Endnotes 1 FactSet, using the number of estimates for earnings per share as of June 2011. 2 Bender, Jennifer; Briand, Remy; Fachinotti, Giacomo; Ramachandran, Sivananth. Small Caps No Small Oversight: Institutional Investors and Global Small Cap Equities, MSCI Research Insight, March 2012. 3 Eun, Cheol S., Wei Huang, and Sandy Lai, International Diversification with Large- and Small-Cap Stocks, Journal of Financial and Quantitative Analysis (Sep. 2006, Volume 43, Issue 2). 4 2012 Pyramis Global Institutional Investor Survey was conducted during June and July 2012, including 632 investors in 16 countries: 302 in the U.S., 149 in Europe, 92 in Canada, and 89 in Asia. The surveys were executed in association with the Financial Times in Europe and Asia, Asset International in the U.S., and the Canadian Institutional Investment Network in Canada. More information is available at www.pyramis.com. Index definitions The MSCI World Standard Index covers all investable large- and mid-cap securities across the developed, emerging, and frontier markets and targets approximately 85% of each market s free-float-adjusted market capitalization. The MSCI World Small Cap Index covers all investable small-cap securities with a market capitalization below that of the companies in the MSCI Standard Index, targeting approximately 14% of each market s free-floatadjusted market capitalization. The MSCI EAFE Small-Cap Index measures the performance of small-cap stocks in the MSCI EAFE Index, a market cap-weighted index composed of companies representative of the developed market structure of 21 developed countries in Europe, Australasia, and the Far East. The MSCI ACWI Index is a free-float-adjusted market-capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. Important Information This material is for investment professionals only and should not be relied upon by private investors. FIL Limited and its respective subsidiaries form the global investment management organisation that is commonly referred to as Fidelity Worldwide Investment. FMR Co, also referred to as Fidelity Investments, is a privately-owned financial services firm based in Boston, Massachusetts, USA. FMR Co established Pyramis Global Advisors (Pyramis) in 2005 as a separate business unit to focus on institutional clients. Pyramis investment team was initially formed through the migration of investment professionals from Fidelity Management & Research Company (FMR Co.), the mutual fund division of FMR Co Fidelity Worldwide Investment has been retained to distribute Pyramis Global Advisors (PGA) products outside of North America. This document has been written by members of PGA s investment team. This document may not be reproduced or circulated without prior permission and must not be passed to private investors. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and currency F symbol are trademarks of FIL Limited. Fund investing in smaller companies invest in smaller markets or target specific industries. This can make them more volatile than funds investing in larger markets or those with more diversified portfolios. Issued by FIL Pensions Management (FCA registered number 144345) a firm authorised and regulated by the Financial Conduct Authority. FIL Pensions Management is a member of the Fidelity Worldwide Investment group of companies and is registered in England and Wales under the company number 02015142. The registered office of the company is Oakhill House, 130 Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ, United Kingdom. Fidelity Worldwide Investment s VAT identification number is 395 3090 35. Issuer in Germany: FIL Investment Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus Issuer for Austria, Hungary, Slovakia and Czech Republic: FIL (Luxembourg) S.A., 2a rue Borschette, 1021 Luxembourg EMEA20135188/2 7

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