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It's often said, and numerous academic studies confirm as much, that investors have home country biases. That is to say that clients visiting an advisor for the first time are likely presenting portfolios heavy on domestic stocks.
This is almost certainly true when it comes to allocations to smaller stocks. Savvier clients may already know that domestic small-cap companies usually aren't big exporters, providing notable levels of immunity to trade wars and a strong dollar, among other benefits.
To be sure, those are points in favor of U.S. smaller stocks, but advisors can help clients realize benefits with international small caps – an asset class that offers lower correlations, strong upside potential and surprisingly less volatility than many clients suspects.
“Investors who ignore international small-cap stocks in their global allocation may be doing so at the cost of risk-adjusted performance. Canterbury believes that a current opportunity exists in the asset class due to its attractive return potential and diversification benefits,” according to Canterbury Consulting.
Indeed, data confirm investors are woefully under-allocated to ex-US small caps.
“Only around 2 percent of mutual fund assets in the U.S. are invested in international small- and mid-cap stocks, while 7 percent of assets are invested in U.S. small-cap stocks. However, there are more than twice as many international small-cap stocks, accounting for more than double the overall market value compared to U.S. small-cap stocks,” notes Canterbury.
Practical Place to Start
For clients warm to the idea of international small caps, Europe is a good place to start because stocks there are attractively valued, more cyclical and less volatile than emerging markets equivalents.
Acknowledging that cyclical/value stocks are back in style in a big way, it's worth noting that 44% of the MSCI Europe Index is considered cyclical compared to just 25% for the S&P 500. That bolsters the case for smaller stocks across the pond.
“We believe there’s a unique opportunity buried among the headlines about new lockdowns in the U.K., France and Germany, along with the bloc’s difficulty to approve, secure and distribute vaccines,” according to WisdomTree research. “Europe’s expectations for both an economic and equity market recovery have been tempered by these difficulties, unlike the roaring equity rally that began in the U.S. late last year. That signals to us that the European economy is still slightly behind in the fight against COVID-19.”
To say European small caps are being left behind relative to U.S. counterparts is accurate, but “left behind” might be strong language. The WisdomTree Europe SmallCap Dividend Fund (DFE) is trailing the Russell 2000 Index by just 36 basis points year-to-date and the former yields 135 basis points more than the latter.
Beta Play, Benefits Galore
As is the case with U.S. equivalents, European small caps are, broadly speaking, domestically focused. That means the asset class is levered to the reopening trade – a concept that's also running behind in Europe. Said another way, the reopening trade is in its latter stages here in the States, but it's in its early innings across the Atlantic.
Additionally, European small caps' beta or sensitivity to large-cap benchmarks, such as the MSCI Europe Index, means the smaller names may outperform as recovery and reopening take shape in Europe.
More good news: Some European small-cap strategies, including the aforementioned DFE, offer clients deep discounts.
“Moreover, we believe DFE also brings an attractive valuation profile to the table. In fact, the extent of its valuation discount reinforces our belief that U.S. small-cap excitement that has not spread overseas just yet,” notes WisdomTree. “DFE is trading at an all-time discount on a price-to-earnings (P/E) ratio basis compared to broader Europe. Since inception in June 2006, it maintained a one-point average discount to Europe in what became a difficult decade-plus for European equities.”
Inexpensive international diversification with a better yield and upside potential. That should be an easy conversation to have with clients.
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