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Raina Oberoi

Raina Oberoi

Managing Director, MSCI Research

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Why global small-cap stocks are becoming an important part of institutional portfolios

Institutional investors worldwide traditionally have tended to focus on the stocks of larger companies, finding them less risky, more liquid and offering greater investment capacity than small-cap stocks.  But asset owners and managers increasingly are allocating strategically to the small-cap equity segment as part of their global equity portfolios i.e., via an “all-cap” approach.

There are four main reasons for this trend:

First, small caps have historically earned a premium compared to their large-cap counterparts. As seen in the chart below, this premium has existed globally since the early 2000s. Contrary to the claims of small-cap critics, our research shows the size premium has historically existed outside the U.S. as well, which has made small-cap investing a global phenomenon.

Small caps have outperformed large caps over the last 15 years

Consider the return of a global equity portfolio with small caps to one lacking small caps. Using the MSCI ACWI IMI, which has constituents across the all-cap spectrum, as a proxy for a global equity portfolio, we find that it had annualized returns of 7.2% for the 15 years that ended Dec. 31, 2016. That return compares with 6.7% for the MSCI ACWI Index, which tracks large- and mid-cap stocks only. As the chart implies, investors who choose to forego 14% of the opportunity set are inherently making an active bet against the investable market. For the past 15 years, they would have given up 50 basis points annually in additional returns.

The 50 basis point gap: Global equity returns with and without small caps

MSCI Investable Market Indexes. Data from 2002-2016

Second, small caps have provided considerable diversification benefits when included in an all-cap portfolio. For example, small-cap stocks tended to react more positively than large- and mid-cap stocks at the beginning of a market rebound, though small-cap companies sometimes suffered greater distress during a financial crisis. From a revenue exposure angle, small caps are more exposed to domestic revenues and thus are less affected by global vs local macro shocks.

Third, investing across all-cap segments reflects the complete opportunity set, providing exposure to the full equity risk premium. MSCI’s Investable Market Indexes, for example, include small-cap stocks, which represent 14% of the global equity opportunity (below chart).

Complete coverage of the investment opportunity

Finally, finding active global small-cap managers who have provided excess returns on a consistent basis has frequently been cited as a key challenge. However, indexed options also exist; these approaches have been aided by the declining cost of trading small caps globally and improved investability of small-cap indexes.

The natural starting universe for equity investors should be the global investable opportunity set, which includes large-, mid- and small-cap stocks. Any deviation from this asset allocation would be deemed an active decision. The question for institutional investors then is: Is there an overlooked premium in your current equity allocation?


Further reading:

How to Think Bigger about Small-cap Investing

One Size Does not Fit All: Understanding Factor Investing

Small Caps – No Small oversight