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Why Invest in Actively Managed International Small Caps?

International Equities
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International small cap stocks1 represent a vast opportunity, yet many investors often overlook them. A portfolio receiving its only small cap exposure from domestic stocks may be missing out on the potential benefits of investing in small caps internationally and ignoring over a third of developed global equities. Historically, many investors have taken great care to diversify their domestic holdings, but when looking outside of the U.S., a single international sleeve seemed to suffice. This is evident when looking at total assets in international mutual funds – assets in developed foreign large cap funds outweigh their small- and mid-size counterparts by more than 15.8 to 1.2 This is changing, as more investors begin to realize the opportunity presented by international small cap stocks. Touchstone believes that a distinctive blend of fundamental and quantitative research in this space helps to facilitate a concentrated, differentiated and focused approach when building an actively managed portfolio of international small cap stocks.

1 For the purposes of this document, international small cap stocks will be limited to those in developed markets — excluding those small cap stocks within emerging markets.
2 Morningstar as of 12/31/18

The International Small Cap Stock Opportunity

While asset levels suggest they are underrepresented in many investor portfolios, international small caps represent about 38.9% of all stocks in the developed universe. By overlooking this opportunity, investors may be missing the largest opportunity set in the developed world.

Exhibit 1
Developed Market Stocks

Region/Market Cap Number of Stocks Percent of Total Stocks
 Russell 1000® Index (U.S. Large/Mid Cap) 983 16.4%
 Russell 2000® Index (U.S.Small Cap) 2,030 33.8%
 FTSE Developed Large Cap Ex-US Index 657 10.9%
 FTSE Developed Small Cap Ex-US Index 2,334 38.9%
 Total 6,004 100%

Source: Morningstar Direct as of 12/31/18

Moreover, due to the size of the international small cap universe, potential inefficiencies may be exploited through the selection of individual securities. International small cap stocks tend to be under-researched by Wall Street analysts. Stocks with less analyst coverage may not fully reflect all relevant company data and therefore may be mispriced. These gaps in research coverage may create opportunities for portfolio managers and analysts to identify and exploit information inefficiencies for potentially promising companies experiencing significant growth. Inefficient market coverage can also subject investors to additional risks, such as heightened liquidity risk, and the possibility that company-specific issues may not be uncovered in a timely manner.

Due to their size, international small cap companies are more likely to be single-product or single-market focused, and therefore potentially less susceptible to the impact of economic events relative to larger firms that operate on a more global scale. However, the size of these companies can also cause them to be subject to more erratic price movements than those of larger, more established companies. These factors reinforce the need for active management in the space, because a portfolio manager must understand not only the companies, but also the markets in which these firms are operating in order to invest successfully.

The Benefits of International Small Cap Stocks

Diversification

Beyond the sheer size of the opportunity set represented by international small cap stocks, there may be diversification benefits that are typically not found in the international large cap asset class. Correlation is a commonly referenced statistic used to determine how closely two securities move in relation to one another. Exhibit 2 displays the correlations of the S&P 500 Index to large-, mid- and small-cap companies, both domestically and internationally, based on their corresponding Russell indices. Historically, international small caps have provided the lowest correlation to the S&P 500 Index of any developed equity asset class — and that correlation has decreased recently. And while investing internationally has often been viewed from a diversification perspective, international large caps have historically had a high correlation to domestic large caps.

Exhibit 2

 
  Russell 1000® Index Russell 2000® Index FTSE Developed Large Cap ex U.S. Index FTSE Developed Small Cap ex U.S. Index 
Average 
(from  12/01/05)
 1.00  0.84  0.77  0.73
Current 
(as of 12/31/18)
 1.00  0.89 0.82 0.87

Source: Morningstar Direct 

As international small cap mutual funds grow in assets, it is possible that their exposure to small caps will wane and drift into larger cap stocks — the same issue that can be observed domestically. Notice the lower correlations attributed to smaller stocks in the previous exhibit. These lower correlations support the notion that identifying funds that are disciplined in regard to their small cap exposures is an important factor to consider. International mutual funds that fail to maintain disciplined small cap exposure may not provide the key diversification benefits available. Diversification does not ensure a profit or protect against a loss.

Market Measures
S&P 500® Index is a group of 500 widely held stocks and is commonly regarded to be representative of the large-capitalization stock universe.
Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe.
Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe.
FTSE Developed Large Cap ex U.S. Index is an unmanaged index of large-cap stocks from developed countries, excluding the United States.
FTSE Developed Small Cap ex U.S. Index is an unmanaged index of small-cap stocks from developed countries, excluding the United States.

The indexes illustrated are unmanaged statistical composites of stock market performance. Index performance is not indicative of fund performance. Investing in an index is not possible. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Historical Performance

As mentioned previously, many investors approach international equity investing by simply utilizing a single blended fund. By asset size, the Foreign Large Blend Morningstar Category ranked as the fifth largest category with $766 billion in assets.2 While we have discussed the diversification benefits of including international small caps in a portfolio, historic returns for the category should also be considered. Exhibit 3 illustrates the hypothetical growth of a $10,000 investment since common inception of the representative indices. Performance for international small caps represented by the FTSE Developed Small Cap ex U.S. Index outpaced that of international large caps represented by the FTSE Developed Large Cap ex U.S. Index.

Exhibit 3

international large cap vs international small cap performance chart

The indexes illustrated are unmanaged statistical composites of stock market performance. Index performance is not indicative of fund performance. Investing in an index is not possible. Performance data quoted represents past performance, which is no guarantee of future results. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Risk-Adjusted Returns

Risk-adjusted returns allow for the comparison of investment returns while accounting for the risk involved in producing that return. Many investors associate international small cap stocks with higher risk and increased volatility relative to other asset classes. While international small caps have displayed more volatility than their large cap counterparts, the asset class has historically been less volatile than domestic small caps. Standard deviation is a common measure of risk which quantifies the volatility associated with returns. Over the 10-year period ended December 31, 2018, international small caps exhibited a lower standard deviation than domestic small caps (15.78% vs. 18.44%) based on representative indices.

Sharpe ratios commonly are used to compare risk adjusted returns, as they measure excess return per unit of risk. Since common inception of the indices, the Sharpe ratio for international small caps has been consistently higher than that of international large caps. In fact, 78% of the five-year rolling periods saw international small caps with stronger risk-adjusted returns relative to international large caps according to their representative indices.

The volatility that can be observed in some international small cap funds can at least partially be attributed to emerging markets exposure. Some international small cap mutual funds have been known to dip into emerging markets in an attempt to enhance returns. While doing so may at times provide more upside potential, emerging markets historically have produced more volatility relative to developed markets.

Over the period from common inception (August 1, 1996) through December 31, 2018, emerging markets have exhibited a standard deviation nearly 5.86% higher than developed markets (xU.S.) small caps (22.57% vs. 16.71%) based on representative indices. Exhibit 4 displays the rolling five-year standard deviations since common inception of the indices.

Exhibit 4

While this is not a statement for or against investing in emerging markets, it is critical to understand an international fund’s emerging market exposure and how it potentially could impact portfolio volatility. Emerging markets carry their own unique set of risks, including greater volatility and a greater likelihood of experiencing turmoil or rapid changes in market or economic conditions relative to developed countries. When grouped with international small cap stocks, emerging market stocks have the potential to alter the risk-return characteristics of a fund.

Why Invest in International Small Caps Now?

Based upon the information presented surrounding international small cap investing, a logical question may be “Why now?” Given the recent performance of domestic stocks over the past several years, many valuation metrics – measurements of relative price – are beginning to look comparatively expensive. International small caps, based on price-to-earnings ratios – or the price being paid per dollar of earnings – are currently the second least expensive of the developed markets, as shown by the purple line in Exhibit 5.

Exhibit 5

historical price/earnings ratios chart from 11/1/09- 12/31/17

The indexes illustrated are unmanaged statistical composites of stock market performance. Index performance is not indicative of fund performance. Investing in an index is not possible. Performance data quoted represents past performance, which is no guarantee of future results. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The same conclusion holds true when examined from the perspective of price-to-book ratios – the stock price divided by the total assets minus intangible assets and liabilities – again illustrated by the purple line in the following chart.

Exhibit 6

historical price/book ratios chart from 11/1/09-12/31/2017

In addition, if one subscribes to the notion that small caps lead economies out of recessions and into recoveries – as has been the case in recent years domestically – international small caps could be positioned well, given that international economies have lagged the U.S. in their recoveries from the most recent economic recession. The following chart, Exhibit 7, shows gross domestic product (GDP) growth over the past 10 years for the United States and the three largest developed international regions – Japan, the United Kingdom (U.K.) and the eurozone. If other developed economies follow the path set by the domestic recovery, international small caps could be an attractive asset class in the coming years.

Exhibit 7

gross domestic product (gdp) growth chart

The indexes illustrated are unmanaged statistical composites of stock market performance. Index performance is not indicative of fund performance. Investing in an index is not possible. Performance data quoted represents past performance, which is no guarantee of future results. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Conclusion on This Asset Class

International small caps are often neglected, but it is clear that the potential benefits of investing in this asset class deserve closer consideration. When selecting a mutual fund in the international small-cap space, it is essential that the management team possesses sufficient experience to grasp the intricacies of the investment universe. Additionally, it is important for an investor to understand the composition of a fund in regard to market cap size and emerging market exposure — both of which can skew the risk-return profile.

While there are risks associated with investing in this more volatile asset class, when properly executed, the addition of an international small-cap fund to a portfolio can be beneficial.

Performance as of December 31, 2018

Name Inception Date 1-Year Return 3-Year Return 5-Year Return 10-Year Return Total Return Since Inception
 S&P 500® TR USD  1/30/1970 -4.38 9.26 8.49 13.12 10.40
 Russell 1000® TR USD 12/29/1978 -4.78 9.09 8.21 13.28 11.54
 Russell 2000® TR USD 12/29/1978 -11.01 7.36 4.41 11.97 11.09
 FTSE Developed Large Cap ex U.S. Index 6/28/1996  -13.68  3.76 0.70 6.65 4.84
 FTSE Developed Small Cap ex U.S. Index 6/28/1996
 -18.52 3.05 1.17 9.34 7.06
 Russell Emerging Mkts TR USD 6/28/1996
 -13.35 9.00 2.06 8.23. 9.18

 

Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in a Fund will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given.


A Word About Risk
International small cap stocks are subject to market volatility and loss. Foreign securities and foreign depositary receipts carry the associated risks of economic and political instability, market liquidity, currency volatility and differences in accounting standards. Emerging markets securities are more likely to experience turmoil or rapid changes in market or economic conditions than developed countries. Stocks of small-cap companies may be subject to more erratic market movements than stocks of larger, more established companies.

Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial advisor or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.

Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.

Not FDIC Insured | No Bank Guarantee | May Lose Value

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