Index Capital Insights Issue #6

This issue of Index Capital Insights is the final entry of a three-part series on small cap stocks. The first two covered US small caps. This month, I’ll discuss opportunities in stocks of small companies domiciled outside of the US[1].

Global ex US small company stocks make up an intriguing opportunity set. Factor returns from Fama-French show the small cap premium has not been particularly strong. However, the time series is limited – beginning in 1991 for Dev ex US and 1990 for emerging markets. The question is whether there are structural reasons to believe the small size premium is, or is not, statistically different from zero, or whether the small sample period simply didn’t provide enough evidence.

One can hypothesize about why foreign small caps, as a group, may not offer a premium. For example, variations in the strength of institutions and the rule of law may explain why, in certain markets, large national champions have returned a premium over smaller less politically connected companies. Nevertheless, there is a great deal of variation across countries. Perhaps selecting small company stocks based on individual countries is a more promising path than selecting from multi-country global benchmarks, but data supporting such an approach is limited for developed markets outside the US and hard to source for individual emerging markets.

Charts 1a and 1b, relative wealth generated by F-F value-weighted small size portfolios

The lackluster record of foreign small caps is evident in past performance of actual investments as well as hypothetical factor portfolios. Comparing the Vanguard FTSE All World ex US Small Cap ETF (VSS) with its all-cap counterpart, the Vanguard FTSE All World ex US ETF (VEU), shows that over 10 years through May 2024 VSS returned 3.71% annually while VEU returned 4.39%[2].

Interestingly, equal weighted factor portfolios show a different picture, with historically strong small company premia exhibited in both developed ex US and emerging stock markets. This means the average small stock did better than the average big stock, which is consistent with the hypothesis that a few well connected firms in certain markets may tend to drive value-weighted returns, particularly in emerging markets where the difference between value-weighting and equal-weighting is greatest.

Despite the promising historical record of the hypothetical equal-weighted factor portfolios, implementing an equally weighted live portfolio of foreign stocks is not simple (with multiple time zones to trade, possibly multiple custodians and settlement processes, etc.) and there are drawbacks. Equal weighted portfolios require relatively frequent, regular rebalancing which results in higher turnover. Such strategies also have lower capacity than value-weighted portfolios. Nevertheless, the fact that, on average, small companies outperform large companies indicates there may be other viable approaches that have a reasonable chance of capturing international small company premia.

Combining small size with value may be promising. The value factor premium has historical empirical support in both developed ex US and emerging markets. There are good small cap value ETFs available in the developed ex US category, but in the EM space we resort to workarounds.

Table 1

Table 1 shows funds (mostly ETFs and 1 mutual fund) from prominent providers that are diversified and take systematic approaches to portfolio construction. Represented in the table are Vanguard, Avantis, and Dimensional. The portfolio construction approach you use will depend on how you segment equities in your portfolio. A typical split is done by segmenting domestic from foreign holdings as [US / Global ex US] or as [US / Developed ex US/ Emerging Markets]. Table 2 shows the same funds aligned by category. It’s clear in this table that there is a gap in EM small value and Global ex US small value.

Table 2

If you treat foreign stocks as one group (Global ex US), a workaround for the lack of small cap value funds is holding VSS (Vanguard FTSE All World ex US Small Cap ETF) in combination with AVNV (Avantis All International Markets Value ETF). The combined holding will duplicate holdings from VSS that Avantis categorizes as value – so you will indirectly overweight small cap value stocks. I don’t usually advocate combining providers like this because they obviously employ entirely different and independent portfolio construction approaches, so there is a loss of efficiency. But it is a viable approach. If you use this framework, be mindful of possible duplications or gaps with respect to your other equities holdings. For example, AVNV holds all size categories, so you may also overweight large cap value if you do not make other adjustments.

My preferred approach is to break out Dev ex US from EM. This has the advantage of utilizing good choices in the Dev ex US small cap value space, and limiting any workarounds to the EM allocation which is typically a smaller portion of the portfolio. I would select from between Avantis and Dimensional based on each provider’s overall approach and lineup. Both are evidence-based, credible providers. Not coincidentally, the Avantis leadership team are former Dimensional executives.

To implement EM small value exposure, you can use a similar workaround cited above for Global ex US, though you can achieve more consistency and efficiency because you can align the selection by fund provider. Combing AVEE and AVES from the Avantis lineup, or DEMSX (the only mutual fund in the Tables) with DFEV from the Dimensional lineup, will result in overweight positions in EM small value stocks. As noted above be careful not to create unintended over/under weights in other categories when using this approach.

Lastly, I should not overlook that a simple low-cost approach to implementing international small cap exposure is to simply buy VSS, the only index tracker in the tables. As noted above, the F-F factor returns do not support this approach historically but, on the other hand, there may not be enough history to draw any conclusions. It would not be unreasonable to make a limited allocation to VSS despite the lack of historical validation.

I am taking a break from writing Index Capital Insights during the rest of July and August. I’ll return in September. In the meantime, please enjoy a fulfilling, fun, and peaceful summer.

[2] From Vanguard’s website. Returns are based on market price rather than NAV.

[1] A note about domicile determination, on which segregation into domestic and foreign equities segments depends. The determination of company domicile is dependent on the characterization of each issuer’s status by index providers, and in certain instances is far from clear cut. You will end up with differing characterizations of some of the same companies if you rely on different index providers.