Portfolio Manager David Nadel describes why international small-cap is an asset class worth considering.

Asset allocators should be looking at the international small-cap asset class as maybe a two to five percent permanent allocation within a total portfolio for essentially one reason. In a sound bite, superior risk adjusted returns with very low correlation.

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Small-Cap Industrials
Image source: Wikimedia Commons

What aspects of the asset class might surprise investors?

I think people are often surprised by the quality of the businesses. I think that this asset class really offers a quality premium, in the sense that if you think about being a $3- or $4 billion company from a market like Australia or Finland or even the UK; you’ve had to figure out how the whole world works. You operate across borders. You have multiple places where you’re producing product, you have a diversified customer base.

These are very, very sophisticated businesses. If you think of the comparable market cap in the US, you could sell just to the state of California and achieve a $3- to $4 billion market cap. So, the standard for these companies is extremely high.

I do think people would be surprised by how big the asset class is, because I think, primarily, asset allocators have tended to go to international large-cap when they think non-US.

But I think they would be surprised to know that there are about three times as many companies in the international small-cap asset class as there are in the comparable sized market cap in the US. And there’s about twice as much aggregate market cap. So, there’s a lot to choose from.

Describe the risk profile of the asset class.

The risk profile of international small-cap is also counterintuitive. I think the impression that people tend to have from watching the news or reading the news is that the international markets are extremely volatile, because there's always some sort of problem going on somewhere in the world.

The reality is, statistically, this is an asset class that has a superior standard deviation to domestic small-cap. It's comparable to international large-cap. On a risk-adjusted basis, it’s superior to both.

And then, when you combine that with low correlation, you're, in terms of building an overall portfolio, you can understand why people come to that kind of two to five percent overall allocation.

What sort of environments does international small-cap tend to do best in?

I think international small-cap tends to do particularly well in rising rates, rising interest rate environments. That's what we found with our studies. It actually outperforms in both declining rate environments and rising interest rate environments but that outperformance over international large-cap is greater in a rising rate environment than in a declining rate environment.

I think its relevant now because with things like the German bund at 25 basis points. More likely, we're headed towards rising rates than further declining rates.

Article by The Royce Funds