After the dizzying investment ride we've been on for the last year and a half, it's only normal to wonder where we go from here. The reality, of course, is that no one knows for sure. We never really do, at least in the short run. And that's one of great takeaways from this tumultuous period.
We'd like to think another big lesson might be the importance of managing risk. Investors who've allowed emotions to influence their decisions across this tough stretch of market volatility have paid dearly through their portfolios. And that's because loss of objectivity almost always leads to susceptibility toward the market's swings--both ways--as stocks and sectors shift quickly between leader and laggard. Check out the financial sector across the last 18 months for a good example.
One way skilled investors mitigate the impact of emotion on their decision-making is through disciplined portfolio rebalancing. In its simplest form, rebalancing is regularly returning a portfolio to a proper mix of stocks, bonds, and cash when they no longer conform to a plan. But rebalancing can and should be a lot more robust than just selling high and buying low...we think it's an outstanding opportunity to add or increase exposure to overlooked asset classes at the same time. And we think one such space right now is international small-cap equity.
Often confused with emerging markets, international small-cap equities tend to be a neglected space within the context of a well-diversified portfolio. And that's unfortunate. In unhedged portfolios, international small caps not only provide exposure to foreign currency, they also offer an opportunity to buy companies that are more sensitive to domestic demand than global economic trends. It's hard to argue the logic of the class as a diversifier.
Moreover, many investment managers think international small-cap equities will have an unusual advantage as we emerge from the recent financial crisis: limited coverage. International small-cap companies have always been less followed by equity research firms, but as these shops scale back to cut costs, coverage of many smaller companies will be even further reduced. (Trading volume associated with these securities is generally less than that of larger-cap companies and therefore less profitable.) As a result, investment managers with sufficient resources and global reach to produce their own international small-cap research should be able to capitalize on this opportunity to create an information advantage over competitors. In the meantime, as improving capital markets allow an increasing number of companies to go public, investors will benefit from an expanding investment universe.
Still, our informed experience tells us that investors are underexposed to the space. Specifically, we know that the ratio of international small-cap stocks to large-cap stocks on a market-cap basis is approximately 8% according to McKinsey & Company and International Bank of Settlements. The ratio of international small-cap fund assets to international large-cap fund assets is only 2%Morningstar. The asset under management ratio, in other words, is smaller than the market capitalization ratio. From that we can infer with a fair degree of confidence that international small-cap stocks are underrepresented within investor portfolios.
All things considered--the unique diversification benefits plus the potential for an information advantage--international small-cap equities represent an attractive investment opportunity. We think the asset class deserves particular consideration as a stand-alone allocation in a well-diversified portfolio. Rebalanced or otherwise.
J. Gibson Watson III is president and CEO of Denver-based Prima Capital (www.primacapital.com), which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.