International Investing and The Small Country Effect
- Research has shown that, when investing in foreign stocks, smaller countries (as measured by market capitalization) tend to outperform their larger peers; this is referred to as the small country effect.
- Investment strategies that attempt to closely track cap-weighted indexes can end up with a large-country bias given that the index is “top-heavy” (concentrated in larger countries).
- The small country effect is independent of the firm-size effect (small company premium); research has shown that smaller countries tend to outperform across the capitalization spectrum.
- We believe multi-factor investing can provide investors with the opportunity to outperform over the long term in both domestic and international markets; in this process, in addition to tilting portfolios toward characteristics such as value, momentum and profitability, exposure to small countries can provide an additional return benefit.
Over the 10-year period ending in 2015, US equity mutual funds have experienced $834 billion in net outflows, compared to $643 billion of net inflows into international funds.1 As of the end of 2016, foreign equities accounted for approximately 48% of global market capitalization as measured by the MSCI All-Country World Index, and represented 77% of the 10,000 developed and emerging market companies with a market capitalization greater than $200 million. Despite the trend in flows and the size and breadth of foreign markets, however, US investors allocated approximately 79% of their portfolios to domestic equities last year.2 This phenomenon, known as home bias, is also observed in other developed countries such as the United Kingdom and Canada.