April 25th, 2017 | by Gregg S. Fisher, CFA, "Invest with Reason"
Do Small-Country Stocks Generate Bigger Returns?
- 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).
- Research has shown that smaller countries tend to outperform across the capitalization spectrum, implying that the small country effect is independent of the firm-size effect (small company premium).
- Reducing weightings in large countries and reallocating some of that capital to smaller countries within the foreign equity portion of a diversified portfolio can offer investors better potential risk-adjusted returns and greater diversification.
Are foreign stocks finally emerging into the sunlight from hibernation? From January 2010 to December 2016, overseas stocks (as measured by the MSCI World ex USA Index) returned just 3.64% annualized, compared to 12.83% for the S&P 500 Index. The cumulative return for US stocks during those seven fat years was 133%, more than 100 percentage points ahead of the meager reward investors earned for their patience with foreign stocks. But in 2017 year-to-date to April 13, international equities returned 7.4% versus 4.6% for the S&P 500 Index. My goal in this column is to discuss a distinct approach to investing in foreign stocks around which we have conducted considerable research.
At Gerstein Fisher, whether we’re investing in foreign or US securities, we practice multi-factor investing, in which we tilt equity portfolios away from a passive index to security characteristics such as value, smaller size, momentum, and profitability. Most passive indexes, such as the S&P 500 or MSCI EAFE Index, are market capitalization-weighted, thus allocating the bulk of weight to the largest companies and creating an inherent large-cap bias in the portfolio. We decided to study whether investors can in fact improve their risk-adjusted returns in foreign stocks by eschewing country-capitalization weightings and, instead, shifting some allocation from the largest countries to smaller countries—in other words, whether there is a small country effect worth tilting towards in a foreign stock portfolio.
Hitting Above Their Weight
For our study, we took a universe of the 19 developed-country markets in the MSCI EAFE Index and constructed monthly cap-weighted portfolios that we divided into three categories: 1) the largest country’s weight, 2) the sum of the next four largest countries’ weights, and 3) the sum of the next 14 countries’ weights. As depicted in Exhibit 1, the trend over the long term has been for the larger countries to represent less of the index (Japan ranked as the largest single country during our entire 20-year study) and for small countries to grow in weight. Yet, as of the end of 2016, the top five countries still accounted for 67% of the market, which hints at the difficulty of achieving adequate portfolio diversification (one of the major benefits of international investing) by adhering strictly to an index-based approach.
Next, we calculated returns in the three country groupings by creating cap-weighted portfolios that we rebalanced annually. As seen in Exhibit 2, the 14 smallest countries outperformed the largest country in the market, returning 7.1% annualized over the 20-year period against just 2.3% for Japan. The small countries also outperformed the next four largest countries by a considerable margin, 2.7 percentage points annually. The small country returns come with higher annualized volatility than for the larger countries (18% vs. 17.1%), but a much better Sharpe Ratio (a measure of risk-adjusted returns): 0.28 versus 0.02 and 0.14 for the largest and next four largest markets, respectively.
Is it Country Size or Firm Size?
Careful readers might surmise that small country outperformance could be linked to the firm-size effect, which is the well-known tendency for small-company stocks to outperform large stocks. After all, it seems logical for small-country equity markets to contain a relatively high proportion of small-cap companies. To test this hypothesis, we delved into the relationship between the small-country effect and firm size. Exhibit 3 illustrates that within all three capitalization ranges, the returns of small countries exceed those of their larger counterparts. For instance, within large caps the largest-country portfolio returned only 0.82% annualized, compared to 3.8% for the next four largest countries and 5.5% for the remaining 14 smaller markets. These results would seem to indicate that the small-country and firm-size effects are independent.
Conclusion and Further Reading
What we conclude from our study is that stocks from smaller countries (of any market-cap size) tend to have higher average returns than stocks from large countries over time. Therefore, investors can meaningfully improve expected risk-adjusted returns and enhance diversification by reducing weights for large countries and reallocating to smaller countries in a multi-country equity portfolio. For more on our study and investment conclusions, we invite you to read our paper: International Investing and The Small Country Effect.
Exactly why the small country effect works is an open question. In an academic paper on the topic that I co-authored, we postulate some explanations for the small-country effect. For example, small country stocks receive less attention from sell-side analysts and attract fewer foreign investors. Interested readers can access the full paper here: Should You Tilt Your Equity Portfolio to Smaller Countries?