Advisors striving for higher returns in their clients’ portfolios should take a hard look at international small-cap stocks.

International small-caps outperformed the broader international market for the period between July 1989 and January 2010. The S&P developed ex-U.S. small-cap index (C$) had an annualized return of 5.6%, besting the 4.5% return of the MSCI EAFE index.

Although this return lagged the 8.8% return from Canadian small-caps, as measured by the S&P Canada small index, the lag was due to the effect of the deflating Japanese stock bubble and the consequent negative returns from this country. International returns were also depressed by the ascent of the Canadian dollar. Absent these factors, both unlikely to occur in the future to the same magnitude, international small-caps would have earned returns of similar magnitude to their Canadian counterparts.

The higher return from international small-caps compared with international large-cap stocks is consistent with research that has identified the size premium as a phenomenon present in most countries’ stock markets. Although this premium is volatile and can be negative for lengthy periods, small companies outperform large firms on average.

International small-caps have a strong diversification effect on Canadian portfolios. The correlation between the S&P developed ex-U.S. small-cap and the S&P/TSX composite indices was 0.57, while the international index’s correlation with the S&P Canada small-cap index was only 0.58.

Correlations, of course, jumped during the recent global credit crisis; but as more typical regional and country economic growth disparities occur, a more normal diversification effect is likely to take greater hold. An example of this diversification effect occurred in 1998: the overall Canadian market was in the red and Canadian small-caps had double-digit losses while international small-caps posted a 20.4% return.

The diversification opportunity from international small-caps is evidenced by the sectoral exposures. The top three sectors in the S&P developed ex-U.S. small-cap index are industrials, financials and consumer discretionary. There are much lower exposures to materials and energy, which constitute more than half of the S&P Canada small-cap index. The broader geographical and sectoral exposure of international small-caps also results in modestly lower volatility than in the Canadian small-cap market.

Exposure to international small-caps is available through an array of investment vehicles. Unfortunately, the Canadian mutual fund classification system doesn’t have a category for international small-cap stocks; funds have to be selected from the global mid- and small-cap category.

One fund that is currently focused outside North America with a strong long-term record of performance is Mackenzie Cundill Recovery Fund, sponsored by Toronto-based Mackenzie Financial Corp. For advisors concerned with currencies, this fund’s most recent report indicates that the fund is 50% currency-hedged.

Advisors using exchange-traded funds will have to go to the U.S. market, in which several options exist. For example, State Street Global Markets LLC distributes SPDR S&P International Small Cap ETF, which replicates, to the extent possible, the returns of the S&P developed ex-U.S. under US$2 billion index. IE



Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. Tacita, its principals, employees and clients may own the securities mentioned herein.