The relative strength line pits a stock’s performance against the benchmark S&P 500, and a stock with a rapidly rising RS line is one to keep an eye on. Two companies that continue to outpace the market, MSCI (MSCI) and Ctrip.com International (CTRP), are featured on IBD’s Bolting RS Lines Screen of the Day. MSCI, a supplier of analytical tools for institutional investors, said Monday that it will add American Depositary Receipts — i.e. China
Summary The notion of a “small-cap premium” is deeply established in investors’ consciousness. Many investors include an explicit allocation to U.S. and international small-cap stocks in their portfolios in order to benefit from the implied outperformance of this market segment. Recently there has been a growing interest in whether making a similar allocation to emerging market small-cap stocks can be beneficial. We detail the motivations of EM small cap investors and whether empirical evidence supports those motivations. By Tim Atwill, Ph.D., CFA, Head of Investment Strategy and Mahesh Pritamani, Ph.D., CFA, Senior Researcher An investor in emerging market small-cap stocks typically has three main motivations behind their interest in the asset class: presumed higher return; better diversification with their developed equity allocation; and more “focused” exposure to the emerging markets, in that small-cap companies tend to be more domestically focused in their economic activities. Below, we lay out the empirical evidence which supports these motivations. We show that while the return advantage and “pure exposure” arguments are strongly supported, the diversifcation benefit is relatively modest. HIGHER RETURNS Historically, small capitalization stocks have been seen as having higher potential returns than mid- and large-cap stocks. However, the bulk of the research examining this premium has focused primarily on the U.S. markets, and, to a lesser extent, the international markets. Below, we compare the excess returns of the MSCI® Emerging Markets Small Cap Index to the MSCI Emerging Markets Index to evaluate whether a similar small-cap premium exists in emerging markets. (click to enlarge) Figure 1 shows that in most years, small-cap stocks earn a relative premium to large- and mid-cap stocks. However, as with most matters in investing, there is no such thing as a free lunch, and several years had notable underperformance. Moreover, the oversized small-cap premium in 2009 highlights the timing risk associated with trying to capture the small-cap premium. This is also evident in Figure 2 which shows the annualized small-cap premium on a rolling 3-year basis, where the realized premium ranges from -5.4% to 9.2%. (click to enlarge) These results indicate that although there is evidence of a small-cap premium in the emerging markets, one has to be invested for the long-term in order to earn it. LOWER CORRELATION WITH DEVELOPED ECONOMY EQUITIES Many argue that small-cap companies are more focused on their local economies, and because of this are less connected to the global economy. Accordingly, such small-cap stocks should provide higher diversification benefits within an investor’s portfolio, versus the benefit from buying equities of larger, more globally-focused companies, which are included in more traditional emerging markets equity allocations. To demonstrate the diversification benefits associated with investing in emerging market small-cap stocks, we calculate the correlation of the MSCI World Index (which represents the equities of the developed markets) to the MSCI Emerging Markets Index, as well as the MSCI Emerging Markets Small Cap Index. (click to enlarge) As can be seen, emerging market small-cap stocks have historically shown a modestly lower correlation with the developed markets than large and mid-cap emerging market stocks. That is to say, emerging market small-cap stocks should provide a higher degree of diversification if included in an investor’s portfolio. Moreover, Figure 3 shows that this diversification benefit persists over most time periods. Therefore, a portfolio which includes an allocation to emerging market small cap stocks should expect to achieve some minor benefits from this lower correlation, including lower predicted portfolio volatility versus a similar portfolio which only includes large- and-mid-cap emerging market stocks. A “FOCUSED” EMERGING MARKETS EXPOSURE One of the reasons for investing in emerging markets, in general, is to gain exposure to smaller, less developed economies which have the potential to grow at a faster rate than developed economies. However, given the globalization of the world economy, several emerging market countries now have a small number of companies that are global in nature and known worldwide. A prime example of this is Korea-based Samsung, a truly global company, whose consumer products (such as TVs and smart phones) are bought all over the world and whose profitability is more likely tied to the world economy than the local Korean economy. A portion of the MSCI Emerging Markets Index constituents is in such global companies, under-cutting to some degree this motivation for investing in the emerging markets. By avoiding such companies, an investor in the small-cap segment of the emerging markets has the potential to obtain an exposure more focused on the local emerging market economies. To quantify this, we look at each company within both the MSCI EM Small Cap Index and the MSCI EM Index, and calculate the percentage of revenue which comes from outside its “home” country. We then capitalization-weight these percentages for each index, and present the results below. (click to enlarge) As shown in Figure 4, emerging market small-cap companies do receive much less of their revenue from outside their home economies (approximately one-quarter, versus almost one-third for large/mid-cap stocks). In addition, this focus on local economies remained relatively static over the past decade, while globally, small-cap companies saw growth in foreign revenues. This data suggests that an investor in the small-cap segment of the emerging markets captures a “focused” exposure to the local emerging market economies, because small-cap names are generally more reflective of local economies, and that this focus is more persistent than is observed globally. CONCLUSION Investors currently hear many arguments for investing in emerging market small-cap stocks, and while these arguments appeal to intuition, we have found varying degrees of support for them in the historical data. After exploring the three most common reasons for investing in the emerging market small-cap stocks – earning a small-cap premium, realizing the benefits of increased diversification, and achieving a more focused exposure to the local economies in emerging market countries – we find supporting evidence for all three of these arguments. One can potentially earn a small-cap premium by investing in small-cap stocks, though there is the risk that small-cap stocks will underperform large- and mid-cap stocks over multiple years. Historical evidence also demonstrates that although emerging market small-cap stocks are less correlated with the developed markets, this diversification benefit is relatively modest in size. It also appears that small companies in the emerging markets are more focused on their local markets, and so are potentially well positioned to benefit from the higher expected growth rates in these developing economies. All in all, we find the data encouraging for those investors who are considering a long-term strategic allocation to emerging markets small-cap stocks.
Summary ETFs are financial instruments that add an extra layer of risk that may not be suitable or ideal for all investors. Interestingly, since 2000, the S&P 600 has significantly outperformed it’s counterpart, the Russell 2000. Subconsciously, fund managers may be hurting their returns by stating they are “overweight” or “underweight” a stock, especially if using an easy to beat benchmark. Individual investors can gain an edge on professional fund managers by simply investing in indices and ETFs with a superior long-term track record. It’s conceivable that “brand names” will start to matter, as ETFs and Index Funds become more popular over the next decade. Introduction Warren Buffett has famously stated that Americans are better off investing in a simple index fund like the Vanguard S&P 500 ETF (NYSEARCA: VOO ). Investing in the S&P 500 exposes investors to American businesses and allows them to reap the benefits of an expanding and capitalistic economy. Branching away into different indices and ETFs introduces investors to varying degrees of risk and fall empty handed on the returns advertised. For example, an ETF that is composed of 30 securities is not only priced based on its underlying portfolio of securities, but also in accordance to the supply and demand of the ETF itself. This double jointed structure introduces several liquidity and volatility risks to investors in times of market turbulence and downturns. Furthermore, there are all sorts of differentiated structures that provide for excessive risk in hopes to achieve higher returns. Notably, all levered bull and bear ETFs. These structures introduce another layer of unknowns and risks for investors, with the speculative potential to increase returns. However, an investor is likely to achieve not only a lower risk profile, but higher returns by simply scrutinizing their portfolio with a careful eye– looking for an edge. The Russell 2000 vs The S&P 600 For the conservative investor, a seemingly simple question of investing in an ETF covering the Russell 2000 (like the iShares Russell 2000 ETF ( IWM)) or the S&P 600 (like the SPDR S&P 600 Small Cap ETF ( SLY)) can yield dramatically different results. As reported by the Financial Times on Monday August 17, 2015, the S&P 600 has outperformed its counterpart the Russell 2000 since year 2000–by a significant margin. Specifically, since the beginning of 2000, the S&P 600 would have turned a $100 investment into a little over $360 and a $100 investment in the Russel 2000 would have turned into approximately $250. Image Sourced from Finanical Times Hence, the framework on an underlying index can have a profound influence on an index’s performance, the related ETF’s performance, and an investor’s overall return. The S&P 600 may cover a slimmer portion of the small cap universe, but this may be for good reason. After all, an investor only needs to own 30 stocks to be amply diversified from systemic market risk. According to the Financial Times, the S&P 600 index requires companies to have a record of making profits before it is included in the index. Furthermore, it sets a far higher standard for liquidity (compared to Russell 2000). It’s no wonder then that small-cap investment firms use the Russell 2000 to track their performance against. It’s easier to beat! It’s amazing how two simple rules can create significant long-term value for clients and investors. As such, it appears reasonable to assume that an index’s brand and portfolio construction will have even more of an impact on investors’ decisions going forward. How robot advisors and, to an extent, human advisors, will account for these seemingly minute details remains to be seen. Regardless, a wise and enterprising investor will have an edge. A passive minded investor, with an enterprising spirit, would be able to increase their returns by sacrificing a small amount of time to discover discrepancies such as this-especially long-term investors who have 15+ year time horizons. Index Business Growing In Size and Power Building ETFs based on indexes has become a huge business, with hundreds of billions riding on the skirts of simple structures. The owners of these indexes, whether it’s MSCI (NYSE: MSCI ), FTSE Russell, or the S&P (NYSE: MHFI ) will continue to have more and more power and influence on the financial markets-along with their clients like Vanguard and Blackrock (NYSE: BLK ). Whether or not they use this power wisely is another question, one that I’m not overly optimistic about. Furthermore, transparency can be a double-edged sword. For instance, the Russell 2000 follows very transparent rules by alerting investors in advance which stocks will move in and out on the day each June when the index is reshuffled (making it easier to beat). The S&P 500 Index has discretion to include companies that have a history of recording a profit, maintaining a balance between sectors, and typically only includes new companies when a vacancy is created (often through a merger). Invariably this causes the stock to pop as it is added to the S&P 500 Index, creating agony among fund managers attempting to beat it. Psychology of the Index Behavior psychology (or anything to do with human behavior) continues to have a heavy influence on the performance of fund managers. It’s well-known that investors and fund managers must account for self-bias and over-confidence once they buy a particular security, otherwise their judgment may become impaired and make mistakes. Recently, there has been a change in the way fund managers and analysts talk about their portfolios. For instance, they often speak of being “overweight” or “underweight” a particular stock, rather than stating they “own” a stock. By stating that they are “overweight” or “underweight,” fund manager’s are subconsciously increasing the influence a benchmark index has on their portfolio allocation and investment returns. It’s well known that the majority of actively managed mutual funds fail to beat their benchmarks. Therefore, it stands to reason that individual investors should outperform fund manager’s who chose the Russell 2000 as their benchmark–by simply investing in the S&P 600! While past performances do not guarantee future returns, it’s hard to argue the long-term track-record of the S&P 600 compared to the Russell 2000 over the past 15 years. In essence, investors who look at a stock as a fractional ownership of an underlying business will have both a psychological and fundamental advantage over other investors during a long-term time horizon. Fund managers that state they “own” a stock are still subject to subconscious self-bias and overconfidence; however, it’s likely they would focus more of their time on the fundamentals of the business, rather than the makeup of a particular benchmark. A stock’s total return, after all, is proportional to the company’s long-term operating performance and returns on capital, not because of its weighting in a particular index. Conclusion Just like it’s never wise to ask your barber if you need a haircut, investors shouldn’t accept over-simplified financial products and investments, especially from Wall Street. A little bit of research and passion to find an edge can go a long way. Remember that in a group of 100 investors, only 49 can be better than average-despite everyone’s opinions that they are in the top 20%. Managing your time wisely and performing diligent research has the potential to add a percentage or two to your total returns over your lifetime. In addition, you will incur fewer trading and tax expenses due to mistakes and disappointments. Apply diligent research, patience, and a long-term time horizon to maximize the benefits you receive from the miracles of compound interest. Don’t let sloppy benchmark indices get in your way–invest in the best ones. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.