Small Caps Back in the Global Spotlight

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Many investors have focused on larger global companies as more stable and more liquid investments, but institutional investors are increasingly looking to the small-cap segments. Through exchange traded fund options, retail investors can also increase their exposure to smaller companies and potentially capitalize on the greater growth potential.

"Asset owners and managers increasingly are allocating strategically to the small-cap equity segment as part of their global equity portfolios," Raina Oberoi, Vice President of Equity Applied Research at MSCI, said in a research note.

Oberoi attributes the shift in strategy to four main factors: Small-caps have historically showed a premium compared to large-caps. Small-caps provide greater diversification benefits in an all-cap portfolio. Small-caps allow an investor to gain broader exposure. Lastly, index-based small-cap strategies are cheap and provide targeted market exposure.

Many market observers and academic research have found a size premium in the markets where smaller companies typically outperform larger companies over time.

"Contrary to the claims of small-cap critics, our research shows the size premium has historically exited outside the U.S. as well, which has made small-cap investing a global phenomenon," Oberoi said.

According to MSCI research, small-caps have outperformed large caps over the last 15 years. Looking at the MSCI ACWI IMI, which includes the all-cap spectrum, the index returned an annualized 7.2% for the 15 years ended December 2016. In contrast, the MSCI ACWI Index, which focuses on large- and mid-caps only, returned an annualized 6.7%. Consequently, investors who choose to forego the 14% tilt to small-caps are missing out on a growth opportunity.

"For the past 15 years, [investors] would have given up 50 basis points annually in additional returns," Oberoi said.

Small-caps also provide greater diversification benefits. For instance, smaller company stocks are quicker to react to market rebounds, usually outperforming larger companies during the initial stages of growth. However, small-caps are also more likely to experience greater volatility during down markets.

The small-cap segment is also more focused on the domestic economy, which makes them less affected by global macroeconomic shocks.

As a one-stop-shop global market investment, the SPDR MSCI ACWI IMI ETF (NYSEArca: ACIM), which tracks the MSCI ACWI IMI, can help investors gain exposure to the global markets through a single ETF holding. The underlying Index is a free float- adjusted market capitalization-weighted index that captures up to 99% of the developed and emerging investable market universe.

Alternatively, if an investor already has international market exposure but just lacks foreign small-cap holdings, there are also a number of focused small-cap international ETFs as well.

For instance, the Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEArca: VSS) follows the FTSE Global Small Cap ex US Index and provides an easy way to gain broad exposure across developed and emerging market companies outside of the U.S.

The WisdomTree International SmallCap Dividend Fund (NYSEArca: DLS) is another option, except this ETF specifically screens for dividend-paying small-caps to help investors satisfy demand for income, along with growth potential.

Additionally, the Schwab Fundamental International Small Company ETF (NYSEArca: FNDC) takes companies with weights below 87.5% of the Russell Developed ex-U.S. Index and applies a fundamental indexing methodology that weights holdings based on adjusted sales, operating cash flow, and dividends plus buyback.

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