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Written by Frank Nielsen, CFA
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Monday, 01 October 2007 00:00 |
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Page 4 of 4
The majority of small-cap products have been closed for new investors when assets under management reached between $500 million and $2 billion. An alternative to overcoming capacity constraints within the small-cap segment is discussed in a research paper by Vanguard.12 They report that the typical outperformance of active U.S. small-cap funds is an artifact of the particular benchmarking method and conclude that, "indexing is a powerful strategy among small-cap stocks, as it is in any market." How should an international index be created to satisfy the characteristics of a representative benchmark?
One important characteristic of a good benchmark is to represent the average performance of all active managers within a segment. Figure 11 displays the MSCI Provisional USA Small Cap Index relative to the Lipper Small-Cap Core Funds Average Index.13
The MSCI Provisional USA Small Cap Index has stayed close to the Lipper Small-Cap Core Funds Average.
For passive products to become an attractive alternative, the underlying indexes have to be replicable and liquid and offer comprehensive coverage of the investable opportunity set. Furthermore, index turnover and maintenance rules are critically important, as transaction costs are significantly higher within the international small-cap space compared with the large- and mid-cap segment.
The enhanced MSCI Global Investable Market Indices family is designed with those goals in mind.14 Its focus on investability is emphasized by the systematic application of liquidity screens, minimum free-float requirements in absolute U.S. dollar terms as well as minimum free-float percentages per security. Such criteria ensure that index constituents are tradable and liquid. The buffer zones applied at rebalancing not only limit reverse turnover but also aim to reflect the investment process of small-cap managers. A small-cap manager will not immediately sell a stock just because its market value has appreciated beyond the maximum target range for the market capitalization of the small-cap mandate. Instead, managers hold on to the stock until they feel it has clearly moved into the mid-cap space.
The MSCI Provisional Small Cap Index offers comprehensive coverage of the small-cap segment, complementing the standard indexes in a nonoverlapping fashion. Its size segmentation along country and regional (for Europe) lines reflects current investment processes.
Conclusion
International small-cap investing has attracted significant attention over the last few years and is following the example of the U.S. equity market segmentation. Dedicated small-cap mandates are no longer the exception, and many products based on MSCI EAFE allow for an opportunistic allocation toward small-caps.
The challenges in small-cap investing are different than those in large-cap investing, as the level of stock return dispersion is larger in small caps than it is within the mid- and large-cap segment. Although correlations between small- and large-caps have increased at the index level, international small caps offer a very different risk and return profile. Furthermore, small-cap portfolios have likely been less correlated to the Provisional MSCI EAFE Index or similar large- and mid-cap portfolios since company-specific bets have likely been more significant. This would have lowered the correlations between the returns of a typical small-cap fund and international standard equity benchmarks.
So far, the majority of small-cap products have been based on active, bottom-up investment strategies and many have outperformed their respective benchmarks. If money inflow continues to increase, and capacity and liquidity concerns amplify however, international small-cap indexing may become more popular.
Footnotes
12 See Davis, Joseph H., Sheay, Glenn, Tokat, Yesim, and Wicas, Nelson, "Evaluating Small-Cap Active Funds," Vanguard Investment Counseling & Research, April 2007.
13 The Lipper Small-Cap Core Funds Average Index represents the average return of all small-cap core funds tracked by Lipper.
14 See "MSCI Global Investable Market Indices Methodology" at www.mscibarra.com.
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