International Equities
By Steven A. Schoenfeld and Stefanie Jaron

As investors become more global in orientation, they are also becoming more sophisticated in their search for additional sources of return and diversification. While most U.S. investors have long held core positions in international equities, this exposure has been heavily concentrated in the large-cap equities of developed countries, supplemented to some extent with emerging market equities. Meanwhile, smaller-cap international companies have been largely ignored, despite their strong performance in recent years and their potential diversification benefits. In this article, we will argue for the inclusion of these smaller-cap companies as part of a comprehensive international equity strategy.

One hurdle keeping investors out of this “subasset class” historically has been the complexity and unfamiliarity of available benchmarks.1 This paper assesses the international benchmark issue and how it has impacted the investment approach taken by most U.S. managers. We then discuss why existing approaches are suboptimal from a risk-and-return perspective, and suggest ways to better integrate small-cap international into a global portfolio.

In today’s market, accessing international markets in an appropriate manner is increasingly important. Today, the international markets represent more than half of total world market cap, and U.S. investors have finally starting addressing their home country bias in a major way by adding to international exposure. As this trend continues, investors need and deserve better and more transparent access to global small caps, to help them build better asset-allocation portfolios.2

Is MSCI EAFE Obsolete?
MSCI EAFE (Europe, Australasia and Far East) has been the dominant international equity benchmark for U.S. investors for over 30 years. Yet in an integrated global capital market, it is increasingly outdated as a measure of the opportunity set available outside the border. As we’ve said before, EAFE is obsolete.

Let us be clear: EAFE is not obsolete as a proxy for the large-cap equities of non-U.S. developed markets (except, of course, for its noted omission of Canada). But as a proxy for the true global ex-U.S. equity markets, it is most definitely outdated.

Unfortunately, it is in exactly this capacity that MSCI EAFE has served too many U.S. investors for far too long. As a result, while there has been a tremendous flow of assets from the U.S. equity market into EAFE-benchmarked strategies—and more recently, to the similarly constructed MSCI Emerging Markets Index—two key … and increasingly important … segments of the international markets have been largely ignored.

To fully understand this issue, one needs to grasp the major impact that a benchmark’s composition has on managed portfolios. With index funds, the linkage is direct and obvious. With active managers, the linkage is less direct, but nonetheless, very important. Most active managers pay very close attention to the benchmark against which they are being measured. They will stray from a benchmark, but not too far, and tracking error versus the index is a frequently cited measure of the “active risk” a manager incurs. Thus, a large-cap benchmark will generally translate into a large-cap portfolio, and that’s exactly what’s happened with EAFE.

The MSCI EAFE index covers 21 developed countries with a total market capitalization of $14 trillion, ranging in size from the U.K. at 22 percent to Portugal at 0.4 percent. Three countries—the U.K., Japan, and France—account for over 50 percent of the index weight.

The index draws its constituents from the larger-cap companies within these countries. In total, EAFE captures approximately 69 percent of total non-U.S. equity market cap, about on par with the 72 percent market coverage offered by the S&P 500.

But while few sophisticated investors would argue that the S&P 500 is a comprehensive benchmark for U.S. equities, many take EAFE at face value. In the U.S., they supplement the S&P 500 benchmark with indexes such as the S&P SmallCap 600, Russell 2000 or the DJ Wilshire 4500, which include smaller-cap companies, to fill in the “benchmark gap” shown in Figure 1. Why restrict the portfolio choices of an active manager unnecessarily?

We hereby challenge U.S. investors to perform the same exercise with their international allocations as they do with their U.S. allocations. Such an exercise is long overdue by both asset owners and their consultants.

What Are Investors Missing?
Because of the “benchmark gap” inherent in using MSCI EAFE as a primary measure of the international equity markets, investors tend to systematically underweight or overlook three important segments of the world outside of the U.S.: Canada, developed international small-caps and emerging markets. Collectively, these three markets account for more than $4 trillion of market cap, almost one-third of the total $12.5 trillion market cap for non-U.S. equity assets (see Figure 2).3 As shown in Figure 3, all three of these market segments have had periods of dramatic outperformance relative to EAFE and its equivalents. More importantly, they have offered different performance, which was not captured by the EAFE benchmark.

Despite its incomplete representation of the international equity class, however, MSCI EAFE still prevails as the default benchmark. It is used as a proxy for “international exposure” in asset allocation analyses and as a performance benchmark for both active and passive managers. In the retail investor and financial advisor space, this “large and developed” bias is even more pronounced.

As American investors allocate a higher proportion of their equity portfolios to international stocks, the importance of precision in the measurement of and allocation to the opportunity set has also increased.

By ignoring or underweighting three key market segments—Canada, developed international small-cap and emerging markets—investors are leaving attractive investment opportunities on the table. They should consider shifting to more complete “total international equity” policy benchmarks concurrent with an increased overall allocation to international equities. Filling this wide benchmark gap can increase portfolio returns while lowering risk, because of the improved diversification.

We have seen progress. More and more investors are integrating Emerging Markets and Canada into their policy framework with the growing popularity of such “integrated international” benchmarks as the MSCI All Country World excluding U.S. (ACWI ex-U.S.) Index or FTSE All-World ex-U.S. Index. But even that is not enough.4 Inevitably we ask, shouldn’t international small-capitalization stocks be integrated as well?

But I’m Exposed To International Small-Cap With My EAFE Mandate!
Some managers with an MSCI EAFE benchmark have invested “opportunistically” in smaller-cap companies, seeing these as a source of potential alpha. In the same spirit, it is not at all uncommon for a manager to invest a (small) portion of an MSCI EAFE mandate in emerging market equities—“dabbling,” as it were. Many asset owners and their consultants explicitly allow or even encourage this approach (with maximum bands) as a way of getting exposure to both subasset categories.5 While a case can be made for having a manager make these sorts of active decisions, the benchmark will still have a significant influence on the weightings. If the benchmark has no exposure to smaller-cap companies, a portfolio’s neutral position will have no exposure either. As a result, any exposure will be carefully monitored for its impact on overall risk. If, on the other hand, an exposure to small-cap equities is included in the benchmark, the portfolio’s neutral position will reflect that.

If a manager is holding small-cap issues as a core component of his/her strategy, one must question whether MSCI EAFE is really the appropriate benchmark to use in measuring performance. As Figure 4 notes, over the last four years, developed-market international small-cap stocks have outperformed MSCI EAFE by 6.3 percent on an annualized basis. A manager making an allocation to this space will likely outperform the benchmark, but does this reflect skill in selecting these stocks or merely the beta of this subasset class? Will the opportunistic manager be able to time his/her moves in and out of this area effectively?

We feel strongly that any attractive asset class should be captured in the benchmark used to evaluate a manager. This holds for value- and growth-oriented managers within international equity.6 The neutral position should represent the mix of assets with which the investor is genuinely comfortable, i.e., “the true opportunity set” for the investment manager.

The Appeal Of International Small-Cap Stocks
Since this decade’s stock market bottom in the spring of 2003, international small-cap stocks (as represented by the S&P/Citi Extended Market Index (EMI)7) have significantly outperformed the MSCI EAFE, S&P 500 and Russell 2000 indexes, as shown in Figure 4. It should be noted that U.S. small-cap benchmarks such as the Russell 2000 and S&P SmallCap 600 also significantly outperformed their large-cap peers over this time period.

This strong performance by small-cap stocks is a recent phenomenon, however, as can be seen in Figure 5. Here, we look at returns over a 17.5-year time period, which includes general market cycles. International small-cap stocks may have been “unloved and underappreciated” by most American investors during the 1990s, but not without reason: As shown, U.S. equities significantly outperformed international equities, and neither large-cap nor small-cap international stocks made much comparative headway.

While it is critical for investors to balance short-term performance- oriented enthusiasm with the sobriety of a longer-term perspective, performance per se is only one of the factors that make this subasset class attractive. International small-cap equities have provided attractive risk-adjusted returns, as can be seen in Figure 6, in which the data covers the five-year period ending September 2007.

Favorable Correlations
U.S. investors have long looked to international equities to provide diversification within a portfolio. In Figure 7, we show how the correlations between the S&P 500 and the MSCI EAFE have changed over time. The correlation is far higher today than it was a decade ago, which is not surprising when one thinks about the global nature of today’s markets. International equities continue to provide some diversification; however, small-cap companies provide more than large-cap (Figure 8).

Clearly, international small-cap adds diversification benefits, whether treated as a separate subasset class or integrated into the broader international equity asset class. This type of diversification is part of what has made foreign investing attractive to U.S. investors. With correlations rising among large-cap securities around the world (and especially among global “mega-cap” companies), developed international small-cap has a more important role to play than ever in helping build strong asset-allocation portfolios.

A Note On Performance And Timing—Caveat Emptor
Looking at performance, adding developed international small-cap and emerging markets to a well-structured portfolio would have also boosted returns over the past decade (Figure 9). Of course, a case can be made that these markets are no longer as compelling as they were in the early part of the decade, when valuations were significantly lower (the P/BV of international small cap was just over 1.1). This should be a cautionary indicator for investors who may not have a longer-term perspective.

The Challenge Of Defining The “Subasset Class”
Because international small-cap equities tend to “fall below” the standard developed-international benchmarks, defining the subasset class has challenged and often confused many in the industry. Determining the correct benchmark for active managers and the best investment strategies to employ in this category has not been easy. Fortunately, this issue has recently been gaining long-overdue attention, and we believe that the industry is finally at the inflection point of shifting toward a more logical, holistic framework.

In November 2006, MSCI announced that it would be updating its methodology to correct an overlap that had long existed between its dominant large/mid-cap indexes (like the MSCI EAFE) and its small-cap index series. Previously, the large/mid-cap indexes had a smattering of small-cap exposure; in the new version, the indexes are discrete.

Provisional indexes were released with two scheduled transition dates: November 2007 and May 2008. Since the previous methodology built in an overlap of the index series, however, it was unclear to many MSCI users how to successfully incorporate small-cap securities within their existing portfolios. Moreover, the methodology fell short of a broad comprehensive representation of the subasset class.

Fortunately, other global index providers have stepped up to offer a solution in this space, including the S&P/Citigroup EMI, S&P/Citigroup “Cap Range,” FTSE, Dow Jones Wilshire and Russell Global indexes. These index families offer coherent solutions for the small-cap market segment, but also offer a series of clearly defined, nonoverlapping indexes, providing broad exposure to international markets.

Gaining Efficient Exposure
As the “subasset” class of international small-cap stocks has become more transparent, investors now have better options for integrating it into their portfolios. Still, getting efficient exposure with talented active managers can be a balancing act. Finding good international small-cap managers with sufficient capacity can be difficult. Though the number of strategies offered within this asset class has expanded, capacity constraints are a growing concern (as they are among top-quartile Emerging Market managers).

In a 2006 survey of the 42 managers that offered dedicated international small-cap portfolios, 14 of them—most with above-median performance—were closed to new investors. The 14 managers represented 48 percent of the market cap of assets managed in this space, thereby highlighting the issue of limited capacity.8 And while active management has delivered strong returns historically, capacity constraints are increasingly reducing the availability of alpha. Thus, active management may not be the most effective and efficient way to acquire additional exposure today.

One simple, cost-effective solution for investors is to utilize an index-based strategy in this space. Again, with the increased offering of comprehensive, investable indexes, index managers can now offer products to complement investors’ large-cap international strategies.

A Complete Solution—Total International Equity Strategy (TIES)
A dedicated international small-cap allocation is not the only approach, and may not be the best approach. Broad-based, all-inclusive benchmarks now exist that include small-cap stocks along with larger-cap issues and emerging markets. At Northern Trust, we call these complete strategies “Total International Equity Strategies,” or “TIES.” Choices of benchmarks include the MSCI Global Investable Market Index (GIMI), S&P/Citi Broad Market Index (BMI), FTSE All-Cap Indexes, Russell Global Indexes and, most comprehensive of all, the Dow Jones Wilshire Global Total Market indexes. These benchmarks can be used to integrate each segment of the international market into one broad-based portfolio. Since they include a broad array of issues across markets and market capitalizations, their adoption as policy benchmarks encourages managers to take positions in smaller-cap companies. Furthermore, adoption of “TIES” for the passive core of an international equity allocation enables investors to fill in gaps where they have not identified active managers, using, for example, an index-based developed-international large-cap value strategy while conducting a search for an active manager in this category.

Just as many U.S. investors have implemented the comprehensive Russell 3000 and Dow Jones Wilshire 5000 as policy benchmarks for their U.S. equity allocations, we recommend that a similar approach be established for international allocations. As portrayed in Figure 10, the combination of the various subasset classes of International Equity into a single “Total International” benchmark (and allocation framework) for policy purposes and investment mandates (both active and passive) has a similar logic and elegance. We view adoption of this framework as the inevitable next phase of sophisticated asset allocation for international equities.

Regardless of the benchmark or the investment style (traditional active, structured or index), investors should not ignore any of the subcomponents of the global markets. One can argue the merits of active versus passive, but as is often the case, simply “being there” is what matters the most. However the position is achieved, we would argue that ignoring international small-cap equities leaves the investor with an incomplete and inefficient global equity allocation. Relying only on a developed-international large-cap benchmark like MSCI EAFE as one’s primary index for the asset class is outdated and inappropriate.

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1.We will emphasize throughout this article that International Small Cap, like Emerging Markets, should be considered subcategories of International Equity, just as U.S. Small Cap is a subasset class within U.S. Equities.