With the performance of Canadian stock market lagging the world market for the past four calendar years, the importance of global diversification has been underscored. What many financial advisors may not know, however, is that this principle does not simply apply to large- and mid-capitalization stocks. The benefits of global diversification are even greater for small-cap stocks.

Global small-caps represent an opportunity that dwarfs the entire Canadian market, let alone Canadian small-caps. Based on the MSCI ACWI small-cap index (US$), as of Feb. 27, the global small-cap universe was composed of 6,104 stocks with a combined market cap of US$5.9 trillion.

In contrast, the MSCI Canada investible market index (US$), comprising about 99% of Canada’s investible market, contained only 349 stocks with a combined market cap of US$1.5 trillion.

Several studies have found that the size premium – the tendency of small-caps to outperform large-caps – exists internationally as well as in North America. From June 1994 to January 2015, the MSCI ACWI small-cap index had an annualized rate of return of 7.5% vs the 6.7% return of large- and mid-cap stocks as measured by the MSCI AC world index.

Global small-cap stocks were more volatile: annualized standard deviation was 14.7% vs 13.2% for large- and mid-cap stocks. But small caps’ superior return more than compensated investors for the bumpier ride – and global small-cap stocks scored higher by risk-adjusted measures. Also, despite a 0.85 correlation with large- and mid-cap stocks and greater volatility, historical portfolio optimization analysis found that the most efficient portfolio combinations had a material allocation to global small-caps.

Combining small-cap stocks from different regions has a stronger diversification effect than can be achieved with large- and mid-cap stocks. All of the correlations between combinations of the MSCI small-cap indices of Canada, the U.S., EAFE (Europe/Australasia/Far East] and emerging markets were lower than for comparative MSCI indices composed of large- and mid-caps. The reason: small-cap firms focus more on local markets and thus have more variation in their sources of return.

Lower correlations and greater volatility result in a higher rebalancing premium for global small-cap stocks in comparison to their large- and mid-cap brethren. From January 1999 to January 2015, a small-cap portfolio composed of 30% each of Canadian, U.S. and EAFE stocks and 10% emerging-market equities (based on the MSCI small-cap indices) had a rebalancing premium that was 67% higher than for a portfolio of an equivalent mix of large- and mid-cap stocks.

High management fees for actively managed small-cap funds historically have eroded much of these funds’ small-cap benefits. However, an explosion in exchange-traded funds in the U.S. has created a wide array of low-cost funds that track small-cap indices in the U.S. and in international and emerging markets.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 securities mentioned in this article.

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