Friday, June 25, 2010


The WSJ Online presented the following piece by Brett Arens on US Small-Cap stocks. The US market is still by far the largest one when it comes to small-cap investing. Small-caps are - on average - riskier than large-caps. The stocks are often followed by less analysts, which translates into information density and 'neglect'. The firms are less diversified and consist of smaller bundles of projects. And last but not least: in a globalizing world in which Emerging Markets are more and more the catalysts for growth, Small-caps in Developed Markets are - due to their size - less well positioned to benefit from this internationalization trend.

However, experience has taught us that there is one important caveat. The 'pool' of small-cap stocks represents a larger universe of investment opportunities. And the variability in returns (i.e. the return-risk characteristics of the best versus the worst intra-category investments) is larger than in the large-cap zone. This implies that those active investors that really know what they are doing have an easier job 'beating' their less-informed opponents.

Arens reports that relative valuation ratios for US small-caps have risen to historically high levels. Earlier work by Mark Reinganum (who recently joined State Street Global Advisors as one of their main investment people in the Developed Markets segment, but was a still an academic at Southern Methodist University when he published his work on small-caps) and others in the 1980s and early 90s has already indicated that small-cap premiums do indeed follow cycles when looking at averages.

LMG does therefore agree that it is time to get worried about US small-caps, even after their excellent performance vis-a-vis large-caps in recent years. Or maybe we should rephrase this: especially because they have done so well it is better to lock in your profits right now.

But we do NOT translate this into a switch into large caps anymore. We believe that active small cap specialists can still reap alpha (excess returns), but that this is especially true in Emerging Markets. With international market correlations going up and Emerging Markets due to their growth and economic policy improvements getting less risky while at the same time still posting lower correlations, a better strategy would be to replace a substantial part of your investment in US (or European small-caps) by an increased exposure to Emerging Markets small-caps. The graph below shows an example of the small-cap premium in an important Emerging Market, the Indian one.

The Small-Cap Premium in Emerging Markets
Be ready for a) a long term strategy and b) bumpy ride and
c) make sure to diversify.

Sure, we can imagine that active investors who were used to do their own investments find this an impossible advice: ''Where do we get the information from?'' Well, there is an alternative. It is especially in the Emerging Markets universe that top asset managers have shown their alpha generating capacity.

One of our favorites in this respect is the Emerging Markets Small-Cap Portfolio, a no-load mutual fund offered by Dimensional Fund Advisors. The Austin-based quantitative manager employs a group of top-level academics that translate theory into applied research with great success. They made it into LMG's 'best-of-breed' selection of asset managers with several of their products.

In our next entry we present the Fact Sheet for this Dimensional Fund. Its performance track record is excellent, and you will avoid many of the risks described by Arens in his article about domestic US small caps. We do not believe that this portfolio switch should be interpreted as a focus on increased risk taking. The world has changed and making sure that your allocation to Emerging Markets grows at least in line with the growing importance of these nations in the Global Economy is actually to be interpreted as avoiding (!) increased risk taking.

Click here for the Arens contribution to WSJ Online.


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