Why International Small Caps Matter

In the U.S., at least $325 billion is currently invested in the three biggest large-cap exchange-traded funds (ETFs), all of which track the S&P 500 Index. At the same time, roughly 20% that total, or $63 billion, is invested in the three largest small-cap ETFs—a ratio of roughly 5 to 1 in favor of the large caps. When we turn to the developed world, we find that investors own international small caps in a much smaller percentage. The three largest developed world ETFs currently total roughly $110 billion in assets under management (AUM). But the three largest international small-cap ETFs currently total just $10 billion in AUM—a ratio of 11 to 1 in favor of predominately large-cap developed world exposure. Given this disparity, investors may well be underallocated to international small caps. Over the last 10 years, their international stock returns were likely lower than they could have been because of that oversight. As shown in the table below, using the MSCI EAFE Index as a proxy for stocks in the developed world, international stock returns have been paltry—1.7% per year in U.S dollars over the last 10 years. But international small caps, as measured by the MSCI EAFE Small Cap Index, advanced 4.1% over the same period. Moreover, if one used only dividend-paying international small-cap stocks, as we do in our WisdomTree International SmallCap Dividend Index, the average annual return for the asset class was 5.1% over the past 10 years, more than 3 percentage points ahead of the broader MSCI EAFE Index. And it did so over that period without taking on more market risk than the MSCI EAFE Index or more volatility than MSCI EAFE Small Cap Index. For definitions of terms and indexes in the chart visit our glossary.   Dividend-Weighting the Developed World Back in June 2006, WisdomTree launched the ETF industry’s first international small-cap ETF, the WisdomTree International SmallCap Dividend Fund (DLS). We did so because we believed the tendency of small caps to outperform their large-cap counterparts over time (the so-called “size premium”) was a market phenomenon that could be observed not just in the U.S. but in international markets as well. DLS was unique not just because it was the first ETF that allowed investors to complete their developed world exposure but because it tracked a WisdomTree Index that used only dividend-paying companies and weighted them once a year based on the dividends they pay. Because there are typically more than 1,000 such dividend-paying small-company stocks, WisdomTree has created a small-cap vehicle that has immense investment capacity and has correlated highly to established cap-weighted indexes. However, because WisdomTree weights by dividends, the WisdomTree International SmallCap Dividend Index typically exhibits a higher dividend yield compared to the MSCI EAFE Index. Ten years later, the real-time results of the strategy confirm our earlier intuition. International small caps, dividend weighted, have outperformed the MSCI EAFE Index for the last 1-, 3-, 5- and 10-year periods. The table below shows annualized Index level returns from June 2006 through August 31, 2016, as well as the trailing 12-month dividend yields.   Average Annual Total Returns and Trailing 12-Month Dividend Yields, June 2006 through August 2016   Conclusion WisdomTree believes international small caps should be a part of every globally diversified portfolio. As shown here, dividend weighting has efficiently captured the size premium while also raising the dividend yield compared to the market over more than a decade. It has added alpha above and beyond the MSCI EAFE Index, on an absolute and risk-adjusted basis, while exhibiting comparable volatility. Click to learn more about DLS.