Why International Small Caps Matter

dividends
siracusanoiii
Chief Investment Strategist
carrano
Quantitative Research Analyst
10/07/2016

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. Average Annual Total Returns 10-Year Summary Stats 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 Trailing 12 Mo Dividend Yields   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.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal.  Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.  Funds focusing their investments on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility.  Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

Diversification does not eliminate the risk of experiencing investment losses. 

Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development.

About the Contributors
siracusanoiii
Chief Investment Strategist
Luciano Siracusano is WisdomTree’s Chief Investment Strategist. He is the co-creator, with CEO Jonathan Steinberg, of WisdomTree’s patented Indexing methodology. Mr. Siracusano led WisdomTree’s sales organization from October 2008 until June of 2015, while also serving as the firm’s Chief Investment Strategist. Luciano stepped down as WisdomTree’s Head of Sales in 2015 to focus full time on his duties as Chief Investment Strategist. From 2001 until October 2008, Luciano was WisdomTree’s Director of Research and was responsible for the creation and development of WisdomTree’s proprietary stock indexes. Luciano is a regular guest on CNBC and FOX Business, and speaks and writes frequently on ETFs, indexing and global financial markets. A former equity analyst at Value Line, Luciano began his career as a speechwriter for former New York Governor Mario Cuomo and HUD Secretary Henry Cisneros. He graduated from Columbia University with a B.A. in Political Science in 1987.
carrano
Quantitative Research Analyst
As a member of WisdomTree’s quantitative group, Chris works closely with data in order to construct and monitor WisdomTree investment products, provide investment insights to WisdomTree clients as well as automate research processes. He is also an active member of the asset allocation team which formulates WisdomTree’s house views on investment markets around the world. He previously worked in WisdomTree’s Investment Strategy department where he researched and wrote about investment markets as well as communicated WisdomTree’s research to clients. Christopher first joined WisdomTree in April of 2014, and later rejoined the company in September of 2015 after spending time abroad. Prior to WisdomTree, Christopher was an investment consulting intern at Mercer where he analyzed the investments and investment managers of retirement plans and endowments. He graduated from Columbia University with a B.A. in Economics in 2014.a