Why Diversification Is Not Dead: A Small Cap Example

“Diversification is dead” has been a common refrain in recent years. Over the last decade, global asset allocators have received complaints from clients who wondered why they were invested in anything beyond the S&P 500 Index, or really any broad measure of U.S. equities, as the U.S. markets outperformed the rest of the world.   Annualized and cumulative returns for the last 10 years:¹ • S&P 500 Index: 7.5% per year, or 106.3% cumulatively • Developed international equities (MSCI EAFE Index): 1.7% per year, or 18.5% cumulatively • Emerging market equities (MSCI Emerging Markets Index): 3.9% per year, or 46.6% cumulatively Anyone who had a global allocation lagged behind those who were focused solely on the U.S. markets, as the typical investor in the U.S. tends to be. One can argue, however, that these disappointing past years for international and emerging market equity returns make it all the more likely those markets could be set to outperform going forward, as they have lower market valuation multiples and performance tends to “mean revert.” A particularly bad stretch for international and emerging market equities means I would look more favorably on their prospects, not less favorably. Yet there is a further case outside of forward-looking returns’ prospects to look overseas. Small caps provide a segment of the market where there may be a surprising benefit to international diversification: risk reduction.   Diversification Is Also about Lowering Risk Profiles One of the central tenets of diversification is that by investing across a broader section of the asset pie, an investor can potentially achieve a similar return at a lower risk profile. That may be especially true in the small-cap arena. In the last 10 years, looking at the risk levels—measured by annualizing the standard deviation of daily index returns—you see the Russell 2000 Index with a volatility level of 26.6%, while the WisdomTree International SmallCap Dividend Index had a volatility level of just 17.3%. That means the volatility of daily index returns for international small-cap dividend payers was more than one-third lower than that of the Russell 2000. Investors might think, “International small caps—that sounds risky,” but data over the last 10 years shows that U.S. small caps had significantly higher volatility in the daily index returns. One reason for this is that international companies tend to be predominantly dividend payers compared to the Russell 2000, in which almost 20% of companies tend to be unprofitable and nearly half the companies tend to be non-dividend payers.² Interestingly, showing the principles of diversification, a 50/50 approach of developed international small caps combined with the Russell 2000 and rebalanced annually back to the 50/50 allocation delivered a risk level that was almost as low as the international small-cap dividend payers and substantially lower than the volatility of U.S. small caps on their own.   Surprise! Developed International Small-Cap Equities Had Lower Risk than U.S. Equities over Past Decade Adding WisdomTree International SmallCap Dividend Index to U.S. Equity Allocations (6/30/2006–6/30/2016)     Currency Hedging Could Reduce Risk Further The analysis above is not even the lowest-risk way of investing in international small caps, in our view. That analysis assumes investors took currency risk unhedged, as has been the case for years. More recently, WisdomTree has advocated that investors consider either full passive currency-hedged strategies or, more recently, dynamic hedged strategies that can raise or lower the currency-hedge ratio based on proprietary signals implemented once per month. WisdomTree has Indexes for developed international small caps that include both passive hedging and dynamic hedging. The data above illustrates that hedging currency risk (shown in the difference between local and U.S. dollar index returns) to focus on the returns for international stocks without added currency could further reduce risk. The international small-cap stocks, measured without currency impact, had a volatility of 14.2%, while the stocks with the currency impact had a volatility of about 17.3%. What’s interesting about this is the 14.2% volatility of the international small-cap dividend payers— there is a dramatic almost 50% volatility reduction on international small caps looking at these stocks without the currency impact and judging relative to the 26.55% average annual risk seen with the Russell 2000. Some investors believe there is a diversification benefit that comes with having currency exposure unhedged. The combinations of U.S. small-cap stocks with international small-cap dividend payers shown here casts doubt on that premise. The lowest-risk combination was the Russell 2000 with international small caps (without currency), and currency risk failed to provide any real “diversification” benefits. Adding international stocks on top of U.S. stocks did, however, help lower volatility significantly compared to being allocated to U.S. small-cap stocks only.   Conclusion While some investors look at the recent past and conclude “Who needs global allocations when U.S. companies operate all over the world?” the analysis presented here shows that in the small-cap arena, there are significant benefits from a risk mitigation perspective to allocate to international small-cap dividend payers combined with the Russell 2000. And if my expectation proves correct and the past decade of U.S. dominance over international markets reverts, there would be a further benefit that these lower risk levels could come with higher returns as well.         ¹Source: Bloomberg, with data from 8/31/2006 to 8/31/2016. ²Sources: WisdomTree, Bloomberg, with data as of 8/31/2016. Refers to companies that did not pay any dividends in the 12 months prior to 8/31/2016 and companies that do not have a trailing 12-month trailing 12-month P/E ratio as of 8/31/2016. Past performance is not indicative of future results. You cannot invest directly in an index.