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The earth isn't flat: Global small caps expand the equity map

By: Mat Lystra, Sr. Research Analyst

Until sometime around 500 B.C., it was widely believed that the earth was flat. As such, explorers dared not venture too far, for fear of reaching—and ultimately falling off—the physical limits of the planet.

There was once a similarly constrained worldview for equity indexing, when the opportunity set seemed limited to the largest stocks from a select number of large countries. But the FTSE Global Small Cap Index has pushed past this narrow view, capturing a vastly expanded global equity universe that includes global small caps.

Generally defined as companies with market capitalizations less than $5B, global small caps only comprise about 10% of the world’s equities by market value, but approximately 70% of the world’s stocks by number. The characteristics of these stocks often differ from their large cap counterparts, such that combining small caps and traditional large cap allocations can diversify the total equity portfolio and offer the potential for enhanced returns.

Global small caps stocks tend to post particularly strong performance when markets have directional strength, either up or down. As illustrated below, this offers the opportunity to participate more in up-trending markets, but also carries the risk of more downside exposure when sentiment turns negative.

As the global financial crisis gripped equity markets in 2008, the return patterns between many asset classes including stocks, industries, countries, etc. converged. Global small caps became more highly correlated with large caps during this time period, but correlations have since receded to levels not observed since the early 2000s.

In addition to the potential of diversifying global large cap returns broadly, global small caps can also provide industry exposures that are different from global large caps. While small cap is often thought of as the realm of cutting edge technology start ups, in fact many global small cap companies exist to serve larger companies. Suppliers to the airline, car and other manufacturing businesses found in the basic materials and industrial sectors make up a substantial portion of the asset class.

Just as the earth doesn’t stop at a flat edge, the world’s equity universe doesn’t end with large companies. The FTSE Global Small Cap Index represents a vast number of small cap stocks globally and therefore provides a useful tool for market participants analyzing this asset class and the diversification it can bring to an equity portfolio. The mix of characteristics and opportunities for growth that global small caps may offer should put them squarely on a global investor’s equity map.

 

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