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Market View

While international small-cap equities have produced strong performance in 2017, they continue to be overlooked by investors.

It has been an exceptional year for international equity investors. Powered by a sustained global economic recovery, continued support from major central banks, and geopolitical stabilization, especially in Europe, international equity returns have outpaced U.S. equities year to date.

As of October 20, 2017, international equities (as represented by the broad MSCI All Country World ex-U.S. Index) are up 23%, compared with the 17% return in U.S. equities (as represented by the S&P 500® Index). Investors clearly have taken notice, with more than $160 billion in net flows to international equity funds and exchange-traded funds over the past nine months. However, a closer look at investor activity reveals that investors still appear to be gravitating toward international large caps and emerging markets, ignoring the opportunities in international small- and mid-cap equities. (See Chart 1.)

 

Chart 1. Flows to International Large Caps and Emerging Markets Dwarf International Small/Mid Caps

Source: Morningstar. International Large Caps, as represented by the MSCI EAFE Index, represents net flows in the Foreign Large Value, Foreign Large Blend, and Foreign Large Growth categories. Emerging Markets, as represented by the MSCI Emerging Markets Index, represents net flows in the Diversified Emerging Markets category. International Small Caps, as represented by the S&P Developed Ex-U.S. SmallCap Index, represents net flows in the Foreign Small/Mid Value, Foreign Small/Mid Blend, and Foreign Small/Mid Growth categories.

 

The year-to-date trend of investors overlooking international small and mid caps is not, however, a recent development. In fact, a breakdown of international equity assets under management reveals that the average investor dedicates only 6% of his or her international equity allocation to small and mid caps. This stands in sharp contrast to U.S. equity assets under management, where small and mid caps represent 23% of the total. When investing abroad, investors appear to have skipped over international small and mid caps to invest in emerging-market equities, which account for 22% of international equity assets. (See Chart 2.)

 

Chart 2. Compared to U.S. Equity Allocations, Investors Are Underweight International Small/Mid Caps

Source: Morningstar. Data as of 9/30/17. U.S. Large Caps represents assets in Large Value, Large Blend, and Large Growth categories. U.S. Small/Mid Caps represents assets in the Mid Value, Mid Blend, Mid Growth, Small Value, Small Blend, and Small Growth categories. International Large Caps, as represented by the MSCI EAFE Index, represents assets in the Foreign Large Value, Foreign Large Blend, and Foreign Large Growth categories. International Small Caps, as represented by the S&P Developed Ex-U.S. SmallCap Index, represents assets in the Foreign Small/Mid Value, Foreign Small/Mid Blend, and Foreign Small/Mid Growth categories. Emerging Markets, as represented by the MSCI Emerging Markets Index, represents assets in the Diversified Emerging Markets category.

 

International small-cap equities may warrant a second look from investors. For one thing, returns this year have been compelling: international small caps are up 25% (as measured by the S&P Developed ex-US Small Cap Index), ahead of international large caps, which have posted returns of 21% (as measured by the MSCI EAFE Index), and near the 32% return of emerging markets (as measured by the MSCI Emerging Markets Index; all returns as of October 20, 2017). The historical trade-off between long-term risk and return in this asset class, however, has been more favorable than in the more commonly used areas of the international equity market. Compared to international large caps, international small caps have provided higher long-term returns, with only a slightly higher level of volatility. (See Chart 3.) In comparison to emerging markets, international small caps have outperformed over the long run, with a significantly lower level of volatility. In both cases, the Sharpe ratio (a common measure of risk-adjusted returns) of international small caps is substantially higher. (See Table 1.)

 

Chart 3. International Small Caps Present a Compelling Historical Risk/Return Profile
Annualized return and standard deviation, September 30, 1997–September 30, 2017

Source: Zephyr StyleADVISOR. Past performance is no guarantee of future results. The information shown does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Data range 09/30/1997 – 09/30/2017.
1S&P Developed Ex-U.S. SmallCap Index. 2MSCI EAFE Index. 3MSCI Emerging Markets Index.

 

Historically, many investors, when considering an allocation to international equities, have gravitated toward international large caps or emerging markets. We believe that international small caps present an overlooked opportunity to complement these exposures.

 

[Note: As with any new investment, know the risks before investing. Keep in mind equity securities are subject to market risk, which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Unlike large-cap companies, small-cap companies tend to be less established, which means they are subject to more fluctuations in their businesses. Investing internationally also brings increased risks. What to keep in mind: Investments in international securities are subject to certain risks of overseas investing, including currency fluctuations and changes in political and economic conditions, which could result in significant market fluctuations. These risks are magnified in emerging markets.]

IMPORTANT INFORMATION
Keep in mind that all investments carry a certain amount of risk including possible loss of the principal amount invested. No investment strategy, including diversification and asset allocation, guarantees a profit or protects against a loss. Stock markets, especially international markets, and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, industry, political, regulatory, geopolitical, and other conditions. Investments in smaller companies may involve greater risks than those in larger, more well known companies.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of terms

Cumulative return is the aggregate amount an investment has gained or lost over time, independent of the period of time involved.

Standard deviation is a measure of volatility. Applied to an asset's return, it provides a measure of the range of those returns. A higher standard deviation means a greater range of returns.

Sharpe ratio is a measure of risk-adjusted performance.

The MSCI ACWI (All Country World Index) ex-U.S. Index is a subset of the MSCI ACWI Index.  The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.  

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The S&P Developed ex US Small Cap Index measures the performance of the small-cap segment of global developed equity markets, excluding the United States, ranked by total market capitalization.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market-capitalization index that is designed to measure the equity market performance of developed markets, excluding the United States and Canada.

The MSCI Emerging Markets Index is a free float-adjusted market-capitalization index that is designed to measure equity market performance of emerging markets.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

No investing strategy can overcome all market volatility or guarantee future results.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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