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It’s a small world after all: International small-cap value

Reprinted courtesy of MarketWatch.com.

To read the original article click here

If small-cap value is the highest long-term producer among U.S. equity asset classes (and it is), you might suspect that the same would be true among international asset classes.

Your suspicion would be well founded, based on historical performance.

In the U.S. stock market, 87 years of performance data (1928 through 2014) give small-cap value stocks a huge advantage: A compound return of 13.6%, versus 9.8% for the Standard & Poor’s 500 Index SPX, -0.57% Data sourced for this report comes from Dimensional Fund Advisors.

In the international stock market, reliable data doesn’t go back that far. But using the 33 calendar years from 1982 through 2014 gives us a reasonably long snapshot.

This period includes two major bear markets, two strong recoveries and a strong U.S. bull market during the 1990s in which the S&P 500 outperformed all its competition.

During those 33 years, international small-cap value stocks compounded at 14.3%, compared with 11.8% for the S&P 500.

At those rates, a $100 initial investment would have grown to $8,223 in international small-cap value; in the S&P 500, $100 would have grown to only $3,974.

(U.S. small-cap value stocks did even better, compounding at 16% and growing from $100 to $13,254.)

Over that time span, a $100 portfolio split evenly between the S&P 500 and international small-cap value stocks, and rebalanced annually, would have compounded at 13.4%, making a $100 initial investment grow to $6,335.

When I looked at 15-year periods, I found similar results.

Over the 21 15-year periods into which we can divide this data, international small-cap value stocks compounded, on average, at 12.3%, making an initial $100 investment grow to $572. By contrast, the S&P 500 compounded at 11%, enough for $100 to grow to $476.

A portfolio split equally between these two, rebalanced every year, on average compounded at 12% and grew an initial $100 to $546.

This combination captured 94% of the gains of international small-cap value, while reducing volatility by about 31% (18% standard deviation for the combination versus 25.9% for international small-cap value alone).

This lower risk was more than theoretical. The combination made things better in the bad times, something that should be of particular interest to retirees who are relying on their portfolios for annual income.

In its worst 15-year period, the combination compounded at 7.5%; the return during the worst 15-year period for the S&P 500, on the other hand, was a gain of only 4.2%.

Once again, we see that combining a higher-performing asset class with the S&P 500 Index made a winning combination.

The results of this study, with international small-cap value (14.3%) outperforming the S&P 500 (11.8%) as well as international large-cap blend (9.5%), international large-cap value (13.2%) and international small-cap blend (11.9%), are exactly what academic research has led us to expect.

Based on that, I believe this data is reliable and meaningful even though it covers only 33 years of performance.

Although I don’t recommend two-asset-class portfolios such as that, this comparison is a good way to demonstrate the value of including a specific asset class (in this case international small-cap value stocks) into a portfolio.

For many years I have recommended diversifying equity portfolios 10 ways. This Performance Series of articles has already covered nine of these components: the S&P 500 Index, U.S. large-cap value stocks, U.S. small-cap blend stocks, U.S. small-cap value stocks, U.S. REITs, international large-cap blend stocks, international large-cap value stocks, international small-cap blend stocks, and (this time) international small-cap value stocks.

The final piece of my recommended equity portfolio is emerging market stocks. This asset class has loads of long-term potential and strong past performance to recommend it.

I’ll look at the evidence regarding emerging markets in the next article.

Richard Buck contributed to this article.