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3 Advantages of Active Management in International Small Cap Equities

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A passive approach to international small cap equity investing doesn’t account for the asset class’s breadth, complexity or inefficiencies. Here are three advantages active management offers in this segment of the market.

1. Passive strategies in this asset class have historically faced performance challenges. The international small cap asset class dwarfs its large/mid cap counterpart. For example, the MSCI EAFE Index (which measures the performance of large and mid cap stocks across 21 developed market countries, excluding the United States and Canada) comprises about 720 names, compared with the MSCI EAFE Small Cap Index’s 2000+ constituents. Because of the breadth and inefficiency of the international small cap asset class, passive implementations have had a hard time keeping up with their actively managed counterparts (Exhibit 1).

Exhibit 1: The international small cap equity index has the worst average Morningstar ranking of any major equity asset class
Exhibit 1: The international small cap equity index has the worst average Morningstar ranking of any major equity asset class

As of 12/31/24. Source: Morningstar, Voya IM. The MSCI EAFE Index measures the performance of large and mid cap stocks across 21 developed market countries, excluding the U.S. and Canada. The MSCI EAFE Small Cap Index measures the performance of small cap stocks across 21 developed market countries, excluding the U.S. and Canada. Past performance does not guarantee future results. Investors cannot invest directly in an index.

2. A significant portion of the international small cap equity universe has little to no analyst coverage, creating inefficiencies that active managers can exploit. Nearly 12% of companies in this universe have no sell-side analyst coverage (Exhibit 2), leaving their true value less understood by the broader market and creating an opportunity for active managers to uncover hidden gems through in-depth analysis.

Exhibit 2: Less analyst coverage provides more opportunities for active managers
Percentage of index categorized by number of analysts covering stocks
Exhibit 2: Less analyst coverage provides more opportunities for active managers

As of 12/31/24. Source: FactSet. X axis represents percentage of broker-dealer analysts providing earnings estimates. U.S. large cap equities represented by the S&P 500 Index. International developed equities represented by the MSCI EAFE Index. U.S. small cap equities represented by the Russell 2000 Index. International small cap equities represented by the EAFE Small Cap Index. Investors cannot invest directly in an index.

3. The international small cap equity universe’s large size, spread across an extensive range of industries and regions, provides ample opportunities for a skillful active manager to identify and capitalize on mispriced securities. Smaller stocks are known for their higher dispersion of returns and low correlations between individual securities, which are statistically linked to an active manager’s ability to generate alpha.1 Over the last 10 years, the average difference between 5th and 95th percentile monthly stock returns was about 29% within the MSCI EAFE Small Cap Index compared with 22% for the MSCI EAFE Index (Exhibit 3).

Exhibit 3: The vast international small cap equity universe offers many opportunities for active managers to exploit
Monthly dispersion of returns between 5th and 95th percentiles
Exhibit 3: The vast international small cap equity universe offers many opportunities for active managers to exploit

As of 12/31/24. Source: FactSet, Voya IM. Performance dispersion is the range of returns for a group of investments over a period of time. It can be used to measure the risk of an investment and the opportunity for picking stocks that outperform the market. Past performance does not guarantee future results. Investors cannot invest directly in an index.

 

A note about risk 

All investing involves risks of fluctuating prices and the uncertainties of rates of return and yield inherent in investing. The principal risks are generally those attributable to investing in stocks and related derivative instruments. Holdings are subject to market, issuer and other risks, and their values may fluctuate. Market risk is the risk that securities or other instruments may decline in value due to factors affecting the securities markets or particular industries. Issuer risk is the risk that the value of a security or instrument may decline for reasons specific to the issuer, such as changes in its financial condition. Smaller companies may be more susceptible to price swings than larger companies, as they typically have fewer resources and more limited products, and many are dependent on a few key managers. International investing does pose special risks, including currency fluctuation, economic and political risks not found in investments that are solely domestic. Risks of foreign investing are generally intensified for investments in emerging markets.

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1 Mauboussin, M. J., & Callahan, D. (2020). Dispersion and Alpha Conversion. Morgan Stanley Investment Management. Available at: Morgan Stanley.

 

Past performance does not guarantee future results. This market insight has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain statements contained herein may represent future expectations or other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors. 

Morningstar is commonly used for calculating an investment’s total return percentile rank against others in its Morningstar Category. With this method, percentile ranks always range from 1 (best) to 100 (worst) with all intermediate values spread evenly over that range. 

Alpha is a measure of risk-adjusted performance that reflects the difference between a portfolio's actual return and the return that could be expected give its risk as measured by beta. 

Beta is the sensitivity of a portfolio's returns to changes in the return of the market as measured by the index or benchmark that represents the market. A portfolio with a beta of 1.0 behaves exactly like the index. A beta less than 1.0 suggests lower risk than the index, while a beta greater than 1.0 indicates a risk level higher than the index. 

Correlation is a statistic that measures the degree to which two securities move in relation to each other. 

Market capitalization represents the value of a company that is traded on a stock market. It is calculated by multiplying the total number of shares by the current share price. "Large cap" refers to a company with a market capitalization of more than $10 billion. "Mid cap" refers to a company with a market capitalization between $2 billion and $10 billion. "Small cap" refers to a company with a market capitalization between $250 million and $2 billion. 

Performance dispersion is the range of returns for a group of investments over a period of time. It can be used to measure the risk of an investment and the opportunity for picking stocks that outperform the market.

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