The Small Country Effect: What research says about whether small-country stocks generate bigger returns
- September 1, 2017: Vol. 4, Number 9

The Small Country Effect: What research says about whether small-country stocks generate bigger returns

by Gregg Fisher, Ronnie Shah and Sheridan Titman

Are foreign stocks finally emerging into the sunlight from hibernation? From January 2010 to December 2016, overseas stocks (as measured by the MSCI World ex USA Index) returned just 3.64 percent annualized, compared to 12.83 percent for the S&P 500 Index. The cumulative return for U.S. stocks during those seven fat years was 133 percent, more than 100 percentage points ahead of the meager reward investors earned for their patience with foreign stocks. But in 2017, year-to-date to July 31, 2017, international equities returned 17.1 percent versus 12.1 percent for the S&P 500 Index.

In connection with that, let’s discuss a distinct approach to investing in foreign stocks around which my firm and co-authors Ronnie Shah and Sheridan Titman have conducted considerable research. Whether we are investing in foreign or U.S. securities, we practice multi-factor investing, in which equity portfolios are tilted away from a passive index to security characteristics such as value, smaller size, momentum and profitability.

Most passive indexes, such as the S&P 500 or MSCI EAFE Index, are market capitalization–weighted, thus allocating the bulk of weight to the largest companies and creating an inherent large-cap bias in the portfolio. We decided to study whether investors can in fact improve their risk-adjusted returns in foreign stocks by eschewing country-capitalization weightings and, instead, shifting some allocation from the largest countries to smaller countries — in other words, whether there is a small country effect worth tilting toward in a foreign stock portfolio.


For the study, we took a universe of the 19 developed-country markets in the MSCI EAFE Index and constructed monthly cap-weighted portfolios that we divided into three categories: 1) the largest country’s weight, 2) the sum of the next four largest countries’ weights, and 3) the sum of the next 14 countries’ weights. The trend over the long term has been for the larger countries to represent less of the index (Japan ranked as the largest single country during our entire 20-year study) and for small countries to grow in weight. Yet, as of the end of 2016, the top five countries still accounted for 67 percent of the market, which hints at the difficulty of achieving adequate portfolio diversification (one of the major benefits of international investing) by adhering strictly to an index-based approach.

Next, we calculated returns in the three country groupings by creating cap-weighted portfolios that we rebalanced annually. The 14 smallest countries outperformed the largest country in the market, returning 7.1 percent annualized over the 20-year period against just 2.3 percent for Japan. The small countries also outperformed the next four largest countries by a considerable margin, 2.7 percentage points annually. The small country returns come with higher annualized volatility than for the larger countries (18 percent vs. 17.1 percent), but a much better Sharpe ratio (a measure of risk-adjusted returns): 0.28 versus 0.02 and 0.14 for the largest and next four largest markets, respectively.


Careful readers might surmise that small country outperformance could be linked to the firm-size effect, which is the well-known tendency for small-company stocks to outperform large stocks. After all, it seems logical for small country equity markets to contain a relatively high proportion of small-cap companies. To test this hypothesis, we delved into the relationship between the small country effect and firm size. Within all three capitalization ranges, the returns of small countries exceed those of their larger counterparts. For instance, within large caps the largest-country portfolio returned only 0.82 percent annualized, compared to 3.8 percent for the next four largest countries and 5.5 percent for the remaining 14 smaller markets. These results would seem to indicate that the small-country and firm-size effects are independent.


What we conclude from the study is that stocks from smaller countries (of any market-cap size) tend to have higher average returns than stocks from large countries over time. Therefore, investors can meaningfully improve expected risk-adjusted returns and enhance diversification by reducing weights for large countries and reallocating to smaller countries in a multi-country equity portfolio.


Gregg Fisher is founder and head of quantitative research and portfolio strategy at Gerstein Fisher. Research partners Ronnie Shah and Sheridan Titman contributed to the article.


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