By Mary Fjelstad
Historically, small-cap stocks have tended to outperform the broader market when the market's risk appetite is higher. Yet despite a notable appetite for risk in 2017, small caps did not outperform large caps last year globally. Using the FTSE Global Small Cap Index to explore the world of small caps, I want to examine why they deviated from their historic trend, and also look at their performance characteristics and potential diversification benefits. Global small caps have historically tended to outperform large caps when markets have directional strength - either up or down. The chart below illustrates how global small caps have tended to outperform global large and mid caps in years of strong overall market performance and underperform in years of weaker performance, as represented by the FTSE Global Small Cap and FTSE All-World Indexes.
Over the last ten years, the small-cap index has outperformed large and mid cap index six times on a calendar year basis. In 2017, however, global small caps slightly underperformed. This was largely due to outcomes in the US where the small-cap Russell 2000® Index underperformed the large cap Russell 1000® Index. US small caps had enjoyed a surge in performance at the end of 2016 based on high expectations of change with the new Trump administration. Delays in enacting legislation in the US resulted in a pull-back across the board in US stocks relative to the rest of the world, and this had a greater impact on US small caps. Though the US market reacted positively to the passage of tax reform legislation in late December 2017, US equities still underperformed other developed equity markets for the year.
The historic trends in performance characteristics of global small caps could potentially offer diversification benefits to a global large cap index. To see these effects, we created a hypothetical index with an allocation of 90% to the stocks of the FTSE All-World Index and 10% to the stocks of the FTSE Global Small Cap Index. The result of this hypothetical allocation shows that in nine of the 15 years evaluated, our blended index would have outperformed the FTSE All-World Index alone.
Obviously, correlations between asset classes determine the level of diversification benefits available. As the world becomes increasingly global, large cap companies around the world tend to move in tandem with each other. Since global small caps tend to be driven more by their local economies, they are less likely to be highly correlated with the more globally driven large caps. Global small caps also offer industry and country exposures that differ from those in the global large cap universe. Although global small caps may have underperformed the market in 2017, their historical performance characteristics and potential diversification benefits give them in a unique position in the global equity map.
For additional analysis on global small caps please see our research paper: Redrawing the equity map with global small caps.
 For more detail please see the Trump trade and the small cap cycle blog.
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