Morningstar Advisor - August/September 2009 - 43

1980s, the small-cap effect seems to have disappeared in the relative returns. Do you think that this is just a temporary matter. Do you think small-cap stocks eventually will still outperform in the long run? Nielsen: Over the past 10 years or so, with Nielsen: Yes. In many aspects, small-cap the drive towards globalization, correlations across markets have increased and the distinction between small caps and large caps have diminished a bit. But the fundamental differences are pretty much still the same. Small caps generally are local businesses with a narrow set of products, and they will exhibit huge company-specific return components, relative to a large conglomerate, which is, in itself, well diversified already. If one large company’s product fails, it doesn’t really make a big difference. So there are still significant fundamental differences between small caps and large caps. What can happen, even over the course of a few years, is that these differences don’t really have an effect on performance. In the long run, however, you would expect these fundamental differences to show up again. Also, historically, small caps have been more risky than large caps on an individual level, because they have a high, idiosyncratic company-specific component. In a portfolio, you can diversify a lot of these company-specific risks away, and it may not look that much more risky than a standard portfolio. But the more fundamental differences will persist; it’s just a question of how these differences drive returns in different economic environments. In the past couple of years, these differences haven’t been that important. But that doesn’t mean that they won’t be more important again going forward. Kay: Over the long run, then, small caps might not outperform large caps, but you think they will still provide diversification benefits? indexes are much more diversified than standard indexes. For example, at MSCI, we have the All Country World Index, which includes standard mid-cap and small-cap companies. There are roughly 2,000 standard companies and more than 6,000 small-cap companies. Even though an individual small cap may be much more risky because of its narrow focus, in the aggregate, you have much more diversification coming out of small-cap investments. Ting: That’s why investing in index funds than buying a standard country index, where you would get a lot of global exposure. For example, if you think that the U.K. is going to recover quickly, it would be better to buy the U.K. small-cap index instead of the standard U.K. index, which would give you huge exposure to energy companies and to telecom globally, but not so much to the U.K. market. Getting exposure to the U.K.’s small caps would give you a more direct access to that bet. Kay: What about the value effect and momentum returns within small caps over time? Will these effects be especially pronounced in small caps? Nielsen: There is a lot of evidence that provides investors easy access to the small-cap market without adding the unexpected risks of a specific industry or firm. You get broad diversification, because there’s not a name that dominates in the small-cap universe. Kay: Frank, does the local nature of small-cap companies provide an opportunity to look at where some of the best small-cap investments might be? Nielsen: We recently wrote a paper where we quantitative managers consistently have a bias towards small caps, value, and to a lesser degree, momentum stocks. That would indicate that value effects and momentum effects are even stronger within the small-cap universe. If you look at momentum, it makes sense, if we come back to this notion that you have these relatively concentrated companies that when they are on a run, they will continue to run, because their product will continue to succeed. Therefore, they will exhibit strong momentum for a while. With value, it’s the opposite argument. First, you have companies that have fallen significantly and are in a restructuring situation and they look like they will come back stronger. There are also small companies that have a very sound business model and generate a lot of cash flow. They produce a lot of value, but they are not necessarily strong growth companies. They own their small niche market and will continue to thrive within that, but they may not have major growth rates. They are strong, value-oriented companies. It’s easier to identify these kinds of companies within the small-cap universe, because they are much simpler in structure. Kay: What does this mean for investors looking at their long-term asset allocation? looked at the dispersion of the small-cap universe and how different small-cap companies behave. What we found was that because they are much more concentrated, small caps may have very big stock runs—they outperform the market by large percentages and maybe double within months in price. Then, as quickly, they sometimes drop in price. So at the individual stock level, there is huge opportunity or risk within small caps. If you add on top of that the current environment, you might bet that certain emerging markets or developed markets will be quicker than the rest of the world in their recovery. To favor those markets, you may see opportunities in small-cap companies that are part of sectors that are likely to benefit from a quick recovery. If you then aggregate these small caps into a portfolio—if you do a country bet or a sector bet—you still end up with a relatively well-diversified portfolio. It’s much more pure MorningstarAdvisor.com 43

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Morningstar Advisor - August/September 2009

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