International Small Cap Is Outperforming US

International small-cap stocks are recently starting to outperform US small-caps. We measure this by looking at the international small-cap ETF, SCZ, compared to IWM, a popular ETF that tracks the Russell 2000. The Russell 2000 is the most popular benchmark for tracking US small-cap stocks. Much has been made of IWM underperforming the S&P 500 this year. But we’ve been more intrigued with the neck and neck battle between international small-cap and US-small cap.

IWM vs SPY doesn’t tell us much

We don’t think it’s wise to draw too much from the performance between a large-cap index like the S&P 500 and a small-cap index like the Russell 2000. Our reasoning is that regardless of relative performance, a portfolio benefits from exposure to both large-cap and small-cap stocks. Additionally, their returns prove to be random, and not much can be gleaned from one time period to the next. Take the following chart for example, which compares the performance of IWM and SPY since the 2009 market bottom:

IWM performed better than SPY off of the bottom, posting back-to-back yearly returns of 27%. Compare that to SPY which returned 26.50% in 2009 but then only 15% in 2010. But what type of predictive value did that hold into the next year? IWM fell 4% in 2011 while SPY managed to eke out a 2% gain. IWM outperformed again in 2013 but went on to underperform 5 out of the next 6 years. In other words, early outperformance by IWM relative to SPY from 2009-2013 was not a sign of further outperformance to come.

Compare small-caps to other small-caps

Ultimately, our point is that the performance of IWM versus SPY shouldn’t be a major storyline. To use a basketball analogy, it would be like comparing a point guard to a center. They play different positions and are going to post different stat lines. A basketball coach doesn’t evaluate his center versus his point guard, he evaluates him versus other centers. With that analogy in mind, we’ve arrived at our evaluation of the international small-cap ETF, SCZ.

SCZ moved to new YTD highs 3 weeks ago and has kept going:

The same cannot be said for her US counterpart, IWM:

Year-to-date, IWM boasts a 19.23% gain vs 18.15% for SCZ, but nearly all of IWM’s gains came in the first quarter of the year. Over the last 3 months, SCZ has been a major outperformer, posting a 7% gain compared to 2.83% for IWM. The graph below shows that SCZ’s outperformance extends to a 1-year time period as well:

The year-to-date performance being so close is interesting because it would be the closest performance for the two ETFs in a given year since the 2009 market bottom:

Expect one to do better than the other

The returns since 2009 have been quite different for SCZ vs IWM. The smallest difference is 3.46% in 2012 and the average is 11.64%. This suggests that the outperformance of the last 3 months could very well last into year-end. In addition, the 1-year outperformance could be signaling a favorable trend for SCZ versus IWM. A shift in favor of international wouldn’t be a surprise given that IWM has spent the last 3 and 5 years outperforming SCZ.

Now, we are the first to admit that this is all very small sample size data. But we’re not the only ones who expect there to be a return differential between US and non-US stocks. Vanguard published a paper in February 2019 arguing that too many investors are ignoring the benefits of global diversification. This isn’t a call to abandon your US small-cap exposure, but rather a call to action to make sure you have exposure to the international small-cap segment as well. If international small-cap stocks are setting up to outperform US small-cap stocks, you’ll want to participate in those gains.