The recent correction in the international equity markets has once again drawn attention to the im-portance of risk diversification for an equity investor. Immediately, the performance of the main equity markets during October does not suggest that an in-ternational diversified eq-uity portfolio offered any protection on the downside.
Characteristic for these indices is that they cover the largest companies in each region. As these companies are global companies, and indeed often quoted on more than one stock ex-change, it is not surprising that they tend to perform more or less in line during a severe correction of the equity market.
It is however interesting to note that smaller companies did not suffer the same dramatic correction as the larger ones. These companies are much more exposed to the domestic economy. Furthermore, index funds or passive managed equity portfolios, which seems to play an increasing role among institutional invest-ors are focusing on the larger companies. When these in-vestors change their tactical asset allocation in an effort to preempt an anticipated market correction these would affect the larger companies, whereas smaller companies would be relative unaffected.
As the table illustrates any international equity investor with an exposure to smaller companies was indeed partly protected on the downside and hence could benefit from a risk diversification.
Obviously, one month is far from enough to use as basis for asset allocation decisions. We have however in several articles presented our analysis based on the longer term performance of larger and smaller companies where the result confirms the case for including smaller companies in an equity portfolio based on the longer term correlation between smaller and larger companies. That this argument is amplified in a situation when global equity markets live through a se-vere correction make the case for using smaller companies in order to enhance the overall return/risk-profile in an equity portfolio all the more convincing.
Peter Dencik is managing director of Singer & Friedlander International Asset Management in London