A Surprisingly Low-Vol Asset Class

Relative valuation discounts typically reflect higher volatility, slower earnings growth, and/or less predictable earnings.

When investors think of foreign small-cap equities, they often intuitively expect discounted valuations relative to U.S. large caps, to compensate for higher volatility. While we are seeing discounted valuations in foreign small caps, these discounts are not necessarily driven by higher volatility.

Looking at rolling three-year standard deviations, the Russell 2000 Index clearly has higher volatility than the S&P 500 Index. But Japanese small caps generally have been lower vol than U.S. large caps for much of the last decade and considerably lower vol than U.S. small caps.

Relative to Japanese large caps—an important comparison as both indexes are measured in U.S. dollars and the risk-off nature of the yen dampens volatility relative to local currency returns—small caps had only modestly higher volatility in the most recent period, but they have had lower volatility over most of this time frame.

Rolling 36-Month Standard Deviation

Figure 1_Rolling 36 Month Std Deviation

Are Japanese Small Caps Good Diversifiers?

The Russell 2000 consistently prints correlations to the S&P 500 above 0.9. The Japanese small-cap market is one of least correlated to the S&P 500, even though it has risen from as low as a 0.16 correlation.

Rolling 36-Month Correlation (to S&P 500 Index)

Figure 3_Rolling 36 Month Correlation to SP 500 Index

The lower correlation and lower volatility yield a beta to the S&P 500 that consistently has been roughly half that of the U.S. small-cap market. If looking for market exposure with less S&P 500 beta, Japan's small-caps represent that.

Rolling 36-Month Beta (to S&P 500 Index)

Figure 2_Rolling 36 Month Beta to SP 500 Index

What Contributes to the Lower Vol?

For one: dividend payers.

In the U.S., we don’t think of small-caps as dividend payers—the Russell 2000 Value Index has less than two-thirds of its index weight in dividend payers. In Japan, 95% of the weight of small caps is dividend payers.

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