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Building Better International Small-Cap Benchmarks How do earnings quality and liquidity improve risk/return in small-cap equities?
BY Phillip Brzenk

INTRODUCTION



Since the documentation of the size premium, market participants have increasingly seen small-cap stocks as a distinct asset class and have started to maintain a dedicated, separate allocation apart from large caps. In recent years, research has shown that quality is the prominent driver of returns in the small-cap space.



Asness et al. found that the variability of the size effect mainly stemmed from the volatile performance of low-quality, or junk, small-cap firms. When junk or low quality is controlled for, the size premium becomes more robust in nature and is found across industries, time periods, and 23 different markets.



Based on evidence found in “A Tale of Two Benchmarks: Five Years Later” and effectiveness across regions in Asness et al., we investigated whether quality has earned a similar premium in international small-cap benchmarks. We tested a number of profitability metrics and found that for international small-cap universes, companies with positive earnings, or higher profitability ratios, incorporated as an inclusion requirement outperformed portfolios without such a requirement. The results were consistent regardless of the profitability metric used and region tested.

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