Following up on our analysis of factor performance in rising interest rates¹, recessions², and bear markets³, we discuss the benefits of remaining invested in stocks and maintaining multi-factor diversification to help weather periods of high inflation.

After years of laying low, inflation emerged in 2021 and has remained elevated. In the United States, the annual rate of inflation as measured by the Consumer Price Index (CPI) was 3.7% as of September 2023. That’s down from its peak of 9.1% in June of last year, but still well above the rates we typically saw during the previous 10 years, when inflation rarely edged much higher than 2%.

We haven’t seen inflation numbers like these since the early 1980s, before the experience of many of today’s investors. The Federal Reserve has been raising interest rates in response. Both the S&P 500 and U.S. Treasuries fell in 2022 as yields rose; while the stock market has recovered this year, bond prices have continued their fall.

The situation is similar around the world, with inflation spiking and markets having fallen. There are a multitude of potential reasons for inflation’s unwelcome return, including ongoing supply chain issues that have made goods scarce, stimulus money that gave consumers more dollars to go after fewer goods, pent-up spending demand unleashed after the pandemic, a decades-long low-interest rate environment and deficit spending. But investors may be less concerned about the causes of inflation than they are about its impact on their portfolios.

Does high inflation always cause markets to drop? We don’t have to look very far back for a counterexample. Inflation was 7.0% in 2021 yet the S&P 500 soared by 28.71%. Contrary to screaming headlines, stocks can do quite well — as well as poorly — during high inflationary periods. That raises important questions about the actual relationship between inflation and stock performance.

In this piece, we examine how stocks have performed historically in different inflationary environments and compare them to the asset classes of bonds and cash. We start by giving brief conceptual arguments before examining historical data going back over a century. We next look at how different segments of the market, such as factors and sectors, have performed. To get even more data and show the robustness of our results, we then extend our work to over 20 developed markets. Finally, we close with some takeaways to guide investors looking ahead.

The highlights: Higher inflation isn’t always bad news for stocks, and it can affect the performance of different factors quite differently. And even when high inflation dampens equity returns, stocks still produce positive returns on average during high inflationary periods—and strongly outperform cash.

These results suggest that investors who let fears of high inflation drive them out of the stock market could be making a costly mistake.

How Might We Expect Markets to React to Inflation?

Reasons why inflation is bad for the stock market often involve that the central banks, such as the U.S. Federal Reserve, will raise interest rates to slow the economy and fight inflation. This slowing of the economy then leads to lower stock prices. Rising interest rates also bring higher discount rates, leading to lower stock valuations. But as we showed (see footnote 1), while higher rates do bring lower bond returns due to the bond math, there is no distinct relation with stock returns. Interest rates will rise because of a strong economy, which should bring higher earnings and cash flows.

This argument is behind why some argue that stocks should provide a good inflation hedge. As prices in general go up, so should the sales, earnings, cash flows, and dividends of the companies in the stock market. Provided valuations such as P/E ratios stay the same, stocks should be a good match for inflation. We can see this in Exhibit 1, which uses over 150 years of US data from Robert Shiller’s website⁴. The plot shows the growth in earnings, dividends, and inflation from 1871 through 2022. Visually we get a long-term perspective. Earnings and dividend growth indeed track inflation over time, but at a higher level. This makes sense. Stocks allow the investor to participate in the growth of the economy, and that nominal growth has typically been higher than inflation. Recall that the most common measure of economic growth, gross domestic product or GDP, is typically given in real terms, meaning after inflation.

Exhibit 1: Growth of $1 in CPI, Dividends, and Earnings, 1871 – 2022

Source: Robert Shiller, Bridgeway calculations

Exhibit 2 puts numbers to the visual and moves to a yearly time frame by giving the correlation of inflation, earnings, dividends, and stock returns for the US. Inflation correlates at 27% and 20% with annual changes in dividends and earnings, respectively. This is modestly positive, but recall that earnings are smoothed by accounting items such as depreciation, amortization, and accounts receivable and payable. Dividends are discretionary, and companies smooth them in order to avoid dividend cuts, which are viewed poorly by the market. Such smoothing can reduce the correlation of earnings and dividends with inflation. Stock returns are even more modestly correlated with inflation at 13%. This is still positive, so stocks do provide a modest hedge to inflation at an annual level. But there is more going on, as the market is forward-looking and moves to perceptions of future cash flows and discount rates. With that said, let’s next look at how asset classes respond to inflation.

Exhibit 2: Correlations of Annual Changes in CPI, Dividends, Earnings and Stock Returns, 1871 – 2022

	CPI	Dividends	Earnings	Returns
CPI	1	0.27	0.20	0.13
Dividends	0.27	1	0.19	0.06
Earnings	0.20	0.19	1	0.29
Returns	0.13	0.06	0.29	1

Source: Robert Shiller, Bridgeway calculations

Stocks and Inflation in the U.S.

We start by examining how the United States stock market fares compared to the risk-free rate in different inflationary regimes. Inflation data is released monthly with a lag and is often subsequently revised. We avoid shorter-term timing and focus on annual returns. Such longer time frames lessen the impact of noise from short-term fluctuations, the details of timing, and transaction costs. Return data comes from the Ken French data library⁵, while inflation comes from the Federal Reserve⁶. We go from the start of annual returns in 1927 through 2022, giving us a 96-year history.

Exhibit 3 shows the returns of US stocks and the risk-free rate (cash, as given by one-month T-bills) according to the same year’s level of inflation. While we explain how to interpret these exhibits, readers whose eyes glaze over at tables of numbers can ignore them and simply focus on the explanation in the paragraphs below.

There are three sets of five columns. The three sets give the amount of inflation, stock market returns, and risk-free returns. The five columns represent different quintiles of inflation; the 19 years of lowest inflation are on the left, while the 20 years of highest inflation are on the right. By definition, average inflation increases from -1.52% in the lowest inflation quintile to 8.63% in the highest quintile. From the “Min” row, inflation of 4.86% or higher puts a year in the highest quintile. The 7.04% and 6.45% inflation of 2021 and 2022 are solidly into the highest quintile of inflation, for example, although well below the all-time high of 18.13% (reached in 1946 as prices spiked in the aftermath of World War II). The next five columns show stock returns grouped according to inflation quintiles, while the last five columns show cash as given by the risk-free rate, also grouped according to inflation quintiles.

Exhibit 3: Stock and Risk-free Returns Dependent on Same Year Inflation (all in %) 1927-2022

Source: Ken French data library, Federal Reserve FRED data library, Bridgeway calculations

We can see that stock returns are consistently positive in each of the five inflationary regimes. However, there is great fluctuation, as seen by the high standard deviations and the spread of the minimum and maximum returns. Returns are highest and quite statistically significant for the middle three inflationary quintiles. Stocks are not as strong on average when inflation is low or negative. This aligns with our argument that stocks might follow prices; when sales and earnings are kept low by deflation, there is little growth to reflect in stocks.

When inflation is highest, stock returns are still nicely positive at 5.84% annually. High inflation does not necessarily mean that stocks will fall; indeed, on average they do just fine. But our caveat of great fluctuations still applies here; in any given year results could be much better or much worse.

Also, note that the average return is not just nicely positive, it is also higher than the average short-term interest rate of 5.03%. Investors who panic about their stock holdings and move into cash when inflation is high tend to do worse. In fact, the term “risk-free” rate is a misnomer from a real inflation-adjusted perspective. When inflation is high, holding cash doesn’t keep up with rising prices, and investors lose purchasing power. On average, stocks also lag inflation when the latter is high, but they do outperform cash.

One could wonder, if I see high inflation now, what will happen in the future? We address this in Exhibit 4. The first five columns tell us the level of inflation based on the inflation of the prior year. We still see that the averages move from low to high as we go from quintile 1 to quintile 5. Inflation is sticky; high or low inflation in one year tends to be repeated the next year. But it is not guaranteed. For example, the highest annual inflation of 18.13% in 1946 is now in the middle quintile, as it followed the moderate 2.25% inflation of 1945.

What is of particular interest to the investor is what happens to stocks and cash. After a year of high inflation, stocks now do quite well, with an average return of 11.07%. This is on par with the returns of the other quintiles, as well as the long-term average of 11.84% for this period. There is plenty of variation from year to year, as can be seen from the standard deviation as well as minimum and maximum, but this is always true for stocks. Cash yields remain elevated in years following high inflation, as the Fed keeps rates elevated. But now, those cash returns are trounced on average by the return of stocks. The upshot for investors? If you pull out of stocks because inflation is high, not only do you get worse returns on average in the current year, but you also risk missing out on the subsequent strong performance of stocks in the following year.

Exhibit 4: Stock and Risk-free Returns Dependent on Prior Year Inflation (all in %) 1927-2022

Source: Ken French data library, Federal Reserve FRED data library, Bridgeway calculations

Inflation and Segments of the Market

While those results make a case that the stock market as a whole delivers positive returns across inflationary regions, what about different segments of the market? Perhaps some do better than others in periods of high inflation?

We first examine the performance of factors — groups of stocks defined by certain characteristics. For example, a common academic version of the value factor, HML, is given by the return of the highest 30% of stocks by book-to-market (B/M) minus the lowest 30%. We use common definitions from the Ken French data library. We show only the average returns by inflationary regime to save space, but suffice it to say that again there is plenty of variation around those averages.

Exhibit 5:             Average Factor Returns (%) Dependent on Same Year Inflation
                                (1927-2022 for Mkt-Rf, SMB, HML, and UMD)
                                (1964-2022 for RMW and CMA)

	Infl Lo20	Infl Q2	Infl Q3	Infl Q4	Infl Hi20
Mkt – Rf	7.47	14.29	12.20	8.39	0.81
SMB	0.83	5.23	4.84	3.20	0.60
HML	0.23	2.68	4.16	5.58	9.26
UMD	11.65	8.35	4.98	10.87	9.49
RMW	5.69	-0.34	2.91	6.31	3.39
CMA	-2.00	4.52	2.72	2.59	6.75

Source: Ken French data library, Federal Reserve FRED data library, Bridgeway calculations

The first row (Mkt-Rf) is simply the equity risk premium — the market’s return relative to the risk-free rate. It is the same as subtracting the appropriate two columns in Exhibit 3⁷, and highlights that excess stock returns are lowest when inflation is high, but still positive.

The remaining rows show how different factors perform in different inflationary environments (again grouped by quintile). For example, smaller stocks always show a premium, but it is lower when inflation is either very high or low. Most other factors⁸ demonstrate no clear pattern, with one notable exception: Value.

As inflation increases, the value premium (as represented by HML) increases as well in a monotonic fashion. This is in exact agreement with what we showed by looking at decades from our perspective Does Value Just Need Some Growth?⁹ While there is plenty of variation (not shown to save space), on average, value performs best when inflation is higher.

We look at returns by sector in Exhibit 6. Generally, returns are lowest in the low and high inflation quintiles, in keeping with the overall pattern of the market returns we saw in Exhibit 3. Otherwise, there is again little noticeable pattern, with the exception of Energy. For this sector, returns rise monotonically with inflation, climbing from 4.89% on average in the low inflation quintile to 21.42% when inflation is high. This perhaps reflects the special role of energy in powering the economy and helping to drive consumer prices. Certainly, the Energy Crisis of the 1970s drives some of this behavior, but we see a similar pattern in other periods of high inflation, as well as currently.

Exhibit 6: Average Sector Returns (%) Dependent on Same Year Inflation (1927-2022)

	Infl Lo20	Infl Q2	Infl Q3	Infl Q4	Infl Hi20
Nondurables	9.04	15.67	11.81	20.26	5.06
Durables	20.04	30.02	15.20	10.10	4.46
Manufacturing	10.52	16.90	17.27	15.23	5.78
Energy	4.89	8.99	11.63	18.10	21.42
Chemicals	15.61	14.45	12.13	14.97	5.93
Business Equipment	11.96	20.17	23.60	12.31	4.60
Telecom	6.83	17.29	16.44	10.40	2.50
Utilities	7.91	10.58	15.82	15.94	5.62
Shops	11.46	22.09	11.18	18.81	3.33
Health	10.08	21.06	11.19	18.19	7.42
Finance	8.36	14.85	15.47	19.71	5.85
Other	5.86	17.88	10.64	13.36	5.07

Source: Ken French data library, Federal Reserve FRED data library, Bridgeway calculations

Developed Markets: How Do Stocks, Bonds, and Cash Respond to Inflation?

Until the recent spike, inflation had been quiescent in developed markets since the early 1980s. To get a full sampling of inflationary regimes, we therefore require a long history. For examining inflation and the returns of the major asset classes of stocks, bills, and bonds, we utilize data for 21 developed markets going back to 1900 from Dimson, Marsh, and Staunton (DMS)¹⁰, augmented by Bloomberg and the OECD¹¹ in recent years. We are interested in inflation and returns from the perspective of a local investor and so use local nominal returns. We omit the hyperinflation years of 1922 and 1923 for Germany and 1922 for Austria so as not to excessively skew results; suffice it to say that when inflation is over 1000% annually, investors are miserable as returns in any asset class fail to keep pace.

Results are given in Exhibit 7. Panel A shows inflation and stock returns, Panel B shows bill and bond returns. Let’s focus on the United States first since it is easily viewable at the bottom of both panels, and we’ve looked at similar data in Exhibit 3, although from another source and a somewhat shorter history. Just as we saw earlier, when inflation is highest then stock returns are lowest, although still nicely positive. Also, as before, this is the only one of the five inflationary regimes where stocks do not keep up with inflation, gaining 6.63% on average while inflation is at 9.66%. But also as before, stocks still provide a risk premium relative to cash even when inflation is high (and indeed in all regimes). What is new here is that we also have bond returns, and these are lowest when inflation is high at 1.01% annually. This makes intuitive sense, as investors will demand a higher yield with higher inflation, causing bond prices to fall. Thus, while stock returns will vary, when inflation is high on average their return is better than both cash and bonds. This is a key insight for investors: if you sell out of stocks because of inflationary fears, on average you would have done worse parking your money in either cash or especially bonds.

Examining all 21 countries shows a similar pattern. In 17 out of 21 countries, stocks fail to beat inflation when the latter is high. Most of the four countries where stock returns are higher are known for having a large amount of their economy dependent on commodities, which as we saw with energy can rise with or cause inflation. But in none of the countries do cash or bond returns keep pace with high inflation. And in almost all countries, stocks are the best asset class when inflation is high. The only exceptions are Norway and Spain where bills are best in high inflation, and Switzerland where both bills and bonds beat stocks in high inflation regimes. But looking at the full set of 21 developed markets over 123 years, stocks are clearly the highest returning asset class on average when inflation rears its head.

Exhibit 7: Stock, Cash, and Bond Returns (%) Dependent on Same Year Inflation in Local Currency

Panel A

Panel B

Source: DMS, Bloomberg, OECD, Bridgeway calculations

Key Takeaways

The market’s poor performance in 2022 has many investors worried that high inflation automatically means bad news for stocks. However, history shows that has not always been the case. For US markets, and international developed markets as well, high inflation environments have still produced positive absolute returns in the stock market on average. These results suggest that allowing fears of an inflationary environment to drive investment decisions out of stocks and into cash or bonds could be a very costly mistake.

The performance of factors, however, is not equal across inflationary environments. Investors should be aware that some factors may perform better or worse in different inflation environments. In the US, for example, value appears to perform better than average in higher inflation environments, while smaller cap stocks tend to perform better when inflation is low. While we don’t recommend timing factor performance, the historical evidence of these factors’ performance could be a preview of what’s to come.

As always, investors should approach these results with some caution. While the average return of stocks in high inflation environments is positive, the variation of returns from year to year can be large. An investor’s experience in one year can be very different in another. Further, we have fewer observations in our evidence on factor performance, and those observations tend to be in lower inflation environments, which may obscure a full picture of factor performance in high inflation environments.

For many investors today, inflation is a new experience. But inflationary fears shouldn’t be the driving force behind whether to get out of stocks. In fact, the opposite may be true given the historical evidence that around the world, stocks have outperformed both bonds and cash in periods of high inflation. And as always, exposure to the factors that drive equity returns can provide additional benefits.

1. Berkin, Andrew L. 2018. “What Happens to Stocks when Interest Rates Rise?” Journal of Investing 27 (2): 126-135. ↩︎
2. https://bridgeway.com/perspectives/stress-test-how-factors-perform-before-during-and-after-recessions/ ↩︎
3. https://bridgeway.com/perspectives/factoring-in-bear-markets/ ↩︎
4. https://www.econ.yale.edu/~shiller/data.htm ↩︎
5. https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html ↩︎
6. https://fred.stlouisfed.org/ ↩︎
7. For example, when inflation is in the highest quintile, Exhibit 3 shows stock market and risk-free rate returns of 5.84% and 5.03% on average, and 5.84% – 5.03% gives the 0.81% return seen here. ↩︎
8. Other factors represented in Exhibit 5 are momentum as represented by Up-Minus-Down or UMD, profitability as represented by Robust-Minus-Weak or RMW, and investment as represented by Conservative-Minus-Aggressive or CMA. ↩︎
9. https://bridgeway.com/perspectives/does-value-just-need-some-growth/ ↩︎
10. https://www.tinyurl.com/DMSdata ↩︎
11. https://data.oecd.org/ ↩︎

Executive Summary

Bridgeway’s goal to be an enduring firm and to serve our clients, colleagues, and community for the long term has led us to consider offering a number of different strategies over the years. Through the lens of relational investing, we have stayed curious and completed countless hours of research, continuously looking for the intersection of where our investment expertise lies and what strategies to offer that could best serve our clients. To that end, in early 2021, we launched our first non-US equity strategy, Bridgeway Emerging Markets Small-Cap. At that time, we felt there was compelling evidence that small-cap stocks in emerging markets were an attractive asset class and that Bridgeway is uniquely positioned to maximize the opportunities in this asset class. More than two years after the launch of our Emerging Markets Small-Cap strategy, we revisited the reasons why, and they still ring true today:

• Emerging markets small-cap equity has historically offered lower correlation not only to non-equity asset classes but also to other equity asset classes.
• Emerging markets small-cap equity offers more diversification compared to other equity asset classes due to a less concentrated universe and revenue that is typically locally sourced.
• Based on past history, active management has the potential to outperform in emerging markets small-cap equity.
• A systematic, quantitative process can assess opportunities in emerging markets small-cap equity efficiently.
• Relative to other equity markets, emerging markets small-cap equity currently has a more attractive value profile.
• Bridgeway’s history of closing strategies at responsible asset levels allows us to explore capacity-constrained areas such as emerging markets small-cap equity without compromising our investment philosophy or process.
• Bridgeway’s global research into intangibles and unique portfolio construction offers a novel approach to investing in non-US markets.

Comparing Emerging Markets Small-Cap Correlation

Much has been written about how the emerging markets equity asset class can be a good diversifier to other equity asset classes. This also holds true for emerging markets small-cap equity. The simplest way to confirm this is to view the correlation of the asset class versus other equity asset classes. We looked at rolling 36-month correlations using monthly returns for various MSCI indexes (to represent various equity asset classes) relative to the MSCI AC World IMI, an index that constitutes large-, mid-, and small-cap companies across 23 developed markets and 24 emerging markets. Since the common inception in 2001 of the indexes shown, the MSCI Emerging Markets Small Cap Index as a proxy for the emerging markets small-cap equity asset class has consistently been among the lowest correlated index relative to the MSCI AC World IMI.

Source: FactSet; Returns for the MSCI Emerging Markets prior to June 2007 are back-tested performance and do not reflect actual index performance. Back-tested index performance was calculated retroactively to show how the index might have performed and may be materially different than actual results would have been.

However, for the most recent three-year period, the lowest correlation has been between the MSCI Emerging Markets Index to the MSCI AC World IMI.  To what can we attribute this sudden dip? The primary reason is the large weighting that China has in the MSCI Emerging Markets Index versus the MSCI Emerging Markets Small Cap Index. The following table shows each index’s average weight to China and overall index return all for the three years ending June 30, 2023.

Three Years as of 6/30/23	Average Weight to China	Overall Index Cumulative Return (Net)
MSCI Emerging Markets Small Cap Index	11.08%	47.06%
MSCI Emerging Markets Index	39.03%	7.12%

While the performance of Chinese stocks in the MSCI Emerging Markets Small Cap Index was worse on an absolute basis relative to the overall MSCI Emerging Markets Index, the lower weighting to China mitigated the negative effect to the overall performance of the MSCI Emerging Markets Small Cap Index. The MSCI Emerging Markets Index’s 3.5 times higher average weight to China had a significant negative effect on performance. This tells us that indeed, the MSCI Emerging Markets Index has lower correlation in the most recent period, but that correlation has come at a cost.

Viewing correlations for the MSCI Emerging Markets Small Cap Index versus various representative non-equity indexes shows that correlations are also low for this asset class relative to non-equity asset classes. And while some correlations have nominally crept up in recent years, the long-term correlations of the MSCI Emerging Markets Small Cap Index have remained low for longer time periods.

Correlation Relative to MSCI Emerging Markets Small Cap Index (Using Daily Returns) as of 06/30/2023

Asset Class	Index Representative	3 Year	5 Year	10 Year
US Broad Fixed Income	Bloomberg Barclays US Aggregate	0.03	0.01	-0.01
US High Yield Fixed Income	Bloomberg Barclays US High Yield – Corporate	0.50	0.62	0.58
US Real Estate	MSCI US REIT INDEX – Gross Return	0.22	0.38	0.33
Commodities	S&P GSCI Total Return	0.24	0.29	0.26

Lower correlations may also be attributed to larger differences in cyclical versus defensive sectors, which can – and have – driven differences in returns even within emerging markets. Comparing the sector weights of the MSCI Emerging Markets Small Cap Index versus the MSCI Emerging Markets Large Cap Index shows these stark differences. In the table below, cyclical sectors (Communication Services, Consumer Discretionary, Financials, Industrials, Information Technology, and Materials) had an average weight difference of 7.32%, while defensive sectors (Consumer Staples, Energy, Health Care, Real Estate, and Utilities) had an average weight difference of 3.10%. As these differences persist, correlations may remain lower particularly during different economic regimes, which provides good diversification opportunities for emerging markets small-cap.

Sector Weights (%) As of 6/30/2023	MSCI Emerging Markets Small Cap Index	MSCI Emerging Markets Large Cap Index	Absolute Difference
Industrials	16.78	4.97	11.81
Financials	10.91	22.28	-11.37
Communication Services	4.02	10.81	-6.79
Materials	13.95	7.49	6.46
Health Care	8.89	2.79	6.10
Information Technology	17.09	22.49	-5.40
Real Estate	6.14	1.35	4.78
Energy	1.77	5.30	-3.53
Consumer Discretionary	11.10	13.20	-2.10
Utilities	3.19	2.28	0.91
Consumer Staples	6.12	5.93	0.19

As seen above with China, another potential contributor to lower correlations and drivers to return within emerging markets small-cap is the difference in country allocations. An examination of country weights of the MSCI Emerging Markets Index versus the MSCI Emerging Markets Small Cap Index shows some stark differences.

Country Weights (%) as of 06/30/2023

Country	MSCI Emerging Markets Small Cap Index	MSCI Emerging Markets Index	Absolute Difference
China	8.07	29.55	21.48
India	24.23	14.63	9.61
Taiwan	21.81	15.60	6.21
Korea	14.99	12.30	2.69
Thailand	3.22	1.92	1.30
Malaysia	2.37	1.33	1.04
Turkey	1.48	0.55	0.92
Mexico	2.37	2.80	0.43
South Africa	2.78	3.21	0.43
Saudi Arabia	3.80	4.22	0.43
Chile	0.89	0.54	0.35
United Arab Emirates	0.96	1.30	0.34
Philippines	0.98	0.65	0.33
Poland	1.12	0.85	0.27
Peru	—	0.26	0.26
Brazil	5.80	5.54	0.26
Kuwait	1.05	0.83	0.22
Hungary	0.04	0.24	0.20
Indonesia	2.19	2.00	0.19
Greece	0.64	0.45	0.19
Egypt	0.26	0.08	0.18
Czech Republic	0.06	0.15	0.10
Qatar	0.83	0.90	0.07
Columbia	0.10	0.10	0.00

As with China, the other top two largest country weight differences – India and Taiwan – have had an outsized effect on performance (and thus correlations). In the last three years, India has had a staggering 122.58% return in the MSCI Emerging Markets Small-Cap versus the MSCI Emerging Markets India return of 72.68%. The difference in weightings have also affected performance and correlation with the MSCI Emerging Markets Small-Cap Index having nearly 10% more in India relative to the MSCI Emerging Markets Index. And while the returns for Taiwanese stocks were similar between the two Indexes, the large positive return and relative overweighting in the MSCI Emerging Markets Small-Cap Index had a positive effect. Like the differences in sectors, as these differences in country weights persist correlations may remain lower, and broader diversification opportunities across countries may continue to exist for emerging markets small-cap.

Active Management in Emerging Markets Small-Cap

The argument on whether to pursue an active versus passive approach in equity strategies has been long debated with strong proponents on each side. Each side has put forth compelling considerations. However, we believe that in the case of the emerging markets small-cap, active management has an edge over passive management.  Historical evidence has shown that active management in emerging markets small-cap equity tends to well outperform a common benchmark, which is not always the case for other asset classes.

In the updated chart below, we show the excess annualized gross return over the long-term (10 years) of the median and top quartile institutional manager in four equity universes from the eVestment database: Global Emerging Markets Equity, and Global Emerging Markets Small Cap Equity, US Large Cap Core Equity, US Small Cap Core Equity against a common benchmark for each universe.

Source: eVestment, Bridgeway analysis; the eVestment universe median and top quartile calculation is using the default reporting method and default vehicle for all universe constituents to determine the median for each universe. The benchmark used for the Global Emerging Mkts Equity manager is the MSCI Emerging Markets Index Net; the benchmark used for the Global Emerging Mkts Small Cap Equity manager is the MSCI Emerging Markets Small Cap Index Net; the benchmark used for the US Large Cap Core Equity manager is the Russell 1000 Index Total Return; and the benchmark used for the US Small Cap Core Equity manager is the Russell 2000 Index Total Return.

Over this long-term period, the median Global Emerging Markets Small Cap Equity manager provides the highest excess performance of any of the other median managers shown relative to their benchmarks. Narrowing it down to the top quartile in each universe shows a similar pattern: the Global Emerging Markets Small Cap Equity manager has the highest excess performance of any of the other top quartile managers shown relative to their benchmarks.  We believe this is strong evidence that persistent excess return in emerging market small-cap equity can be achieved with an active approach to management.

Is Emerging Markets Small-Cap an Attractive Asset Class Now?

More than two years has passed since we launched our own emerging markets small-cap strategy. At the time of launch, we believed it was an attractive asset class and continue to believe so now.  However, a strong caveat: the question of whether to invest in any asset class at a particular time very often hints at market timing, something we do not suggest attempting. Even the most sophisticated investors would need to get the timing right multiple times for each asset class if a market-timing approach were implemented.

Nevertheless, asking the question of whether emerging markets small-cap is an attractive asset class now can be informative and assist with understanding how the asset class fits into an overall asset allocation. To do this, we plotted the distribution of tangible book-to-price ratios for the past 20 years and noted where each index stands as of June 1, 2023.

Source: FactSet, Bridgeway analysis

As the chart above on the left demonstrates, the MSCI Emerging Markets Small Cap Index generally has a distribution of book-to price ratios that are higher (meaning it represents a stronger value profile) than the other indexes represented. Further, within that distribution, the MSCI Emerging Markets Small Cap Index is currently cheap relative to its own history, making it an attractive opportunity for value investors. The chart on the right decomposes the MSCI Emerging Markets Small Cap Index into sectors and similarly plots the book-to-price ratios for each over the past 20 years. Except for the outlier of Information Technology, the chart shows that within MSCI Emerging Markets Small Cap Index, each sector is currently cheap relative to its own history demonstrating that the value opportunities in this space are broad based and not just driven by one particular sector.

For almost ten years, cheap stocks have lagged expensive stocks in terms of performance. This is a rare occurrence in the history of the market. Moreover, this trend is not limited to one region or country, but has affected the whole world. Therefore, we believe that emerging market small-cap stocks are poised to outperform, as they offer a great opportunity for value-focused investors. These stocks are currently trading at very attractive valuations, both compared to other global equities and to their own historical averages. Investors who are looking for the best bargains in the market should not miss the chance to invest in emerging markets small-cap stocks now.

Investing Quantitatively and Managing Capacity in Emerging Markets Small-Cap

In our 2021 piece, we discussed why a quantitative approach has some advantages over a non-quantitative approach. In summary, because a quantitative approach relies on data and can use modern programming and statistical analysis to evaluate companies, quantitative investment managers can cover the large number of names in the universe more quickly and efficiently than a non-quantitative manager. Further, because a quantitative approach allows an investment manager to cover all the names in the universe on a daily basis, there may be more potential opportunities for a quantitative investment manager than a non-quantitative manager may ever discover.  Reviewing the data in eVestment appears to back up this hypothesis.

Source: eVestment, Bridgeway analysis; for each period, the average return of managers with a non-quantitative investment approach is subtracted from the average return of managers with a quantitative investment approach. The returns used are for the default reporting method and default vehicle for all universe constituents to calculate the average.

Over the trailing, 1-, 3-, 5-, and 10-year periods ending June 30, 2023, the average return for managers with a quantitative approach have outperformed their non-quantitative peers in the range of 1.01 – 4.47% annualized.

However, a good performing strategy is only good as long as it sticks to its mandate, which is why managing capacity is so important. At Bridgeway, we believe in doing what is best for the long-term interests of existing investors. This means that in asset classes that are capacity constrained, we will close at responsible levels in order to maintain the integrity of the investment process for our existing investors. Bridgeway has a history of closing strategies early to protect the process and existing investors, even when it means turning down large amounts of assets. In fact, in one of our most capacity-constrained strategies, we have been closed to new investors for more than a decade.

Bridgeway’s experience in managing assets in capacity-constrained asset classes can help successfully guide our experience in the emerging markets small-cap universe. Additionally, Bridgeway’s international equity team, led by our Co-CIO and Head of International Equity, Jacob Pozharny, PhD, has more than 25 years managing non-US equity strategies, including in capacity constrained asset classes. Along with the support and expertise of the entire investment management team at Bridgeway, this creates an experience in which our investors can be confident that we have their long-term interests in mind and that our investment philosophy and approach maintain integrity.

Bridgeway in Emerging Markets Small-Cap

In our last piece on “Why Emerging Markets Small-Cap?” we noted our innovative approach incorporating intangibles in our own Emerging Markets Small-Cap strategy. To summarize, we believe that equity price changes are driven primarily by financial fundamentals over the long run. However, as companies increasingly rely on intangible assets to drive business, we have seen these intangible assets displace traditional tangible, physical assets affecting financial statements. Based on our research, we believe that categorizing companies based on their Intangible Capital Intensity (ICI) has the potential to improve stock selection by using the most relevant metrics, particularly in non-US markets. Our framework for ICI is determined at the industry level, with high ICI industries having higher levels of intangible investment (e.g., pharmaceuticals, software, telecom services, media, etc.) while low ICI industries have lower levels of intangible investment (e.g., utilities, materials, capital goods, real estate, etc.). We then contextually apply factors like value, quality, sentiment, and trend to shape stock selection.

Bridgeway further differentiates our approach to investing in emerging markets small-cap stocks through portfolio construction innovation. We use a unique approach to invest in emerging markets small-cap stocks that focuses on both picking the best stocks and building the best portfolio, emphasizing both equally.

Our portfolio construction is driven by sizing index-relative exposures using an innovative technique we call Active Share Proportionality rather than classical mean-variance optimization. Our research indicates that off-the-shelf optimizers that are based on mean-variance optimization depend on the stability of a covariance matrix and use too much turnover to adapt the portfolio to noisy volatility estimates. Unlike most investors who rely on these standard tools that adjust the portfolio based on how stocks move together, we construct our portfolio in a differentiated manner. Our method of Active Share Proportionality allows us to size our systemic risks directly based on how much they proportionally differ from the index, rather than how much stocks vary with each other. This way, we seek to avoid the problems of using unreliable and changing estimates of stock correlations, which often lead to unnecessary trading and higher costs. By not requiring a covariance matrix estimate, our portfolio construction technique reduces turnover requirements and transaction costs, thus turnover exists primarily to express stock preferences rather than adapt to covariance noise.

This technique is geared to source active return from idiosyncratic elements rather than systematic risks. Our method helps us to reduce the impact of market-wide factors, such as country, sector, size, and Beta, and to increase the contribution of stock-specific factors, such as company fundamentals, growth, and sentiment, to our performance. By doing this, we aim to generate more consistent and diversified returns from our stock selection and mute systematic exposures to improve the risk-adjusted excess return of our portfolio.

Conclusion

We have demonstrated some convincing reasons to invest in emerging markets small-cap equity including an attractive value profile and diversification opportunity.  Most convincing, though, may be the emerging markets share of global GDP and global GDP growth.  Currently, emerging markets countries “account for 50% of Global GDP and 66% of global GDP growth in the past 10 years (2012-2022).”[1] With this kind of representation globally, it is likely that most investors are underallocated to emerging markets.  This evidence should compel investors to look at emerging markets more closely and potentially as a larger portion of an overall allocation.

With the Bridgeway Emerging Markets Small-Cap strategy, we combine an attractive asset class with established experience, expertise, and a reputation for maintaining integrity by managing capacity responsibly. The Bridgeway Emerging Markets Small-Cap strategy lies squarely at the intersection of our investment expertise and how we can best serve our clients. We are confident we can offer a unique strategy in emerging markets small-cap equity with high conviction in our investment philosophy and process.

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[1] https://www.worldeconomics.com/Regions/Emerging-Markets/