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Can you profit from small stocks abroad?

(MoneyWatch) As we've previously discussed, Rolf Banz published the paper "The Relationship Between Return and Market Value of Common Stocks" in 1981. Banz found that small-cap stocks provided higher returns than large-cap stocks. The finding fit nicely with modern portfolio theory -- just as riskier stocks should provide higher expected returns than safer bonds, riskier small-cap stocks should provide higher expected returns than safer large-cap stocks. (My post then demonstrated that well-constructed, passively managed funds have been able to capture a large share of the small premium, addressing the issue of whether trading costs would make that impossible.)

Today, we address the issue of whether that small premium can be captured in international markets. We do that by comparing the returns of the DFA International Small Company Fund (DFISX) and the DFA Emerging Markets Small Cap Fund (DEMSX) to appropriate benchmarks. Note that trading costs are generally higher in international markets than they are in the U.S.

DFISX went live in October 1996. Through February 2012, the fund returned 6.6 percent per year. DFA produces the Dimensional International Small Cap Index based on simulated data from Bloomberg. The index returned the same 6.6 percent. Note that the large cap MSCI EAFE Index returned 4.3 percent for the same period.

The MSCI EAFE Small Company Index begins in 1999. For the period ending February 2012, the index returned 8 percent. DFISX returned 9.6 percent. Note that the large-cap MSCI EAFE Index returned 3.6 percent for the same period.

DEMSX went live in April 1998. The only index for emerging markets small-cap stocks is the Fama/French Emerging Markets Small Index. The index is calculated annually. For the period ending December 2011, the index returned 10.6 percent, and DEMSX returned 13.0 percent. Note that the large cap MSCI Emerging Markets Index returned 8.3 percent.

In each case, we found that small stocks had outperformed large caps, and the DFA funds had done a good job of capturing the returns of the asset class, after all expenses. Thus, we have compelling evidence that a well-designed, passively managed fund that uses patient trading strategies can do a good job of capturing the returns of their asset class.

Photo courtesy of Flickr user Albertane