Unlocking Alpha in International Small-Cap Equities: The Case for Active Management in a Fragmented Market

In the ever-shifting landscape of global investing, international small-cap equities remain a paradox: a segment brimming with growth potential yet plagued by inefficiencies that passive strategies often fail to navigate. For investors seeking to capitalize on this overlooked corner of the market, active management—when executed with discipline and a long-term lens—offers a compelling path to outperformance. Harding Loevner's approach to international small-cap equities exemplifies how a quality-driven, concentrated strategy can unlock alpha in a fragmented asset class.

The Limitations of Passive Indices in International Small-Cap Markets

Passive index investing in international small-cap equities faces inherent structural flaws. Market-capitalization-weighted indices, such as the MSCI All Country World ex US Small Cap Index, often force investors to overexpose capital to weak performers. For instance, a handful of large-cap stocks within these indices can dominate returns, diluting the impact of high-quality, fast-growing companies. A 2025 analysis revealed that nearly 40% of companies in such indices exhibit subpar fundamentals, including low return on equity (ROE) and minimal growth trajectories. This lack of quality control means passive strategies may inadvertently hold underperforming or speculative stocks, amplifying risk during market downturns.

Moreover, valuation metrics in passive indices can be misleading. The Russell 2000's reported price-to-earnings (P/E) ratio, for example, excludes non-earning companies, understating the index's true valuation. A more comprehensive calculation would reveal a significantly higher P/E, signaling potential overvaluation. These methodological quirks underscore why passive strategies, while convenient, often fail to deliver consistent alpha in small-cap markets.

Harding Loevner's Disciplined Approach: Quality Over Quantity

Harding Loevner's International Small Companies Equity strategy, launched in 2007, takes a starkly different approach. By focusing on a limited number of high-quality, growing companies with modest market capitalizations outside the U.S., the firm prioritizes fundamentals over index inclusion. As of March 31, 2025, the strategy's Composite performance showed a 7.24% return since inception, with a 9.36% annualized return over five years. These results reflect a disciplined process rooted in three pillars:

1. Process Pillar: A repeatable, research-driven framework for identifying companies with strong balance sheets, sustainable growth, and competitive advantages.
2. People Pillar: A seasoned team with deep expertise in global markets, capable of navigating geopolitical and economic shifts.
3. Parent Pillar: A firm structure aligned with investor interests, ensuring long-term stewardship over short-term gains.

The firm's active management allows it to avoid the pitfalls of passive indices. For example, in Q2 2025, while the MSCI ACWI Ex-US Small Cap Index returned 11.78%, Harding Loevner's strategy delivered 11.67%, demonstrating its ability to closely track benchmarks while selectively avoiding overvalued or structurally weak stocks.

Case Studies: Active Management in Action

Harding Loevner's strategy shines in markets where fundamental analysis is critical. Consider Brazil, where U.S. trade policies threatened to isolate the country. Instead of retreating, the firm identified opportunities in resilient sectors like e-commerce and commodities. MercadoLibre, a Brazilian e-commerce leader, exemplifies this approach. By expanding across Latin America and adapting to shifting trade dynamics, the company's growth trajectory aligns with Harding Loevner's focus on quality and adaptability.

In cybersecurity, the firm spotlighted CyberArk, an Israeli firm addressing the surge in AI-driven machine identities. As AI agents proliferate, CyberArk's CORA AI tools—designed to detect threats and manage digital credentials—position it as a leader in a high-growth niche. This kind of sector-specific insight is rarely captured by passive indices, which often underweight emerging technologies.

Why Now Is the Strategic Moment for Active Strategies

The current macroeconomic environment amplifies the case for active management. A weaker U.S. dollar, easing trade tensions, and technological innovation are reshaping global markets. For instance, the rise of AI and cybersecurity has created new opportunities in small-cap tech firms, many of which are in emerging markets. Passive strategies, constrained by index rules, may lag in capturing these trends.

Additionally, the underperformance of international small-cap passive funds in 2025—exacerbated by short-term volatility and liquidity challenges—highlights the need for nimble, quality-focused strategies. Harding Loevner's ability to adjust portfolios in response to market shifts, such as its cautious approach to Chinese AI startups like DeepSeek, illustrates how active managers can mitigate risks while capitalizing on long-term growth drivers.

Conclusion: A Call for Quality-Driven Investing

International small-cap equities remain a fertile ground for alpha generation, but only for strategies that prioritize quality, adaptability, and long-term value. Harding Loevner's disciplined approach—rooted in rigorous fundamental analysis and active stock selection—offers a blueprint for navigating this complex asset class. As passive indices struggle with structural inefficiencies and market volatility, now is the time for investors to consider concentrated, active strategies that align with the realities of a rapidly evolving global economy.

For those seeking to build resilience in their portfolios, the message is clear: in a world of fragmented markets and fleeting trends, active management is not just an alternative—it's a necessity.