In the weeks following the start of the war between the U.S. and Iran, international small-cap stocks were hit particularly hard, dropping nearly 12% from Feb. 27 through March 30.
Investors were selling off international small caps because they were less able to withstand the energy shocks from the closure of the Strait of Hormuz. Geopolitical concerns sparked a flight to safety, prompting investors to move into more stable, liquid investments.
Image source: Getty Images.
But over the past month and a half, international small-cap stocks have rebounded, recovering most of their March losses. And there is a good reason to expect international small-cap stocks to continue to outperform in the months ahead. Here's why.
International small caps bounce back
International small caps were already trading at lower valuations, certainly compared to U.S. large caps, and were considered excellent diversifiers. But after the war-fueled sell-off, valuations plummeted even lower, making them too cheap to ignore.
That was the sentiment of investors as they piled back into dirt cheap international small caps, fueling the relief rally.
NYSEMKT: VSS
Key Data Points
The Vanguard FTSE All-World Ex-US Small-Cap ETF (VSS +0.54%), an exchange-traded fund (ETF) that tracks international small-cap stocks, is proof. It has returned about 10% since March 30.
The international ETF picked up where it had left off before the war started. At that point, it had been outperforming its U.S. counterparts, both small- and large-cap.
The international small-cap rally at the start of 2026, before the war, was driven by a confluence of factors. According to an analysis by American Century Investments back in January, global small caps were poised to outperform due to expanding defense and infrastructure budgets, pro-growth policies, supply chain improvements, increased mergers and IPO activity, and attractive valuations. This created an environment in which international small caps were expected to have higher earnings growth potential than large caps.
An attractive diversifier
While the war in Iran throws some uncertainty into these trends, investors may still expect them to prevail as geopolitical tensions subside. And the rock-bottom valuations after the first month of the war presented a strong buying opportunity for VSS and international small caps in general.
The VSS ETF, which holds about 5,000 mostly small-cap international stocks, is up about 12% year to date after the recent rally.
About 28% of the portfolio is in emerging-market small caps. Among developed nations, 33% of stocks come from Europe, 27% from Asia-Pacific, and 11% from North America. No single stock makes up more than 0.23% of the portfolio.
While there remains significant uncertainty about how the war will impact the global economy, international small caps remain an attractive diversifier within a balanced portfolio, with significant return potential. And the broadly diversified VSS ETF is an excellent vehicle for tapping international small caps.
