In my last article, “International Small-Cap Equities: Poised to Outperform,” I made the case for allocating 5-10% of portfolio equity to international developed market small-caps. International small-caps have been out of favor for at least 10 years. The prospects for a worldwide economic recovery and declining dollar act as potential catalysts. The small cap sector is the cheapest since 2000, which has historically resulted in an annual return size premium of seven percentage points for subsequent three year periods.
So what is the best way to implement a position in this sector? Below I consider six funds that passed my initial screen and compare key metrics. My top pick is the iShares MSCI International Small-Cap Multifactor ETF (ISCF). Also worth serious consideration is the iShares MSCI EAFE Small-Cap ETF (SCZ).
I should note that I’ve taught university courses as an adjunct faculty member. In fairness, there is usually judgment and subjectivity in grading, so the same applies here. My metrics however are objective and come from reliable sources, so I encourage you to review them below and arrive at your own grades. And your choice could also depend on your investment objectives and preferences.
The Importance of the Quality Factor
While considering my screening criteria, I recently discovered very important findings from one of my favorite investors, Larry Swedroe, in his article “Has the Size Premium Disappeared?:”
“Asness, Frazzini, Israel, Moskowitz and Pedersen found that, “controlling for junk produces a robust size premium that is present in all time periods, with no reliably detectable differences across time from July 1957 to December 2012, in all months of the year, across all industries, across nearly two dozen international equity markets, and across five different measures of size not based on market prices.”
Translation: adding a quality factor (and removing “junk” stocks) in a small-cap portfolio results in a strong return premium across all countries and time periods.
The paper adds, “AQR demonstrated that the size premium doesn’t work alone, but does work when combined with other factors (such as momentum, value and high quality) – those factors all have larger premiums in small stocks than in large stocks. In other words, the size effect can be resuscitated by building portfolios that combine it with other factors.”
Leading International Developed Markets Small-Cap ETFs
Based on these findings, I placed high importance on finding ETFs that have high quality – and as a bonus – utilize momentum and value factors.
First, I applied a screen using what I call “foundational factors.” These are critical metrics that identify the most solid and attractive funds. This gave me a short list of funds to analyze in greater depth.
Those who follow me know that I utilize a passive, index-based investing strategy. The data show a large majority of actively managed funds fail to outperform their indexes over time. So actively managed funds are not included in my candidate list. Here are the criteria for my foundational screen.
- Index construction and suitability:
- Diversified, international developed markets index small-cap equity funds, ex-U.S.
- Passively managed, index-based, including factor based indexes; quality factor desirable but not required
- Not currency hedged (since we want to benefit in the event of a declining dollar)
- Age: inception date at least five years ago
- AUM: greater than $550M
- Fund expenses: less than or equal to 0.60%
- Liquidity and Access: At least $500k average daily trading volume; Accessible to investors (no RIA relationship required)
- Parent Institution: Solid quality and track record of parent (per Morningstar ratings)
I utilized etfdb.com and Morningstar to arrive at the top five funds shown in the table below. I also added ISCF at the bottom of the table. More on that in a moment.
The screen knocked out Vanguard’s FTSE All-World ex-US Small-Cap ETF (VSS), since it holds emerging market positions, and the DFA’s International Small-Company ETF (DFISX) since it can only be purchased through an investment advisor. It should be noted these are worth consideration depending on investors’ goals, portfolio design and ability to access DFISX.
I’ll add that I am bullish on emerging markets, but prefer to invest in them with dedicated funds, rather than using a broader based international fund. Examples are DGS and CXSE, which I’ve written about in DGS: My Favorite Emerging Markets ETF and CXSE: The Best China Equity ETF.
So why is ISCF in there when it has AUM of only $153M, well below my screening threshold? Because it was the only fund with reasonable size that utilizes a quality factor. As a bonus, it applies value and momentum factors in its security selection process.
Foundational Factors Analysis
Schwab’s SCHC stands out due to its ultra-cheap 0.11% expenses, good size and liquidity, and above average Morningstar parent rating. I rated SCZ second. It is distinguished due to its longevity, size, outstanding liquidity and parent rating. Since studies show fund expenses are one of the most important (if not the most important) determinants of long-term performance, SCHC distinguishes itself.
I rated ISCF only a C+ overall due to its relatively low assets and liquidity. Yet, etf.com rated the fund as a solid 4 out of 5 stars in terms of its ability to trade a $1M block in a single day. While this likely won’t work for institutional investors, it should for most individual investors, especially buy and hold investors. If the sector takes off as expected, ISCF will likely grow assets and liquidity over time. Given the high importance of the quality factor, I decided to make an exception to my screening threshold and evaluate it further.
So far, we see that all these funds are viable options to capitalize on the long-term prospects for the sector. But there is much more to consider, as I’ll show below.
Summary Foundational Grades:
Why ISCF: A Closer Look at Additional Factors
To further evaluate and differentiate these funds I looked at:
- Valuation: P/E, P/B, price to sales, price to cash flow, yield
- Quality: quality/financial health, return on invested capital and ESG rating
- Performance: total return, category rank
- Risk-adjusted performance: Sharpe ratio, capture ratio, risk/return vs. category, volatility
- Fund composition: countries, industry sectors, style box, market cap, number of holdings
ISCF Has an Attractive Valuation
On an absolute basis, all these funds are cheap with P/E ratios ranging from 11-16. ISCF trades at less than 15 times earnings, price to book of 1.4, price to cash flow of 6.8, and price to sales of 0.85. It has an average yield (1.76%) compared to the group.
While these are good numbers, valuation purists might lean towards DLS, FNDC and GWX. DLS has the lowest P/E and highest yield of 3% (by design, as it seeks high dividend payers). FNDC is the cheapest based on price to sales and cash flow. GWX competes well based on P/E, price to book, and price to sales. Other than the standout DLS, yields are comparable across the board. While yield isn’t a perfect valuation metric, higher yielding stocks typically go hand in hand with lower valuations.
ISCF Is Tops in Quality, A Decisive Factor
Stocks are often priced at attractive valuations for a reason: poor growth or profitability, impaired balance sheets, a declining business sector, management missteps, threats from new market entrants or other reasons. Therefore, we want to look at valuation in the context of the underlying quality and strength of the business. Most importantly, as Swedroe noted, the data show this generates the small-cap return premium.
The chart below shows the overall fund quality ratings from etf.com. The site defines quality as: “This factor captures excess returns to stocks that are characterized by low debt, stable earnings growth, and other quality metrics.” ISCF is by far the top fund based on this metric.
Again, ISCF clearly stands apart from the rest. It has the highest return on invested capital and earns an above average quality mark from Morningstar. Morningstar’s rating is based on profitability and financial leverage. Consistent with the Swedroe paper, Morningstar notes that higher quality stocks have tended to outperform their lower-quality counterparts.
ISCF earns a slightly above average ESG rating of A. Funds with higher ESG ratings consist of companies that tend to show strong and/or improving management of financially relevant environmental, social and governance measures. Sustainable investing is steadily gaining traction. And it’s not just about doing the right thing. Studies have shown a correlation between stock performance and ESG scores. And Blackrock has said they want to be a leader in sustainable investing solutions, which ensures fund managers will be paying attention to this factor.
In summary, the combination of ISCF’s attractive valuation with high quality makes it a clear favorite.
Summary of Valuation Combined With Quality Ratings
ISCF is a Top Performer, But SCZ is the Best on an Absolute Return Basis
ISCF returned 8.26% and 3.07% per year in the recent five and three-year periods respectively, ranking in the 20th and 25th percentile respectively, compared to its peers. However, SCZ was better, earning 8.89% and 4.05% per year in those periods, ranking it in the 14th and 18th percentile, respectively.
SCZ also posted an impressive ten-year run, earning 7.81% annually during a relatively poor period for the sector. Morningstar says SCZ outperformed the competition by about 1.5 percentage points per year over the past 10 years. It cited its lower than average expense ratio as a reason. Note that ISCF hasn’t been around for ten years and has an identical 0.40% expense ratio to SCZ.
GWX is worth a closer look. It has been above average over the recent three and five year periods, earning 2.29% and 8.03% respectively. But the fund is about average over ten years at 5.8%/yr. SCHC deserves honorable mention for its solid three and five-year performance. DLS was strong over the last ten years, but has performed poorly in 2020 and over the past three years.
I don’t consider short term trends very important, unless they might be clues to new longer-term trends. So far this year, GWX is the top performer, gaining 10%, followed by SCZ at 8.7%. ISCF has lagged, gaining 5.4%. All these funds are up significantly from the March bottom with GWX and SCZ pulling away from ISCF since early November. This could be explained by the positive vaccine news combined with the higher volatility and upside capture ratios of GWX and SCZ.
All in all, SCZ has been the most consistent and impressive performer over the ten-year period. Morningstar notes the fund has outperformed the average of its category peers in nine of the 13 years from 2008 through 2019. ISCF doesn’t have the longevity to compare it to SCZ. Nonetheless, since its launch about five years ago it has performed roughly the same as SCZ (63 annual basis points difference). And its valuation, quality and overall fundamentals suggest it will continue to compete well, if not outperform SCZ going forward.
Summary Absolute Performance Ratings
ISCF and SCZ Have Strong Risk-Adjusted Performance
Not only has ISCF done well on an absolute basis, it has done even better on a risk-adjusted basis. Morningstar rates the fund’s risk as below average with above average returns – always a nice combination. And it is the only fund in the category with that distinction. Preservation of capital is paramount, especially in a highly uncertain world.
ISCF is in a virtual tie (0.45 vs. 0.47) with SCZ for the highest Sharpe ratio. ISCF also has one of the best upside to downside capture ratios at 102/102 and the lowest volatility. SCZ is also very strong overall with a capture ratio of 106/105, average risk and above average return. As a result, I scored both funds an “A” for risk-adjusted performance. Conservative investors might prefer ISCF for its slightly lower risk and volatility, while historically SCZ has captured slightly more upside.
Summary Risk Adjusted Performance Grades:
ISCF and SCZ Are Well-Diversified and Have Similar Composition
Since ISCF and SCZ stand out from the rest, below I will focus on just these two. Given ISCF was the front runner so far in my analysis but SCZ had slightly better absolute performance, I was curious if the funds’ country, industry and market cap allocations might have anything to do with it. The short answer appears to be no.
ISCF and SCZ Are Well Diversified
The iShares MSCI EAFE Small-Cap ETF (SCZ) seeks to track the investment results of an index composed of small-capitalization developed market equities, excluding the U.S. and Canada. SCZ provides a classic, market-cap weighted representation of the international developed, small-cap market. With over 2393 holdings, the index covers approximately 14% of the market cap in each country. Its 10 largest holdings account for only 3% of its assets. The portfolio does not include stocks from emerging markets, while a typical competitor has a about a 5% stake. The fund has a nice market cap mix, with an average market cap of $2.19B. Over 60% of the fund is invested in stocks with market caps below $600M, providing solid participation in the most rapidly growing small companies.
The iShares MSCI International Small-Cap Multifactor ETF (ISCF) seeks to track the investment results of an index composed of global developed market small-capitalization stocks, excluding the U.S., that have favorable exposure to target style factors. ISCF is more concentrated than SCZ. It has 731 holdings with an average market cap of $1.57B. Its ten largest holdings account for 9% of assets. About 57% of its holdings are in stocks with market cap less than $600M. Unlike SCZ, it holds substantial positions in Canada (more on that below).
ISCF and SCZ Have Similar Industry Allocations
ISCF’s and SCZ ’s industry exposures are balanced, with the heaviest allocations to industrials, consumer cyclical, real estate, financials and information technology. Material differences worth noting are:
- SCZ has a higher weighting of industrials and financial services
- ISCF has higher technology and healthcare weightings; these have been better than average performers this year
ISCF and SCZ Provide Significant Exposure to Japanese Small-Caps
The biggest number that jumps out in the country allocation table below is Japan.
Both funds allocate substantial amounts there: ISCF 27.6% and SCZ 29.2%. However, this is in line with world index weights and other funds in the category. While this might be a red flag to investors who know the Japanese market has stagnated for decades, I uncovered some surprising things during my research. The fact is, Japanese small caps have performed on par with the S&P 500 index over the past twenty years and since 2012, in local currency terms, according to “Japanese Equities, Small Companies, Big Opportunities.”
Source: M&G Investments
Earlier this month, legendary investor and value hunter Jim Rogers was quoted in Barrons:
“The guy at the Bank of Japan goes to work everyday and says he will print unlimited amounts of money- his words- so he can buy stocks and bonds and exchange traded funds. Well, I own Japanese ETFs. He’s got more money than I do, and if he’s going to buy Japanese ETFs, I am too.”
Rogers then comments on valuations:
“The Japanese market is down 30% from its all-time high, and the American market is near an all-time high, so I’d rather buy Japan.”
ISCF and SCZ Have One Notable Geographic Difference: CanadaBesides Japan, SCZ carries a large dose of the UK (18%), another beaten up market, followed by Australia (9%) and Sweden (7%). The fund has no exposure to Canada, given its exclusion from its benchmark index. Canada has a high historical correlation with the U.S., so the exclusion enhances its diversification value for U.S. and Canadian investors. Canada also has a heavy weighting (28%) in the energy and materials sector, which could be a positive or negative depending on your view. My take is bullish on natural resources equities.
Similarly, ISCF allocates 16% to the UK, 10% to Australia and 6% to Switzerland. The biggest difference is that ISCF allocates 11% to Canada, its third largest country allocation. The Canadian market has returned 7.7% annually over the past five years, not far below the returns for each of the two ETFs. But investors who want maximum diversification away from the U.S. may prefer SCZ. Some investors might already participate in the Canadian equity market via a developed market large-cap ETF.
To summarize, I don’t see significant enough differences in country, industry and market cap allocations that lead me to strongly prefer one ETF over the other. I gave SCZ a slightly higher grade due to its better diversification for North American investors. To save space I didn’t report on my analysis of the other ETFs, but provided below are my sector grades for all the funds.
Summary Sector Grades:
Worldwide equity markets have roared back from the spring bottom. ISCF is up 62% since late March. Foreign markets may be due for a significant correction or even new bear market. While there is promise for a revival of the sector, its relative underperformance could continue for some time.
Japan, which represents ISCF’s largest country allocation, has high debt, an aging population and poor long-term economic prospects. ISCF has below average liquidity, so short-term traders with substantial positions could have trouble exiting the fund in the event of a market dislocation. The fund’s multifactor based approach is based on past data and has no guarantee of working in the future. However risks are mitigated by cheap valuations and a modest downside capture ratio, providing a factor of safety for buy and hold investors.
Is Now a Good Entry Point?
As illustrated in the chart below from the Swedroe article, right now small caps are cheap. The historical annualized size premium following periods of extreme cheapness has been over 7% a year. In my last article I noted that during the U.S. “lost decade of 2000-2009,” (which began with similar small-cap valuations), international small-caps generated annual returns of 8.7% versus -0.96% for U.S. large caps.Source: Advisor Perspectives, “Has the Size Premium Disappeared?”
A counterargument is that we haven’t had a meaningful pullback since the March low. Therefore, investors looking to add new positions might wish to wait for a pullback. But this year’s runup exhibits strong momentum, so I would be inclined not to hold my breath for a major price break before beginning accumulation.
For purposes of disclosure, I have been long GWX for more than five years – before ISCF even existed. Given this analysis, I am plan to rotate funds out of GWX into ISCF. See my previous article for recommendations on allocations.
The combination of ISCF’s attractive valuation, excellent risk-adjusted performance and high quality makes it a favorite for international developed market small-cap exposure. ISCF and all the funds carry risk, and ISCF has marginal liquidity compared to its peers. SCZ is very large and liquid, and is the most reliable historical performer, making it a close second. Given the characteristics of the funds and the compelling long term track record of SCZ, a reasonable alternative approach would be splitting an allocation between the two funds.
I look forward to your comments. If you found this article useful, please consider liking it, following me, and forwarding it to a friend.
Disclosure: I am/we are long GWX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I plan to initiate a position in ISCF.