Why I Like Foreign Small Cap ETFs

Photo Credit: amanda tipton || It may not be foreign, and not an ETF, but it IS a small cap

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This should be a short post.? When I like a foreign market because it seems cheap (blood running in the streets), I sometimes buy a small cap ETF or closed-end fund rather than the cheaper large cap version.? Why?

  • They diversify a US-centric portfolio better.? There are several reasons for that:
  • a) the large companies of many countries are often concentrated in the industries that the nation specializes in, and are not diversified of themselves
  • b) the large companies are typically exporters, and the smaller companies are typically not exporters.?Another way to look at it is that you are getting exposure to the local economy with the small caps, versus the global economy for the large caps.
  • They are often cheaper than the large caps.
  • Institutional interest in the small caps is smaller.
  • They have more room to grow.
  • Less government meddling risk.? Typically not regarded as national treasures.

Now, the disadvantages are they are typically less liquid, and carry higher fees than the large cap funds.? There is an additional countervailing advantage that I think is overlooked in the quest for lower fees: portfolio composition is important.? If an ETF does the job better than another ETF, you should be willing to pay more for it.

At present I have two of these in my portfolios for clients: one for Russia and one for Brazil.? Overall portfolio composition is around 40% foreign stocks 40% US stocks, 15% ultrashort bonds, and 5% cash.? The US market is high, and I am leaning against that in countries where valuations are lower, and growth prospects are on average better.

Full disclosure: long BRF and RSXJ, together comprising about 4-5% of the weight of the portfolios for me and my broad equity clients.? (Our portfolios all have the same composition.)

9 thoughts on “Why I Like Foreign Small Cap ETFs

  1. I wish I had longer data, but I am being lazy on this March Madness Friday. Since the small-cap ETFs you listed inception dates (2011 for RSXJ and 2009 for BRF), the diversification bonus has been pretty non existent on a monthly or daily basis.

    Now I do agree that small-developed and emerging provide better diversification to US Large, as an example, using DFA funds which have longer data, there does seem to be a diversification bonus to going small.

    As an example for the newer ETFs, since inception in June 2009, BRF has had a monthly correlation of .57 to IVV while it’s Large-Cap counterpart, EWZ, has had a monthly correlation to IVV of .59.

    Which leads me to 2 thoughts:

    Too short of a time period to take anything from it. This is the most likely scenario.
    These newer ETFs sometimes promise to be allocated in certain ways but fall a bit short. The pessimistic view.

    Thanks for the portfolio update and analysis.

  2. What do you think of vfsvx. It is a small cap fund more diversified than just 2 countries. (That is what I use for a purpose similar to yours).

  3. How did you decide on 40% exposure to foreign stocks? If the US is (roughly) 30% of global GDP, should foreign exposure be around 70%? I understand that many large cap US stocks have significant exposure to foreign markets, but they are also priced to near perfection (I agree with your other post “Estimating Future stock returns”). Are US large caps, priced to perfection, the best way to get that 70% of global GDP exposure?

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