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A Compelling Option for International Small-Cap Exposure

This ETF's diversified portfolio and rock-bottom fee make it stand out.

Morningstar, 11/18/2016

Vanguard FTSE All-World ex-US Small-Cap ETF VSS is one of the cheapest (0.17% expense ratio) and best diversified international small-cap stock portfolios available. It offers broad market-cap-weighted exposure to stocks listed in foreign developed and emerging markets. This approach promotes low turnover, effectively diversifies company-specific risk, and accurately represents its target market. Its large emerging-markets exposure has recently been a drag on performance, but over the long term this fund’s cost advantage should give it an edge over its foreign small/mid-blend Morningstar Category peers. It earns a Morningstar Analyst Rating of Silver.

This portfolio of over 3,400 holdings effectively diversifies company-specific risk. Its top 10 holdings account for less than 3% of assets, which is significantly lower than the 20% category average. Stocks domiciled in Canada and the United Kingdom dominate the fund’s top holdings, accounting for 24 of the fund’s top 25 holdings. Sector weightings are comparable to the category average except for industrials, which account for only 18% of this fund’s portfolio compared with 23% for the category average.

From its inception in April 2009 through October 2016, the fund has trailed the category average by 1.13% annualized. Much of this underperformance can be attributed to the fund’s large emerging-markets exposure. These stocks account for nearly one fourth of the fund’s assets, which is significantly higher than the 10% category average. During the 2013 and 2015 calendar years, emerging markets significantly underperformed developed markets, creating a drag on this fund’s performance. However, when emerging markets are strong, such as in 2010, the fund has tended to produce strong performance.

Historically, emerging-markets stocks have tended to exhibit higher volatility than developed markets, but over the trailing five-year period through October 2016, this fund’s volatility has been comparable to the category average, partially because of its well-diversified portfolio.

Fundamental View
International small-cap stocks can provide a significant diversification benefit when combined with a U.S.-equity-focused portfolio. Over the trailing 10-year period through October 2016, this fund’s index, the FTSE Global Small Cap ex US Index, and the S&P 500 had a correlation of 0.85. Small-cap companies tend to better reflect their local economies, compared with many foreign large-cap multinationals that generate a significant portion of their revenue abroad. Historically, small-cap stocks have also modestly outperformed large caps.

The fund’s market-capitalization-weighting approach promotes low turnover and skews the portfolio toward the larger stocks in the small-cap segment. This weighting approach promotes low turnover. In fact, its turnover ratio is consistently less than half of its category peers, which helps keep transaction costs low. But market-cap-weighting could also increase the fund’s exposure to stocks as they become larger and more expensive and away from firms as they become smaller and cheaper, which may have higher expected returns.

In contrast to this portfolio, the majority of funds in the foreign small/mid-blend Morningstar Category maintain fairly small allocations to Canadian and emerging-markets stocks, which creates some significant differences in country exposure. This fund has nearly 15% of its assets in Canada-domiciled stocks, which is 3 times the category average. It also has a 6% exposure to Taiwan compared with the 1% category average. Inversely, the fund’s allocations to Japan and developed Europe stocks are significantly less than the category average.

Despite these differences, Japan and the United Kingdom still represent two of the fund’s largest single-country exposures, accounting for nearly one fourth of the portfolio. These countries are both dealing with economic headwinds. The U.K.'s recent decision to leave the European Union, along with Japan's aging workforce and tremendous public debt, have the potential to slow new investment and weaken demand. However, these risks should already be reflected in market prices.

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