Passive vs. Active: Debating International Small Caps

An important decision investors make is whether to use an active or passive strategy in a particular segment of their portfolio. Passive investing is popular for more "efficient" areas of the market, but less-efficient areas, like international small-cap stocks, are thought to provide active managers more opportunities for outperformance.

Passive and Active
An examination of all mutual funds from the Morningstar international small/mid-cap categories (value, growth, blend) shows that the categories are littered with underperforming funds. We created a data set of all actively managed mutual funds in Morningstar's international small-cap growth, value, and blend categories from the beginning of 2001 through the end of May 2014 and calculated the group's average alpha relative to the MSCI EAFE Small Cap Index. Alpha can be an indication of the unique skills a portfolio manager brought to the table. Three-year return data (from June 2011 through May 2013) was used. The average alpha produced by the active funds over the past three years was 0.02, or almost zero. An investor picking from the broad list would have a less-than-50% chance of picking an outperforming fund. However, it is important to note that the international small-cap categories are somewhat heterogeneous. Funds can invest only in developed markets, or include a slice of exposure to emerging markets. Regional exposure, in addition to stock selection, drives return. In years when emerging-markets stocks outperform, funds with exposure to the region will have a boost to return relative to the category regardless of their stock-picking skill.

The average results are mediocre, but when we look at the list of funds that receive a Morningstar Analyst Rating, actively managed funds begin to look more attractive. Morningstar analysts generally rate funds that have a track record of reasonable length and significant assets--that is, the funds that investors are likely to be most interested in. These funds have provided significant alpha over the past three- and five-year periods. In the chart shown, funds are compared with the MSCI EAFE SMID Index if they have less than 10% exposure to emerging-markets stocks, and otherwise to the MSCI ACWI ex-USA SMID Index. SCZ is shown compared with its benchmark, the MSCI EAFE Small Cap Index.

These funds can be quite expensive, however, and their outperformance might not persist. For investors who doubt that these funds' outperformance will persist, choosing a passively managed ETF for one's international small-cap exposure is a reasonable proposition.  IShares MSCI EAFE Small-Cap (SCZ) offers exposure to small-cap stocks from 22 developed nations, excluding Canada and the United States. The fund tracks the smallest 15% of the developed international small-cap market and holds more than 1,300 stocks that do not overlap with the MSCI EAFE Index, making it a good complement to exchange-traded funds like  iShares Core MSCI EAFE (IEFA).

SCZ's index tracks more than 2,100 stocks, so the fund uses representative sampling to lower the number of stocks but maintain a similar return profile. By sampling, SCZ can use depository receipts instead of local listings and avoid the most illiquid stocks altogether. The fund has outperformed its benchmark over the past five years (demonstrated by the fund’s alpha of 0.38 relative to its own benchmark shown above) because of its sampling, but it could just as likely underperform. Investors should expect this fund to track its index closely, but not perfectly.

This fund's 0.40% expense ratio is average among international small-cap ETFs, but quite low relative to actively managed funds. The funds rated by Morningstar average a 1.22% expense ratio. Over time, that average 0.82% difference in expenses is a high hurdle for active managers to clear.

SCZ's average market cap is $1.85 billion, compared with the Morningstar medalist average of $3.12 billion. Smaller companies generally offer higher return than the broad market over time in exchange for more volatility, so this ETF is most suitable as a satellite investment for long-term investors with high risk tolerance. SCZ's sector and regional holdings have remained constant over time. The fund does not include South Korean or Canadian stocks. Top country weightings include Japan (27%), the United Kingdom (20%), and Australia (7%). The fund's three primary sector exposures are industrials (23%), financials (21%), and consumer discretionary (17%).

A portion of the fund's distribution is withheld for foreign tax purposes from companies in some countries, and the dividend yield figure is net of this tax. Investors can file for a foreign tax credit to offset these taxes, but not if the fund is held in a tax-advantaged account. In 2012 and 2011, more than 70% of distributions from this fund were qualified.

Other Passive Options
The only ETF to offer both developed- and emerging-markets small-cap exposure is  Vanguard FTSE All-World ex-US Small Cap Index ETF (VSS), which allocates about 15% of its holdings to emerging markets. VSS' 0.20% price tag is one of the lowest available. Only Schwab International Small-Cap Equity ETF (SCHC) is priced to compete with VSS, and it costs 0.19%. SCHC's portfolio gives more weight to European stocks than VSS does.

Another popular fund is  SPDR S&P International Small Cap (GWX), which includes securities with a market cap of less than $2 billion instead of sorting constituents by market-cap percentile. As a result, it has one of the smallest average market caps in the category. GWX has the most exposure to Asian stocks and includes South Korean and Canadian equities. Unfortunately, GWX's 0.59% expense ratio is very high.

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