International Small-Cap Funds Offer Better Diversification

The main reason to own international small caps is diversification. Many international large caps (such as

Investors usually perceive small caps as being more risky, as U.S. small caps are more volatile than U.S. large caps. However, this small-cap fund is not much more volatile than a corresponding large-cap index. Over the trailing five years through February 2015, the standard deviation for the FTSE Global Small Cap ex US Index was 17.6%, whereas for the FTSE All World ex US Index, the corresponding figure was 16.6%. One reason for this is that small caps from different countries tend to be fairly uncorrelated. This helps mitigate volatility in a geographically diversified fund such as VSS. A U.S. small-cap fund only holds U.S. small caps. In addition, U.S. small caps tend to have a greater exposure to young, risky, and potentially high-growth companies. Outside the United States, small-cap companies tend to be more established, less volatile companies that just happen to be small.

Like most of its peers, this fund does not hedge its currency exposure, so its returns reflect both asset-price changes and changes in exchange rates between the U.S. dollar and other currencies. During periods of high volatility in the global markets, the U.S. dollar tends to rise, which would weigh on the short-term returns of this fund. But over the long term, currency volatility comprises a small portion of the total risk for this portfolio.

Fundamental View This fund is in the foreign small/mid-blend Morningstar Category; within this category, there is a range of funds with fairly different portfolios. Relative to its category peers, this fund's 12% emerging-markets exposure is a distinguishing feature, as the average emerging-markets exposure across the funds in the category (including actively managed funds) is only 2%. However, this overweighting is not a bet on emerging markets--this fund is passively managed and tracks a market-cap-weighted index. As such, country weightings are determined by the quantity and availability of small caps in each individual country. Other significant differences in country weightings between this fund and the category average include Canada (12% versus the category average of 3%) Taiwan (7% versus 0%), and Japan (15% versus 20%). These differences can have an impact on this fund's performance within its category over the short term. But over the past decade, the performance of this fund's index has been in line with the category average, which suggests this fund is a reasonable option for international small-cap exposure for the long-term investor.

As an index fund, it has had low turnover and has not made a capital gains distribution over the past four years. This compares favorably to actively managed small-cap funds, which tend to have higher turnover and more capital gains distributions. In the 12 months ended February 2015, this fund’s tax-cost ratio (which measures the cost of taxes from both dividends and distributed capital gains) was 1.09 versus the category average of 1.85.

However, this fund will not always be tax-efficient. Some emerging-markets countries, such as Brazil and Taiwan, do not allow in-kind redemptions. Transactions in those countries' stocks must be done in cash, which can result in realized capital gains during rebalances or periods of strong outflows. In 2009 and 2010, the fund paid out $0.55 and $0.76 in capital gains distributions, respectively, which accounted for about 1% of its net asset value. This is because international small caps enjoyed a very strong rally in those years, and as a young fund (2009 inception), VSS was not able to build up sufficient realized tax losses to offset gains resulting from rebalances. VSS is less likely to distribute capital gains now that the fund has accrued some tax losses to offset future capital gains distributions.

Portfolio Construction This fund tracks the FTSE Global Small Cap ex US Index, which comprises about 3,200 companies from 43 countries. This FTSE small-cap index seeks to measure the performance of companies that fall between 91% and 98%, by market cap, of seven regions. Constituents must pass a liquidity screen before inclusion and are weighted by float-adjusted market cap. Constituents are reviewed quarterly, and the index employs buffers to reduce turnover. FTSE's index construction methodology is slightly different from that of MSCI. MSCI's comparable index--MSCI ACWI ex US Small Cap--includes companies that fall between 86% and 99%, by market cap, of 43 countries. The main differences between the two indexes is that the FTSE index has heavier weightings in Canada and Taiwan, whereas the MSCI index has a heavier weighting in Japan. The MSCI Index also has more constituents. While this fund has more holdings than its benchmark index, it's not really straying. This is because it can use locally listed securities, overseas-listed depository receipts, or both to get exposure to its index's constituents. The end result is the fund owns nearly everything in the index at its benchmark weighting. The fund may use futures contracts to manage cash in the portfolio. The fund's largest country (and currency) exposures include the United Kingdom (16%), Japan (15%), and Canada (13%). It also has a large 17% exposure to companies domiciled in the eurozone. Fees VSS costs 0.19% a year, making it one of the cheapest funds of its kind. The median expense ratio for all the funds in the foreign small/mid-blend category (which includes actively managed funds) is 1.43%. We expect an index fund to provide the returns of its index, less fees. Over the trailing five-year period through Feb. 28, 2015, this fund has trailed its index by 17 basis points, annualized. This indicates the fund has done a good job tracking its index. 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. On average, about half of the distributions from this ETF were historically treated as qualified dividend income.

Alternatives Within the foreign small/mid-blend category, this is one of the few funds (out of both ETFs and actively managed funds) to provide a sizable exposure to emerging markets. Investors interested in more options with emerging-markets exposure can consider funds in the foreign small/mid-growth category.

Among ETFs, the most liquid option is

Those looking for a value tilt can consider WisdomTree International SmallCap Dividend DLS. This dividend-weighted fund does not hold Canadian equities and tends to have a very large (currently 16%) weighting in Australia, as Australian companies tend to pay out higher dividends. This fund’s annual expense ratio is 0.58%.

Only Schwab International Small-Cap Equity SCHC beats VSS on price; it carries an annual expense ratio of 0.18%.

Investors can also consider actively managed funds. A list of international small-cap funds that carry Positive Morningstar Analyst Ratings can be found here.

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