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This Small-Cap Fund Provides Better Exposure to Foreign Economies

Diversification potential comes with some risk.

Some of the oldest foreign index-tracking funds focus on large-cap stocks. But several fund providers also offer complementary small-cap funds that tap into a wider range of overseas stocks. Unlike large multinational corporations, small-cap firms tend to derive a majority of their revenue from their local economy. Therefore, they provide better exposure to foreign economies, offering an incremental diversification benefit over the multinationals that dominate many large-cap index-tracking funds. Schwab International Small-Cap Equity ETF SCHC focuses on small firms from foreign developed markets. Its solid index-tracking performance and low fee earn a Morningstar Analyst Rating of Bronze.

SCHC tracks the FTSE Developed Small Cap ex-U.S. Index. It holds small-cap stocks listed in 23 developed markets outside of the United States and weights them by market capitalization. This approach helps mitigate turnover and the associated trading costs, and it reflects the market’s collective wisdom about the relative value of each holding.

The management team employs a statistical sampling technique to replicate index performance, allowing it to avoid trading stocks that are expensive to transact. This fund can also help diversify a U.S.-centric portfolio, as foreign small-cap stocks tend to have lower correlations with U.S. stocks than their large-cap counterparts.

While the portfolio excludes stocks from emerging markets, it still effectively diversifies stock-specific risk. Its 10 largest holdings account for only 4% of its assets. However, its country composition is biased toward the Canadian market, which makes it riskier than its average Morningstar Category peer. Canadian small-caps feature a heavy dose of companies in the materials and energy sectors. These types of companies are risky because of their exposure to volatile commodity prices, so they can add to the fund’s risk.

Overweighting these sectors relative to the category average has hurt this fund’s performance. From its launch in January 2010 through April 2019 its return landed in the bottom quartile of the foreign small/mid-blend category. It was also one of the more-volatile funds in the category over this stretch. Despite these risks, Schwab charges an ultralow 0.12% annual fee for this fund, which should give it a durable edge over its more-expensive competitors.

Fundamental View One of the benefits associated with foreign small-cap stocks is their ability to better diversify a portfolio of U.S. stocks. They tend to have slightly lower correlations with U.S. stocks than large-caps listed overseas. Over the trailing 10-year period through April 2019, this fund's target index, the FTSE Developed Small Cap ex US Index, and the Russell 3000 had a correlation of 0.84. Meanwhile, the large-cap-focused FTSE Developed Ex US Index and the Russell 3000 had a correlation of 0.89 over the same period. This is because small-cap stocks tend to be more closely tied to their local economies than large-cap stocks, which are typically more global. Small-caps can be more volatile than their larger counterparts and don't always compensate investors for this additional risk.

Market-cap-weighted funds, like this one, provide cost-efficient, diversified access to the opportunity set that active managers select from, and make no active bets on specific regions, countries, sectors, or individual stocks. This approach essentially free-rides on the collective judgment of active investors. The weight of a given stock, country, or sector stems from the collective opinions of these investors. The overall composition of this type of fund should look a lot like the average of its category peers. However, this fund does not include stocks from emerging markets. Therefore, it does not take advantage of the full opportunity set that its competitors can select from. A typical fund in this category has a 5% allocation to stocks from developing nations. This modest difference should have little impact on its long-term category-relative performance.

The portfolio’s exclusion of emerging-markets stocks causes its country weightings to look different from the category norm. A typical peer has about 6% of its assets invested in Canadian stocks, while the fund is closer to 15%. Collectively, the materials and energy sectors account for about 40% of the Canadian small-cap market. So, overweighting Canadian stocks directly causes the fund to overweight stocks from these sectors. This has made the fund more volatile than many of its competitors.

Despite these differences, stocks listed in Japan and the United Kingdom still represent two of the fund’s largest single-country exposures, collectively accounting for roughly one third of its assets. Like many of its peers this fund does not hedge its currency risk. Therefore, it has substantial exposure to currencies like the yen, pound, and Canadian dollar. Changes in the exchange rates between these currencies and the U.S. dollar can add to the fund’s volatility.

Portfolio Construction This fund tracks a well-diversified, market-cap-weighted portfolio that mitigates stock-specific risk and harnesses the market's collective wisdom, earning a Positive Process Pillar rating.

The managers use a sampling approach to track the FTSE Developed Small Cap ex-U.S. Liquid Index. This bogy starts with all stocks listed in 23 developed-market countries outside of the U.S. It ranks them by full market capitalization and targets those that land between the 86th and 98th percentiles. The index applies some additional liquidity screens and a minimum free float-adjusted market capitalization of at least $150 million to make the index easier to track. It weights stocks that pass these screens by their float-adjusted market capitalization. FTSE rebalances the index semiannually in March and September. Both existing stocks and those considered for inclusion are subject to buffer rules around the market cap cutoff points that are intended to reduce turnover.

Fees This is one of the cheapest options in the foreign small/mid-blend Morningstar Category, so it earns a Positive Price Pillar rating. The fund weights its holdings by market capitalization, which mitigates turnover and the related trading costs. Its total return beat its target index by 12 basis points annually over the trailing five years through April 2019. The fund was able to recover its fees through securities-lending revenue and save on trading costs with its statistical sampling approach. These advantage provided by these activities can change over time, so investors should not expect the fund to consistently beat its target index.

Alternatives Vanguard FTSE All-World ex-US Small-Cap ETF VSS (0.12% expense ratio) has a broader portfolio than SCHC because it includes small-cap stocks from more than 40 developed and emerging markets. But it still has the same sector risk as SCHC, so it also earns a Bronze rating.

Bronze-rated iShares MSCI EAFE Small-Cap ETF SCZ (0.39% expense ratio) is another worthy alternative. It includes small-cap stocks from 21 foreign developed markets but excludes those listed in Canada and South Korea. Excluding Canadian small-caps leads to a lower allocation to stocks from the materials and energy sectors, which should help keep SCZ’s sector risk in check. Its relatively higher fee limits its appeal and warrants a Neutral rating.

DFA International Small Company Portfolio DFISX (0.53% expense ratio) is another solid foreign small-cap fund. It holds stocks from 22 developed markets including those listed in Canada. It avoids the most-expensive and least-profitable stocks in its selection universe, contributing to the fund’s Bronze rating. The managers also have the freedom to trade patiently which can reduce transaction costs. This fund is only available to individuals through a qualified advisor or select platform, such as a 401(k).

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