Where Smaller Is Better

Investors frustrated with the laggard performances turned in by U.S. small-caps and the related exchange-traded funds this year have been able to that frustration into profits with international small-cap ETFs.

That has not meant taking on excessive risk, either. The iShares MSCI EAFE Small-Cap ETF SCZ is higher by almost 20 percent year to date, well ahead of the 2.6-percent returned by the Russell 2000 Index.

Not only is SCZ proving to be a superior alternative to U.S. small-caps this year, but historical data indicate the fund has some advantages over the MSCI EAFE Index, which is heavy on large-cap developed market ex-U.S. stocks.

The Differences Matter

Over the long term, SCZ can also be a valid alternative to funds that track the MSCI EAFE Index. Although that benchmark is one of the most widely watched gauges of developed market equities outside the U.S., it has some flaws, including an emphasis on larger companies and geographic concentration risk.

“To start with, the diversification of the MSCI EAFE Index was compromised in the late 1980s, with 60 percent of its portfolio dedicated to Japanese stocks following their strong rally in that decade,” said Morningstar in a recent note. “As a result of this Japan stock bias, the category-relative performance of the index went from first to worst in a short span when the Japanese stock market crashed in the early 1990s.” 

Japan looms large in the large-cap MSCI EAFE Index and SCZ, but SCZ's three largest countries combine for 45 percent of that ETF's weight compared to over half in the large-cap benchmark. There are also sector-level differences. The MSCI EAFE Index's three largest sector weights combine for over 48 percent while SCZ's three biggest sector allocations combine for 41 percent.

Enviable Track Record

“The result of diversifying across a broader selection of countries and the inclusion of small-cap stocks not only improves category relative performance, but also enhances absolute and risk-adjusted returns,” said Morningstar.

SCZ's tale of the tape is impressive. Over the past three years, the ETF is up nearly 26 percent compared to an almost 9 percent gain for the MSCI EAFE Index. SCZ has also been less volatile than its large-cap counterpart over that period and during that three-year stretch, SCZ was 220 basis points less volatile than the Russell 2000 Index.

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