Where Small Caps Are Working

Less than three months into 2017, investors are already hearing plenty about the laggard status of small-cap U.S. stocks. While the Russell 2000 Index and the S&P SmallCap 600 Index are getting trounced by large-cap U.S. equity benchmarks, that does not mean all small-caps deserve dud status.

In fact, several small-cap, exchange-traded funds hit record highs Monday. The thing is none of those ETFs were U.S. funds, but one was the iShares MSCI EAFE Small-Cap ETF SCZ. SCZ tracks the MSCI EAFE Small Cap Index, the small-cap cousin to the MSCI EAFE Index, one the most widely followed gauges of ex-U.S. developed markets equities.

What Is SCZ?

SCZ, which debuted in December 2007, has $7.2 billion in assets under management. That is an impressive sum among international small-cap ETFs, but like its U.S. peers, SCZ is dwarfed in size by its large-cap equivalents. For example, the iShares MSCI EAFE Index Fund (ETF) EFA and the iShares Core MSCI EAFE ETF IEFA have $65.9 billion and $20.6 billion in assets under management, respectively.

Japan and the U.K. are the largest country weights in the MSCI EAFE Index, combining for 41.3 percent of that benchmark's weight, but those countries combine for 48.5 percent of SCZ's geographic exposure. Japan, the world's third-largest economy, represents the only economy that SCZ is significantly overweight relative to the large-cap benchmark. The ETF is underweight Australian, French, German and Swiss stocks compared to the large-cap MSCI EAFE Index.

Strategy And Small Caps

This year, the formula is working as SCZ is up 8.6 percent, outpacing the MSCI EAFE Index by 80 basis points. Interestingly, SCZ has been 70 basis points less volatile than its large-cap counterpart to start the year. SCZ's year-to-date returns are better than triple those offered by the Russell 2000 Index and SCZ has been 600 basis points less volatile than the U.S. small-cap benchmark.

Still, international small-caps are thought of as being even more volatile than their U.S. peers. Data indicate something else. Although SCZ has trailed the Russell 2000 in terms of returns over the past three years, the international small-cap ETF has been significantly less volatile over that period. Over that period, SCZ offered better than quadruple the performance of the MSCI EAFE Index while being less volatile.

SCZ allocates almost half its weight to industrial, consumer discretionary and financial services stocks. In order, financials, industrial and discretionary names combine for less than 48 percent of the MSCI EAFE's weight.

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