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3 Foreign Small Cap ETFs Likely to Outperform

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Recent market gyrations resulting from worries over the end of cheap dollars and a slew of downbeat economic data in the U.S. have shaken investor confidence in the U.S. equity markets. This has compelled them to seek alternative and promising investment avenues.

Amid such a scenario, foreign small cap stocks emerged as winners easily outpacing their large cap counterparts to start 2014. In fact, the MSCI EAFE small-cap index grew about 29.3% in 2013 against 22.8% return offered by its larger cousin the MSCI EAFE index, showing investors clear attention on the smaller part of the capitalization spectrum.

The trend is continuing this year, as evident from iShares MSCI EAFE Small-Cap ETF (SCZ) gain of 2.8% so far this year versus a gain of 1.7% in the price of iShares MSCI EAFE ETF (EFA) in the same time frame.

All large-cap foreign funds were in red so far this year, as investors flee these types of securities. The foreign small-caps also returned better than the S&P index as marked by a 0.8% gain in SPDR S&P 500 ETF (SPY)’s share prices. This pushes us to delve into what exactly is pushing the foreign small-cap rally (read: 3 Low Risk ETFs for a Stormy Market).

Behind the Foreign Small-Cap Rally

Normally, smaller companies pick up faster than the larger ones in a growing economy. With more focus on the domestic segment, smaller firms are poised to surge in a trending market against larger counterparts which generally have more global exposure.

Being more focused to the global economy, large-caps are often highly vulnerable to global shocks thus limiting the scope for diversification. As a result, a pure resurging international exposure can best be achieved via these pint-sized securities.

If these were not enough, investors should note that, these often-ignored tiny stocks are normally illiquid in nature thanks to their weak trading volume. Thus, a limited number of shares makes it more difficult for worried traders to easily sell at a good price, promoting long term investment (read: Top Ranked Foreign Small Cap ETF in Focus).

Is there Any Preference for Geographies?

Probably yes. 2013 can easily be tagged as the year for developed market resurgence with the Euro-zone’s stock index – EURO STOXX 50 Index – reaching a 5-year high, Japan Nikkei stock index hitting 6-year high and the U.S. striking new all time highs day in, day out. On the contrary, most of the emerging markets are facing weakness thanks to the ‘Fed Tapering concern’ and the resultant currency slump.

So, quite expectedly, the small-cap ETFs that have gathered immense investor interest lately are inclined toward developed markets.  In the year-to-date frame, two Canada-based ETFs IQ Canada Small Cap ETF and iShares MSCI Canada Small Cap Index Fund have gained 6.5% and 2.9%, respectively, the highest in the foreign small and mid cap equities space.  Both the funds currently have a Zacks ETF Rank #3 (Hold).

The duo soared on the back of accelerating growth in Canada. Notably, Canadian GDP stepped up in 3Q13 to its best pace in about two years. The Bank of Canada now expects as much as 2.3% growth rate for 2014. So these Canada ETFs offer potential for the near term.

However, for investors who don’t want to be bound by a single country and look for a diversified exposure in various high-potential markets, we have highlighted a handful of the small-cap international ETF options which can offer decent returns in this rocky market environment:

iShares MSCI EAFE Small-Cap ETF (SCZ)

This ETF targets the small cap segment of the developed market space. This is done by tracking the performance of the MSCI EAFE Small Cap Index. The fund is the most popular choice in the space amassing $3.3 billion in AUM.
Holding about 1,311 stocks in its basket, SCZ is highly represented by Japan (25.8%) and the U.K. (22.96%) with Australia taking a distant third position (6.4%) (read: Time to Bet on the British ETF?).
Putting just 3.61% assets in the top-10 holdings, SCZ eliminates company-specific concentration. Expense ratio comes in at 0.40%. SCZ is up 29.2% in 2013 and 2.8% so far this year.
Vanguard FTSE All World ex-US Small-Cap ETF (VSS)

VSS – which tracks the FTSE Global Small Cap ex US Index – invests about $1.7 billion in assets in its 3,129-stock portfolio. The fund has its greatest exposure in the U.K. (18.6%) closely trailed by Canada (12.5%) and Japan (11.3%). Europe consists of about half of its portfolio (read: Is Another Great Year Ahead for Japan ETFs?).

VSS has minimal concentration risk as it invests as low as 3.2% to its top-10 holdings. It is also a low cost option charging only 25 bps in annual fees. The fund returned about 10.6% in 2013 and 4.3% year to date. VSS currently has Zacks ETF Rank #1 (Strong Buy).

FTSE Developed Small Cap ex-North America ETF (IFSM)
This iShares product, though returned greatly (27.35%) in 2013 and also advanced 2.6% year to date, remains unloved by investors in its six-years of being on the market. IFSM has garnered $53.7 million in assets invested in 1,153 securities.

Its expense ratio is higher at 50 bps. Geographic exposure wise, U.K. takes the largest allocation 26% followed by Japan (16.5%) and Germany (6.82%). Like the other two, IFSM also bears minimal concentration risk with only 4.71% put in the top 10 holdings.

Bottom Line

All these aforementioned ETFs are well exposed to the fast-recovering economies like the U.K., Japan and Germany. These funds should go a long way provided the underlying nations witness upbeat economic releases.

As a caveat, investors should note that, VSS and IFSM are susceptible to the movement in foreign currencies which might eat up profits (in case of adverse translation) when converted to American currency, but we are liking these picks as solid international ETFs which can hold up well this year (read: Inside the New Currency Hedged ETFs from iShares).

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