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Summary SCZ has a much higher expense ratio than SCHC or VSS. SCZ also has a smaller volume of holdings than either of the other companies. Despite those drawbacks, it thoroughly outperformed the peers over the last several years. When using daily numbers, it appears that SCZ is a riskier investment. If investors switch to using monthly numbers, SCZ becomes less volatile than the other two. When investors are considering adding some international small-cap equity exposure to their portfolio, three of the first names to come up may be the iShares MSCI EAFE Small-Cap ETF (NYSEARCA: SCZ ), the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ), and the Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEARCA: VSS ). These three ETFs all have well over a thousand international small-cap holdings to offer investors to a less developed part of the equity market that may be expected to have decent returns on the basis of limited analysis in foreign small-cap equity markets leading to companies trading at low valuations due to higher risk premiums. If the investor can diversify away a significant portion of the risk and rely on those markets to become more developed, it could be expected that the companies will trade at higher valuations when lower risk premiums are demand. That can make this exposure fairly attractive for an investor that is using ETFs to establish very large amounts of diversification within their portfolio. Expense Ratio The first metric for comparing these ETFs is simply looking at the amount of value that will flow out of the fund to pay for the management expenses. When it comes to expense ratios SCHC and VSS are extremely similar but SCZ struggles with a dramatically higher expense ratio. If investors assumed that markets were fairly efficient the lower expense ratios would make SCHC and VSS very easy picks over SCZ. However, if the investor assumed that markets were that efficient, it is unclear why they would also believe that international small-cap equity was going to warrant much higher risk premiums and therefore be expected to outperform over a long time period. It would simply be contrary to only look at the expense ratio and argue for efficient markets while selecting the sector on the basis of inefficient markets. Holdings A larger volume of holdings can reduce idiosyncratic risk by reducing the importance of each individual holding. The following chart shows the number of holdings within each ETF. It might be reasonable to think that the number of holdings would be correlated with the expense ratio, but that assumption would be faulty. With less holdings and higher expense ratios, it would seem that SCZ should be riskier and produce lower returns. However, that concept is about to be challenged. Portfolio Test I ran a portfolio test using returns since early 2010 through Investspy: (click to enlarge) Looking from left to right, everything appears to be about right. SCZ has the highest annualized volatility and the greatest risk contribution of the three international ETFs. To adjust for the fact that it would be absurd for an investor to only hold international small-cap equity, I used a 70% allocation to the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the core of the portfolio. SCZ also suffers from a higher beta than the other funds, but when investors look at the total return it should seem very curious that SCZ substantially outperformed the other two ETFs. It appears that SCZ actually beat the costs of more expensive management and more portfolio volatility by delivering materially stronger returns. Switching to Monthly I changed the strategy for comparing the ETFs to running the numbers through my own spreadsheets to test monthly data. By switching to monthly data it is possible to get a different picture from looking at longer term data which may do a better job of showing the volatility in the value of the underlying holdings rather than focusing on swings in the share price on a single day. When I run correlation on the monthly numbers the resulting data is very similar but it shows SCHC as having a slightly high correlation. Of course, the numbers are still within a reasonable margin of error. The more interesting numbers come when I run standard deviation on the monthly numbers. When the numbers are ran on a monthly basis the volatility of returns for SCZ are actually lower than for the other two funds. Given that the correlations appear to be fairly similar, the natural conclusion is that perhaps the required return on SCZ should be slightly lower rather than the slightly higher assumption made from the previous conclusion of a higher beta being assigned to SCZ. Conclusion SCHC and VSS appear to be the natural choices, but SCZ has done very well and assuming that the performance is simply luck and that expense ratios will drive the long term performance may be assuming that markets are too efficient. If the markets are that efficient, what is the point of investing in this segment? When I’m covering the mREIT sector my goal is to rapidly spot market failures and those seem to occur most frequently with smaller companies. When those smaller companies also have investors that are less familiar with how the company works, they are prime candidates for deviating from intrinsic value. If SCZ is able to deliver superior performance through paying for some high quality analysis to determine where to allocate more of their money, it may be possible for them to continue delivering strong performance. On the other hand, it could simply be a matter of choosing to make larger allocations (by luck) to the right areas or the right sectors within those areas which would be less likely to lead to stronger performance in the future. This is an area where investors may want to look deeper in determining which small-cap ETF is the best fit for their portfolio. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Scalper1 News
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