In this article, we will look at the case for investing in international small-cap stocks and identify some of the best funds for building exposure into your portfolio.
Why Invest in Small-Caps?
Small-cap stocks are generally defined as publicly traded companies with a market capitalization of less than US$2 billion. While that may not seem like a small number, the odds are that your portfolio holds mostly large-cap stocks worth US$10 billion or more. The reason for this imbalance is that most funds track indexes that are weighted by market capitalization—that is, the largest companies attract the greatest allocation in a portfolio. The problem with investing solely in large-cap stocks is that they tend to have a high correlation with the overall market—after all, they are the overall market. By diversifying into less correlated assets, investors can offset declines in the overall market and reduce their portfolio’s overall volatility. This means that their portfolio may not decline as much during a bearish market, but could still hold up relatively well during a bullish market. There are several benefits to investing in small-cap stocks:
Diversification. Small-cap stocks are less correlated to the overall market, which makes them a great way to diversify a portfolio. For instance, the Schwab U.S. Small-Cap ETF (SCHA) has only a 0.877 correlation with the S&P 500 compared to a 0.998 correlation for the Schwab U.S. Large-Cap ETF (SCHX). Better Returns. Some studies have shown that small-cap stocks tend to outperform their large-cap peers over the long run. For instance, “The Cross-Section of Expected Stock Returns,” published in the Journal of Finance, showed that small-cap stocks outperform large-cap stocks and value stocks outperform growth stocks over the long term.
International small-cap stocks have the added benefit of geographical diversification into markets outside of the United States. This can help investors smooth volatility stemming from the United States’ economic cycle and potentially improve risk-adjusted returns. Investing in international equities also makes a lot of sense when you consider that U.S. equities account for less than half of the global equity market’s size.
Important Considerations
Small-cap stocks may not be appropriate for every investor’s portfolio. For example, an investor approaching retirement may want fixed-income or blue-chip stocks to minimize volatility, which means that international small-caps may not be right for their portfolio. Other investors that have a short time horizon may also want to avoid small-cap equities since they tend to be more volatile and may take time to generate higher returns. Investors who are interested in international small-cap stocks have many different options when it comes to funds. While many small-cap indexes function like traditionally weighted indexes, newer smart-beta funds offer unique indexing strategies that may be of interest to investors. A great example would be a fundamentally focused indexing strategy that prioritizes small-cap companies with compelling fundamentals to reduce risk. Finally, investors should carefully consider a fund’s expense ratio and management team before investing in one. Expense ratios can have a dramatic impact on long-term returns and the expenses charged on small-cap funds tend to be more than large-cap funds. Smart beta strategies tend to have among the highest expense ratios, which means that investors should make sure the additional cost provides enough benefit to them.
Best Small-Cap Funds
Exchange-traded funds (ETFs) and mutual funds are the easiest way to add small-cap exposure to your portfolio, especially when it comes to international stocks. Purchasing individual stocks involves a substantial amount of research and requires regular rebalancing to keep risk factors in check. ETFs handle the day-to-day selection of stocks and rebalancing in exchange for a small expense ratio that tends to be much lower than mutual funds. The largest international Small-Cap ETFs include:
iShares MSCI EAFE Small-Cap ETF (SCZ)Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)WisdomTree International Small-Cap Dividend Fund (DLS)Schwab International Small-Cap Equity ETF (SCHC)Schwab Fundamental International Small Company Index ETF (FNDC)SPDR S&P International Small-Cap ETF (GWX)iShares FactorSelect MSCI International Small-Cap ETF (ISCF)
Investors that would prefer mutual funds also have many options:
Oppenheimer International Small-Mid Company Fund (OSMAX)T. Rowe Price International Discovery Fund (PRIDX)Fidelity® Series International Small-Cap (FFSTX)Wasatch International Opportunities Fund (WAIOX)MFS International New Discovery Fund (MWNIX)Oberwise International Opportunities Fund (OBIOX)Fidelity® International Small-Cap Opportunities (FOPAX)
The Bottom Line
International small-cap stocks are a great way to diversify any portfolio. In addition to geographical diversification, small-cap stocks are significantly less correlated to the overall market and can help smooth out returns. The funds mentioned in this article provide investors with an easy way to gain access to these assets, but it’s important to carefully consider the costs before investing in them. The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
