Why I Like Foreign Small-Cap ETFs

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Includes: BRF, RSXJ
by: David Merkel, CFA

This should be a short post. When I like a foreign market because it seems cheap (blood running in the streets), I sometimes buy a small-cap ETF or closed-end fund rather than the cheaper large-cap version. Why?

  • They diversify a US-centric portfolio better. There are several reasons for that:
    (a) the large companies of many countries are often concentrated in the industries that the nation specializes in, and are not diversified of themselves;
    (b) the large companies are typically exporters, and the smaller companies are typically not exporters. Another way to look at it is that you are getting exposure to the local economy with the small caps, versus the global economy for the large caps.
  • They are often cheaper than the large caps.
  • Institutional interest in the small caps is smaller.
  • They have more room to grow.
  • Less government meddling risk. Typically not regarded as national treasures.

Now, the disadvantages are they are typically less liquid and carry higher fees than the large-cap funds. There is an additional countervailing advantage that I think is overlooked in the quest for lower fees: portfolio composition is important. If an ETF does the job better than another ETF, you should be willing to pay more for it.

At present, I have two of these in my portfolios for clients: one for Russia (RSXJ) and one for Brazil (BRF). Overall portfolio composition is around 40% foreign stocks, 40% US stocks, 15% ultrashort bonds, and 5% cash. The US market is high, and I am leaning against that in countries where valuations are lower, and growth prospects are on average better.

Full disclosure: Long BRF and RSXJ, together comprising about 4-5% of the weight of the portfolios for me and my broad equity clients. (Our portfolios all have the same composition.)