- The US stock market is expensive, and forward returns are not exciting.
- International markets may offer more value.
- ISCF, through its Size, Value, Quality, and Momentum factor tilts, may be the best place to park some of one's international stock allocation.
The US stock market is aggressively valued. It seems unlikely that an investor buying the blanket S&P 500 basket today is going to be particularly thrilled with that decision over the coming 5-10 years. Certain international markets may offer more value, and we may be able to capture more of that value by employing factor tilts. iShares Edge MSCI Multifactor Intl Small-Cap ETF (NYSEARCA:ISCF) is an interesting ETF designed to capture four factor tilts in the international market: Size, Value, Quality, and Momentum. While there are risks, ISCF looks like a good choice for a portion of one's international stock allocation.
It is hard to ignore the fact that US markets are expensive.
It doesn’t really matter what valuation or future return measure you use. The stock market returns from here over the medium term are unlikely to be impressive. To add a little nuance to what I am saying, I do expect the market to continue to rise as the Fed’s wall of cash washes into and over it and the “reopening trade” or “Roaring 20s” thesis plays out over the next 1-2 years.
However, as a long-term investor, I find it difficult to be excited about the broader market’s return over the coming decade. While I am not, perhaps, quite as pessimistic as GMO (GMO 7-Year Asset Class Forecast: 1Q 2021), I think they are directionally correct:
Rather, I suspect we will be looking at something a lot like the recent past:
We are also seeing increasing signs of topping behavior in the broader capital markets. I mean… does anything, anything at all that you have ever seen, scream “Go to cash!!!!” like the CumRocket cryptocurrency chart?
As a person looking to build my wealth over the long run, I am not going to go fully to cash, particularly as the government seems utterly hell bent on debasing our native currency.
Instead, I am avidly scouring the globe - often ex-US - for opportunities to enjoy positive and hopefully outsized returns over the coming decade.
If have followed my writing, you will know that I employ something of a barbell approach with my investing. IE, the overwhelming majority of my equity investments are locked up in long term, buy and hold passive ETFs with a tilt towards certain “factors” that are expected to provide alpha over long durations of time. The overwhelming minority is held in an actively managed account where I trade stocks.
Today’s article is about an ETF I recently stumbled onto that I think may not only provide the opportunity for alpha but may also allow us to sidestep some of the more overvalued parts of the market and the US market altogether.
Introduction to ISCF and Factor Investing
The iShares MSCI International Small-Cap Multifactor ETF is a small-cap international ETF that is designed to capitalize on the theoretic outperformance of a number of investing “factors” by tilting towards Value, Quality, Momentum, and Small stocks.
Please note that this is an international ETF. This is attractive to me right now given how expensive the domestic market is. We will largely be comparing ISCF to Vanguard’s International Stock ETF (VEU) and Vanguard’s International Small Cap ETF (VSS) as opposed to the typical comparison of the S&P 500 via SPY.
ISCF is unique, because it attempts to capture alpha by tilting its investments towards a number of investing factors rather than simply picking an international or international small-cap portfolio.
While an in depth discussion of factor investing is outside the scope of this article, I will attempt an introduction. In short, there are several “factors” that have been shown to produce durable alpha over the broader stock market over long periods of time. Chief among these are:
- “Value,” or choosing cheap stocks
- “Quality,” or choosing stocks that are profitable and have clean balance sheets
- “Momentum,” or choosing stocks that have been appreciating in value
- “Size,” or choosing small stocks.
From Cliff Asness’ “A New Core Equity Paradigm,” I have chosen a chart that sums things up nicely:
As you can see, over long periods of time, each of the factors individually produced alpha, but when they were put together, the alpha was considerable (8.6% annualized outperformance above the benchmark). The factors' outperformance held up in international markets as well.
As I will describe below, ISCF’s factor metrics function to create a portfolio tilted towards all four of these: Value, Momentum, Size, and Quality (similar to “Profitability” in the Asness article). In theory, if the future returns of the market looks anything like the past, this means ISCF has a very high likelihood of outperforming the broader international stock market.
If you are interested in learning more about Factor Investing, I recommend following Seeking Alpha’s own Ploutos, who is phenomenal. Additionally, you can check out the AQR Learning Center that has introductory material but lets you go much further down the rabbit hole by linking to a number of higher level research papers.
ISCF achieves its factor tilting through a weighting system in which it assigns each stock in the MSCI World ex USA Small Cap Index a composite score based on the sum of its scores in the Value, Quality, Momentum, and Size factors.
Of course, the finer details of the scoring are “proprietary,” but we can get a decent idea about what is going on from the Prospectus. The scoring system is an evidently complex calculation based on: “forward and trailing earnings to share price, cash earnings to share price, book value to share price and enterprise value to earnings before interest & taxes (EBIT)” to assess "Value." Similarly, the "Quality" score is based on the company’s “profitability metrics (asset turnover, gross profitability, gross margin and return-on-assets), investment quality metrics (total assets growth rate, issuance growth and capital expenditure growth), leverage ratios (market leverage, book leverage and debt-to-assets) and earnings variability.”
Personally, I like that there is a little nuance to the assessments that are made. In my experience, companies that scream cheap when a single ratio is used are much less attractive underneath the hood. Simply factor tilting with a bland PE ratio would not impress me.
What I find particularly exciting about this ETF, though, is that it is essentially the only small cap international ETF that uses significant factor tilting. While in the domestic stock market you can find an ETF - or multiple ETFs - for essentially any factor you would like, the ETF market for international stocks is much less developed. This is, in short, the entire basis for my ISCF thesis.
When looking at ISCF, it is worth noting that its factor tilts have skewed its holdings compared to most international ETFs, both in terms of industry and country:
Source: iShares ISCF Page
If we compare the industry holdings against Vanguard's International Small Cap ETF, VSS, we see that ISCF has a much lower Financials holding (20% vs 8.3%) and has a considerably higher Health Care allocation (12% vs 7%).
Functionally, this is by design, as ISCF is built to capture out of favor industries and then ease out of them as investors begin to smile upon them via its Value tilt. Buy low, sell high. It is worth noting, though, that no matter how cheap a given industry gets, ISCF limits its industry concentration to 25% of its holdings.
Source: iShares ISCF Page
Again, if we compare to Vanguard's VSS, we will see that ISCF is overweight Japan (24.5% vs 14%) and the UK (17.5% vs 11%). You will also note that ISCF only invests in developed markets, while VSS is willing to invest in emerging markets.
While country concentration is a risk, I do also see it as an opportunity. Having worked off historic overvaluation, Japan in particular seems to offer a vast realm of undervalued stocks. Much like the industry concentration, I do expect the country concentration to vary over time as markets fall in and out of favor, with the ETF designed to capture out of favor markets and then ease out of them as they gain investors' favor. Again, the ETF wants to buy low and sell high via the Value tilt.
ISCF has favorable valuation metrics, with its portfolio sporting a PE ratio of 16.29 and a PB ratio of 1.57. This compares favorably to VEU (PE 20.4, PB 1.9), VSS (PE 17.7, PB 1.6), and certainly to the S&P 500 via SPY (PE 22.2, PB 4.37).
ISCF has a 1-year trailing yield of 2.2%. This compares favorably to VEU’s 1-year trailing yield of 1.96% and VSS’s 1-year trailing yield of 1.81%. Last, the ETF is well diversified at the stock level, with no single position greater than 1.2% of the portfolio.
ISCF has handily outperformed both VEU and VSS since inception. Note that in this chart, I also included SCZ, the iShares EAFE Small Cap ETF for fairness, as this is one of the best-performing international small cap ETFs.
ISCF has only been around for a little over 5 years. Given that factors are supposed to produce long-term outperformance over the business cycle, I think it is too early to tell if the fund will deliver on its theoretic promise. That said, I do find the early results at least reassuring as we compare ISCF to a basket of its peers.
As with any investment, there are a number of risks to consider.
This ETF is fairly small, as they go, clocking in at ~$183 million in market cap, thus, there are a handful of associated risks.
This exposes us to liquidation risk. iShares could decide tomorrow or next month or 11.9 months from now that running this fund isn’t worth it anymore, exposing us to capital gains taxes - or, if inopportunely timed during a pullback, to losses.
Additionally, due to low trading volume, the Premium or Discount at which the ETF can be bought on the open market will occasionally rise as high as 2% and approaches 1% with relative frequency. This may not make a meaningful difference for long-term investors but is something to be aware of.
Source: iShares ISCF Page
Last, the ETF has a median daily volume of about 14,000 shares, raising concern for liquidity issues.
The Risks of Factor Tilts
While the factor tilts are essentially the basis for thesis regarding ISCF, it is worth recalling that factor tilts have inherent risks.
First, factor investing carries the risk of overfitting. Overfitting is when the model captures “noise” and interprets it as a rule. The noise exists because it is a pattern in the data that does not suggest an actual investing “truth.”
Or, in other words, there is the risk that factors and their theoretic outperformance is just a bunch of nonsense. Combining not one but four factors, ISCF could be particularly exposed to the curse of overfitting. Personally, I continue to believe in factor investing.
Second, it is worth remembering that these factors have and always will go through significant periods of underperformance. In fact, the Value factor has been much maligned over the last decade or so as it has performed poorly against an aggressively valued, growth-story stock market. If you choose to engage in factor investing, it is worth keeping in mind the possibility that “this time really is different” or that these factors will fail to outperform in the future.
Personally, I find this unlikely, and, actually suspect that they will outperform by a large margin over the coming decade due to historic overvaluation in certain parts of today’s stock market. Cliff Asness’ recent article A Gut Punch neatly describes the pain of being value tilted in recent months/years as well as reasonable expectations for multi-factor investing and value in the future.
Fees are not, per se, a “risk,” but they are something to be aware of. This fund carries an expense ratio of 0.4%. This compares unfavorably to VEU’s expense ratio of 0.08% and VSS’s expense ratio of 0.11%.
In the grand scheme of international ETFs, ISCF is expensive. On the flip side, if the factor tilt thesis plays out, then you are paying this expense ratio for outperformance that will be disproportionate to the higher cost.
Small Caps Get Hammered in Drawdowns
There is no getting around this one, and in my mind, this is the largest risk with this fund. If you want to capture the Size factor's return premium, you have to accept that small caps tend to get disproportionately whacked during drawdowns.
Look no further than 2020's COVID drawdown for this:
In this chart, I have cherry picked some dates and compared ISCF to its larger cap weighted brethren the SPY and VXUS to show that ISCF not only had a larger drawdown but also recovered more slowly.
You can expect to see something similar in more or less every recession or pullback.
The US stock market is aggressively valued. It seems unlikely that an investor buying the blanket S&P 500 basket today is going to be particularly thrilled with that decision over the coming 5-10 years. International markets may offer more value, and we may be able to capture more of that value by employing factor tilts.
ISCF is designed to capture four factor tilts in the international market: Size, Quality, Value, and Momentum.
Taken together, it seems likely that ISCF will outperform a standard international stock allocation over longer periods of time. Additionally, with the above described factor tilts, it seems likely that ISCF will outperform a small-cap weighted international stock allocation over long periods of time. With an expensive domestic market at present, this may be a particularly attractive opportunity today.
ISCF looks like a reasonable choice for a portion of one’s international stock exposure.
This article was written by
Analyst’s Disclosure: I am/we are long ISCF. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.