International small cap

Since US large-cap stocks and international large-cap stocks have high correlation, some investors look for international small cap mutual funds and ETFs to further diversify their portfolios. This page is intended to present a summary of international small cap mutual funds and ETFs.

Tracking error
Since these ETFs trade in illiquid stocks, many of them only sample the indexes they track, and they incur transaction costs when the indexes change. Therefore, the ETFs do not necessarily track the index well; deviations of 1% annually are common, and EWX has underperformed its index by 2.10% annualized from its May 2008 inception, as of November 30, 2013. (This tracking error is based on the net asset value; when you buy or sell an ETF, this may add to the tracking error because these ETFs frequently trade at a premium or discount to net asset value.)

Tax efficiency
Vanguard International Explorer Fund has been very tax inefficient at least for the past 10 years, and since it is actively managed, it is likely to remain tax-inefficient,  You should strongly consider holding it in a tax-advantaged account.

Vanguard FTSE All-World ex-US Small-Cap Index Fund imposes non-expiring purchase and redemption fees on its mutual fund shares and thus discourages trading by imposing a cost on every trade. Given the volatility of small cap stocks, there are many opportunities for tax loss harvesting, but the redemption cost significantly reduces the benefit.

The purchase and  redemption fees can be avoided by using the ETF class; there are still brokerage fees and trading costs, but the fees can be less than purchase and redemption fees. This Calculate and compare costs for Vanguard ETFs and mutual funds calculator can help quantify the fund vs. ETF decision.

Small-cap international ETFs tend to distribute more capital gains than other ETFs, possibly because there is less creation/redemption activity. Small-cap ETFs should be less likely to distribute gains after several years of operation, because the redemption process is more effective at reducing gains when shares have been purchased at a wide range of prices. As of 2013, only the SPDR ETFs GWX and EWX have distributed gains after the second year, and none distributed a gain in 2012 or 2013 despite a rising market.

VSS distributed a 0.7% short-term gain in its first year (2009) and 0.4% short-term and 0.4% long-term in its second year (2010); GWX distributed a 1.5% short-term gain in its first year (2007) and an 0.8% long-term gain in its fifth year (2011); DLS distributed an 0.8% short-term gain in its second year (2007); and EWX distributed a 1.5% short-term gain in its second year (2009), a 2.1% short-term and 0.5% long-term gain in its third year (2010), and a 1.3% short-term and 2.2% long-term gain in its fourth year (2011).

Independent of capital gains, DLS and DGS are likely to have higher tax costs than the other ETFs, because their indexes overweight stocks with a higher dividend yield.

Trading costs
Many of the ETFs above are thinly traded, and even those which have fairly high volume have larger-than-average bid/ask spreads because the value of the underlying stocks is more difficult to estimate. VSS, for example, traded at an average spread of 0.17% in December 2012(according to Vanguard Average Bid/Ask Spreads)

Underlying securities
The products above have quite different sets and weights of underlying securities. Because of different definitions of developed and emerging markets, two indexes in the same market segment may have different country holdings. Even within the same countries, market-cap-weighted indexes have different country weights because of different definitions of small-cap by country. You are strongly advised to read the prospectus of each product and, if necessary, do additional research before investing in any of the products above.

International developed markets small cap index returns
Indexes: Dow Jones Developed Markets Small Cap Total Stock Market Index; FTSE Developed Small Cap ex-North America Index; MSCI EAFE Small Cap Index; Russell Developed ex-U.S. Small Cap Index; S&P Developed Ex-U.S Small Cap Index

Resources

 * Altruist FA: Foreign Developed Markets Small Cap Funds
 * Altruist FA: Emerging Markets Small Cap Funds