Small Cap ETF Performance in 2009 Relative to Large Cap Peers: Not Even Close

The tremendous increase in the number of ETFs launched in recent years has seemingly brought cheap, efficient access to nearly every corner of the globe within reach of U.S. investors. There are now funds devoted to Vietnam, Turkey, Israel, Colombia, among countless others. But while the breadth of international options has expanded significantly, the exposure offered by these funds is fairly limited, as most international exchange-traded products are dominated by mega-cap equities.

Blue chip indexes may technically offer exposure to foreign markets, but their correlation with the local economy is often far from perfect. Spain is perhaps the best example of this phenomenon. The iShares MSCI Spain Index Fund (EWP) invests exclusively in Spanish companies. A look under the hood, however, reveals that nearly 45% of EWP is allocated to Banco Santander (STD) and Telefonica (TEF), two companies that are listed on Spanish stock exchanges but derive a significant portion of revenues and profits from foreign markets. While the Spanish economy struggled with skyrocketing unemployment and a deteriorating fiscal environment, EWP actually gained 33% in 2009. This gain was largely attributable to big growth in the operations of Santander and Telefonica in Brazil.

International investing used to be binary process: your portfolio either had exposure to a country or it didn’t. But ongoing innovation in the ETF industry has significantly increased options. Small cap domestic ETFs have long been popular with investors, but opportunities to access smaller companies listed in foreign markets have historically been limited. That is beginning to change, however, as investors focus more on the international component of portfolios and begin seeking out alternatives to foreign equivalents of the Dow Jones Industrial Average.

A look at the performance of small cap funds relative to their mega-cap competitors in 2009 sheds some light on the increase in popularity of these ETFs, and hints at a bright future:

Developed Markets: PDN vs. PXF

For investors looking to gain exposure to developed economies beyond the U.S., the PowerShares FTSE RAFI Developed Markets ex-U.S. Portfolio (PXF) has become a popular holding. But PowerShares offers another way to gain developed market exposure through the FTSE RAFI Developed Markets ex-U.S. Small-Mid Portfolio (PDN). This ETF is based on an index that selects small and mid cap companies based on four fundamental measures of firm size: book value, cash flow, sales, and dividends.

PDN has been somewhat slow to accumulate assets, with just $10 million in cash inflows in 2009. But those investors who have bought into this fund have no doubt been delighted with the results, as PDN delivered almost 20% more in 2009 than its large cap counterpart.

2009 Returns: PDN +54%, PXF +36%.

China: FXI vs. HAO

With a market capitalization of more than $10 billion, the iShares FTSE/Xinhua China 25 Index Fund (FXI) is by far the largest China ETF available to U.S. investors. But it isn’t the only way to gain China exposure. The Claymore/AlphaShares China Small Cap ETF (HAO) has seen its popularity surge over the last year, thanks in part to a return of more than 95% in 2009 (making it one of the year’s top ten performing equity ETFs).

In addition to offering more of a “pure play” on the domestic economy, HAO offers more complete exposure across the various sectors of the Chinese economy. FXI has minimal exposure to consumer stocks and tech companies, concentrating about half of its assets in financials firms. HAO, on the other hand, spreads exposure across all industries, giving a material weighting to consumer services companies.

2009 Returns: HAO +97%, FXI +47%

Brazil: BRF vs. EWZ

Since its launch in mid-May of 2009, the Market Vectors Brazil Small Cap ETF (BRF) has seen almost $500 million in cash inflows, making it one of the most successful new ETFs of 2009 (see the top ten in this feature). From a performance perspective, BRF has been a hit too, more than doubling between its launch date and the end of the year.

While the iShares MSCI Brazil Index Fund (EWZ) has a huge holding (20%+) in Petroleo Brasileiro (PBR), BRF has a minimal allocation to the energy sector, focusing instead on companies that derive a larger portion of revenues from within Brazil. Brazil’s mega-cap companies are dependent on the global industrial cycle and other external factors (such as oil prices), but small cap stocks depend more heavily on real growth in the domestic economy to prosper.

2009 Returns (May 14-December 31): BRF +104%, EWZ +59%

EAFE: SCZ vs. EFA

For investors looking to gain exposure to developed markets outside of North America, the EAFE region is one of the most popular options. The iShares MSCI EAFE Index Fund (EFA) offers exposure to more than a dozen developed European, Australasian, and Far Eastern markets, with the most significant weightings given to Japan and the UK.

The index underlying EFA has a median market capitalization of more than $6 billion, and counts HSBC (HBC), BP, Nestle (NSRGY.PK), Banco Santander, and Total SA (TOT) among its largest holdings. Another iShares fund, the MSCI EAFE Small Cap Index Fund (SCZ) maintains similar country weightings, but offers completely different exposure. SCZ targets 40% of the eligible small cap universe in each industry group of each country represented by the MSCI EAFE Index, resulting in a benchmark composed of stocks with a market capitalization between $200 million and $1.5 billion.

2009 Returns: SCZ +43%, EFA +27%

Japan: SCJ vs. EWJ

Japan is home to the world’s second largest economy, making it a vital component of any portfolio with a truly global focus. But many of the largest Japanese companies, such as Toyota (TM), Mitsubishi, Honda (HMC), Canon (CAJ), and Sony (SNE), generate significant revenue outside of Japan, maintain large customer bases in the U.S. and elsewhere. The aforementioned companies are major components of the iShares MSCI Japan Index Fund (EWJ), but are nowhere to be found in the Japan Small Cap Index Fund (SCJ), which primarily in companies with a market capitalization of less than $1.5 billion.

It should be noted that Japan is one region that has a number of small cap options: in addition to SCJ, the SPDR Russell/Nomura Small Cap Japan ETF (JSC) and WisdomTree Japan SmallCap Dividend Fund (DFJ) also target these equities.

Japanese stocks missed out on the recovery efforts of 2009, but small caps still managed to outpace the bellweather stocks, a fairly consistent trend across international equity ETFs.

2009 Returns: CSJ +6%, EWJ +3%

Huge Potential

The foregoing review isn’t meant to imply that international small caps will consistently generate excess returns over mega cap companies. Small companies tend to be more volatile than larger companies, a phenomenon that applies to the upside as well as the downside. But the big gaps in returns delivered in 2009 does clearly show that small cap stocks maintain a significantly different risk and return profile than large cap funds. Achieving international equity exposure is now a multi-step process, and the choice between large cap and small cap exposure can have a material impact on portfolio performance.

Although the above list of small-cap international ETFs isn’t exhaustive, it comes pretty close to covering the universe of available funds — a testament to the potential for expansion in this space as the ETF industry continues to develop. Given the success of many of these small cap ETFs — both in terms of cash inflows and performance — expect new fund launches to come in waves in coming years.

Disclosure: No positions at time of writing.