Small Comfort for Storm-Tossed Investors

06/22/2010 12:39 pm EST

Focus: STOCKS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, Morningstar’s director of ETF analysis, and analyst Patricia Oey see value in a recently discounted global small-cap fund.

The IShares MSCI EAFE Small Cap Index (NYSE: SCZ) ETF is an excellent holding to complement foreign and domestic large-cap equities. This fund tracks the MSCI EAFE Small Cap Index, which aims to capture the performance of small-cap companies domiciled in developed European and Asian markets. The index does not include US and Canadian equities. Top country weightings are Japan (which accounts for 26% of the index), United Kingdom (20%), Australia (8%), and Germany (6%). While about 60% of this fund is invested in European equities, only about 25% of the holdings are domiciled in the eurozone. As for sector weightings, top holdings include industrials (26%), consumer discretionary (18%), and financials (17%).

This fund has no overlap with its large-cap sibling, iShares MSCI EAFE Index(NYSE: EFA). But while SCZ and EFA have similar country weightings, SCZ has a higher exposure to industrials and consumer discretionary and a lower exposure to financials, relative to EFA.

Because smaller companies have more local revenues, they have far less exposure to the dollar’s rise or fall than international large caps. This fund’s broad diversification across major currencies thus provides an even better hedge against a fall in the dollar than most other foreign-equity indexes.

Prior to the 2008 global economic downturn, which has driven up correlations across most asset classes, developed international small-cap stocks demonstrated a lower correlation to US equities relative to developed international large-cap equities. Another plus: while small-cap stocks tend to be more volatile than large-cap stocks, the volatility of SCZ is not much higher than that of EFA.

For the 10-year period ended May 28, 2010, the MSCI EAFE Small Index returned 3.8% annually, which was better than the S&P 500’s annualized loss of 0.9%. The recent market woes did not fully wipe out years of outperformance by international stocks, though they reduced P/E values to surprising lows. The MSCI EAFE Small Cap Index is trading at a trailing 12-month price/earnings ratio of around 13 times, which is in line with levels reached in early 2008 prior to the global economic downturn. At this time, we think this fund is fairly valued, as we expect growth in developed Europe and Japan to remain lackluster in the near term.

The annual expense ratio is 0.40%, which is cheaper than similar offerings.

Subscribe to Morningstar ETFInvestor here…

Related Articles on STOCKS