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How to go global the easy way

Kongkon Gogoi discusses the opportunities in global small caps and how to access them.

Vanguard MSCI International Small Companies Index ETF (ASX: VISM) offers Australian investors incredibly cheap and highly efficient access to the global small-cap markets.

The global small-cap market is a broad and heterogeneous opportunity set. It is fraught with many incoherent idiosyncratic risks fostering inefficiencies, which has empirically led to a wide return dispersion.

Conventionally, these attributes would make any market segment a mecca for an active approach to generating significant alpha or excess return over the benchmark. But in reality, the evidence points to the contrary. The risk/reward fragmentation in the global small-cap landscape has been a demanding segment for active strategies.

The two primary challenges here are the extensive opportunity set and generally uncorrelated diverse risk elements present in the market. Specifically, for actives, the Achilles heel is scale rather than skill. An average active manager lacks the scale to deploy cross-sectional analysis weighing up both opportunities and threats at the global level across the different sectors and countries, putting them at a disadvantage relative to passive managers.

Being passive, Vanguard’s strategy doesn’t have stock-picking or risk-management flexibility, but it compensates more than enough by tracking an excellent index. The underlying MSCI World ex Australia Small Cap Index benchmark represents almost the full opportunity set of global small-cap shares available for active managers. For instance, against a quintessential global small-cap manager holding 850-900 stocks, the strategy is composed of 4,300 stocks. Albeit with a notable country skew (a common feature in any global index) to the United States, this strategy effectively and efficiently captures the overseas small-cap market.

We highly recommend this index for global small-cap exposure. Given the absence of strong active rivals, Vanguard MSCI International Small Companies Index ETF offers unbeatable value in a difficult to navigate market segment at a compelling price. The ETF has a total cost ratio of .33%.

 

Index composition

U.S. companies account for about 62% of the MSCI World ex Australia Small Cap Index. While many large U.S. companies have global footprints, small companies tend to be more domestically focused, implying a substantial bias to the U.S. economy.

The benchmark has significant stakes in healthcare, industrials, and technology and only a modest allocation to resources, thus offering diversification for Australian investors. Global small-caps can add diversification to a local portfolio through exposure to foreign currencies and company-specific earnings drivers.

The Australian dollar often has acted as a "risk" currency, rising during buoyant conditions and coming under pressure when sentiment dips. This can reduce the volatility of global equity returns on an unhedged basis, compared with when currencies are hedged. However, it is worth noting that smaller businesses may be less mature than their large-cap counterparts and may thus display greater cyclicality, sensitivity to the business cycle, or volatility. For that reason, we believe this strategy is best used as a supporting player within a broader global equity sleeve of a portfolio.

Kongkon Gogoi is a Senior Manager Research Analyst for Morningstar.

 

First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.

 

 

All prices and analysis at 29 February 2024.  This information has been prepared by Morningstar Australasia Pty Limited (“Morningstar”) ABN: 95 090 665 544 AFSL: 240 892. 

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Firstlinks

Firstlinks is an investments newsletter providing content written by financial market professionals with experience in wealth management, superannuation, banking, academia and financial advice. Authors are investors and market practitioners with long careers in senior management positions. Firstlinks shares both their knowledge and their battle scars. Our community of 80,000 users discusses ideas from an informed and impartial point of view. Firstlinks was acquired by Morningstar Australasia in October 2019 to enable an expansion of its services and audience.