Investing in international small-cap value ETFs

A brief re-introduction to factor investing & small-cap value

Back in the 1990s, Eugene Fama and Kenneth French identified a set of three (later expanded to five) risk factors that drove investment returns. Today, the list includes market, size, value, profitability, and investment. 

Of interest to us are the size and value factors:

• Size: Returns of small-cap stocks minus the returns of large-cap stocks (Small minus Big, or SmB).
• Value: Returns of high-book-value stocks minus the returns of low-book-value stocks (High minus Low, or HmL).

Combining the two factors creates small-cap value stocks, which have historically been the strongest performing component of the U.S. market by a long shot. 

The small-cap value effect can also be found internationally, as seen here with a backtest of international small-cap value stocks vs. the global ex-U.S. stock market:

There have been periods of time, however, where the small-cap value premium returns negative. That is, large-cap growth stocks beat them. This is to be expected. Even the market risk premium has returned negative at times, with risk-free T-Bills beating stocks. A small-cap value tilt requires a long-time horizon and conviction to pay off. 

International small-cap value ETFs

Investors should note that currently only international small-cap value funds that hold developed market (Europe, Canada, Japan, etc.) equities exist. As of right now, there are no dedicated international emerging (China, Russia, Africa, Middle East, South America) small-cap value funds, only proxies that target small-cap dividend stocks that offer incidental exposure.

Moreover, selecting a small-cap value fund isn’t as easy as just looking at the name of the ETF. Many funds purport to target small-cap value but actually hold mid-caps or non-value stocks.  A better way is to conduct a factor regression analysis, which can be done via Portfolio Visualizer. Investors can use factor regression for back-testing various funds and comparing their "loadings" for the size and value factors. 

In my opinion, the best small-cap value ETFs on the market come from two fund managers with a strong history of factor investing expertise: Dimensional Fund Advisors and Avantis Investors. Some examples of their ETFs include:

• Dimensional International Small Cap Value ETF (DISV): 0.51% expense ratio
• Avantis International Small Cap Value ETF (AVDV): 0.36% expense ratio

Both ETFs use systemic screening methodologies and rigorous frameworks to sift out small-cap stocks that truly trade in value territory. DISV, in particular, is the ETF variant of Dimensional's existing small-cap value mutual fund, which has been in operation since 1997.

For a more passive, lower-cost approach, investors can also use more traditional index ETFs, but keep in mind that for factor investing, these funds might have lower loadings:

• iShares International Developed Small Cap Value Factor ETF (ISVL): 0.40% expense ratio. 

Please note this article is for information purposes only and does not constitute investment advice.