VSS - VSS: Ex-U.S. Small Cap Tends To Get Abandoned

2023-09-21 07:57:25 ET

Summary

• Small cap ex-US keeps correlations low with overperforming US large cap indices.
• Having lagged in performance compared to US large caps, ETFs like the Vanguard FTSE All-World ex-US Small-Cap ETF could be an attractive factor to cycle into.
• PEs are low, there are usually idiosyncratic growth opportunities in small cap, and the expense ratio on VSS is low, making this a useful factor asset.

The Vanguard FTSE All-World ex-US Small-Cap ETF ( VSS ) is an ETF that follows the non-US small cap space, which is a pretty distinct slice of the market. In particular, ETF investors that like to stay very macro can use VSS in order to take an exposure that is expressly uncorrelated with the dominant US market. VSS has lower PE ratios, more idiosyncratic growth prospects and alpha potential on greater liquidity and index inclusion that makes it attractive against US indices which have overperformed of late. VSS has super low expense ratios to boot compared to other ETF in the same zone. It's definitely a decent ETF to know about for non-correlated ideas against US index allocations.

VSS Features

The expense ratio is low at 0.07%. Much lower than other ETFs in this same zone which can go pretty high, above 0.42% in a lot of cases. The PE is less than 8x.

A similar ETF, iShares S&P Small-Cap 600 Value ETF (IJS), is small cap but not ex-US. As is typical, US ETFs tend to trade at higher valuations, here of 11x . The sector exposures are similar between IJS and VSS, but different from broader US markets. There is an emphasis on financials, industrials and consumer products in the small cap space. This drives pretty low correlations from the SPY since 2020, the first year of major political and geopolitical factors that changed market paradigms.

However, IJS is weighted towards much weaker regional banking and mortgage trusts in the US, while VSS is on more solid footing with less immediate liquidity fallout. VSS could be argued as a higher margin of safety pick.

Bottom Line

The point of looking at VSS is that it's a useful portfolio factor if you're looking for something that isn't correlated to the broader market, which has rallied meaningfully of late and is going to be more subject to narratives such as rates, global economy and geopolitics, since that's the theatre than large caps operate on.

Cycling out of large cap indices into those with less correlation to large cap indices and also who have lagged in performance makes some sense. Small cap ex-US is also naturally rich with alpha. Firstly, there is no major liquidity premium yet which could change as some of the constituent companies scale. Secondly, the average PEs are low. Thirdly, idiosyncratic businesses are usually able to buck global trends in terms of growth, especially by often having less exposure to matters of the global theatre like China, which is a vulnerability as a demand and supply node these days. Lower PEs and higher growth opportunities in a stalling global demand environment is a good thing, especially as competing risk-free rates rise.

These qualities are addressed by VSS by both being ex-US, where the US is the dominant market, and also being in smaller listings. VSS comes at an efficient expense ratio, and gets you away from regional finance and banking in the US, which is tremorous. With lower PEGs than a lot of other market segments, we like VSS which takes a slice of those segments and offers it to investors at very low expense ratios.

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