Are Small-Cap Foreign ETFs Up To The Challenge?

November 07, 2008

ETFs aren't the lowest-priced option now in small-cap international waters. An active mutual fund with a strong track record enters the scene. 

 

Earlier this week, Vanguard reopened its International Explorer Fund (VINEX) to new investors. The fund, which focuses on international small-caps, has been closed to new investors since 2004.

VINEX isn't an index mutual fund or exchange-traded fund, which makes it an odd fund for this column to focus on. But a few unique factors make it worth noting.

First, it is a well-established mutual fund run by a shop known for giving managers very short leashes on making big bets.

More importantly, with an expense ratio of just 0.35% a year, VINEX beats all of its current broadly diversified ETF and index fund rivals.

Now that's a switch. Typically, active mutual funds are the more expensive types of investments. But in small-cap international, that hasn't been the case. The first to market among broad-based and highly diversified ETFs was the WisdomTree International SmallCap Dividend Fund (NYSE: DLS). It came out in mid-2006, when VINEX was still closed.

But even though its assets have grown past $300 million, its ER is still some 40% greater than the venerable mutual fund, charging 0.58% in expenses. WisdomTree has pointed out that dividend-based funds are different than traditional market-cap-weighted ETFs in defending its existing pricing structures. But can such marketing logic prevail now that VINEX is back in the fold? After all, it seems something of a stretch to argue that running a portfolio based on screening by dividend streams is more expensive than running a truly actively managed mutual fund.

One of WisdomTree's chief rivals, index creator Research Affiliates, also takes a nontraditional market-cap approach to building portfolios. Its fundamentally weighted benchmarks are tied in to a number of ETFs, including the PowerShares FTSI RAFI Developed Markets ex-U.S. Small-Mid Portfolio (NYSE: PDN). Curiously, on the same day that VINEX was reopening, PowerShares slashed ERs on 11 of its Research Affiliates-linked ETFs, to a uniform 0.39%. An exception was PDN, which remains at 0.75%.

WisdomTree and PowerShares aren't the only ETF sponsors facing increased pricing pressures in small-cap international waters. Although a total of 11 different ETFs can claim a portion of the field by targeting more specialized markets or distinct niches, five funds compete directly among broadly diversified portfolios.

Below is a brief comparison of the broadest low-cost ETFs available directly to retail investors, with VINEX thrown into the mix. Since all but one of the ETFs launched last year (with the oldest not even reaching age 3 yet), performance data is represented by each fund's underlying index returns through the third quarter. The exception is VINEX, which has been around under various managers since late 1996. ETF assets are through Wednesday.

 

Name

Ticker

Exp. Rat. (%)

12-mth (%)

3-year (%)

5-year (%)

Assets ($mil)

WisdomTree Int'l SC Div.

DLS

0.58

-33.86

1.41

13.08

311

SPDR Int'l SC

GWX

0.60

-35.58

-1.50

10.87

300

PwShr   RAFI Dev. Mkts

PDN

0.75

-31.45

-0.40

10.97

14

iShares EAFE SC Index

SCZ

0.40

-35.35

-2.01

9.85

151

iShares FTSE Dev. Mkts.

IFSM

0.50

-35.49

-0.08

11.70

25

Vanguard  Int'l Explorer

VINEX

0.35

-35.47

-0.83

10.97

1,100*

*Total assets at the time of VINEX's reopening on Nov. 1

 

A number of caveats pop up when looking at the competitive landscape of these small-cap international stock funds. For one, VINEX requires an initial investment of $25,000. It also charges redemption fees of 2% on assets held less than two months. After that time, it's certainly possible to keep less than $25,000 in the fund, although Vanguard probably wouldn't appreciate such a move.

(Anyone with $100,000 or more in combined assets with Vanguard faces fewer restrictions on minimum asset levels, although it's probably wise to keep at least $500 in a fund regardless of your position.)

With an expense ratio of 0.40%, just 0.05% more than VINEX, the iShares MSCI EAFE Small Cap Index (NYSEArca: SCZ) offers an attractive low-cost alternative. But it doesn't provide emerging markets exposure, which VINEX does to a limited degree (less than 10% of the fund's total assets through the third quarter.)

The other question is how much does the increased risks associated with active management mean to you? For those of us old enough to remember, VINEX was a laggard when it first got started. That changed when Schroders Investment Management took over in 2000. But that also meant a tweaking of strategies and changes in the underlying portfolio.

 

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