Small Cap International Equity

For years, my fund of choice for building an international portfolio has been a broadly based index fund like the Vanguard FTSE All-World Ex US (VEU) ETF. It includes emerging markets and Canada which are left out of many index funds. As good as this fund is, it's not exactly the international equivalent of a Total US Stock Market Index fund. It's missing small cap international.

Enter the Vanguard FTSE All-World Ex-US Small-Cap (VSS) ETF, which was launched nearly a year and a half ago to plug this hole in international holdings. I didn't jump in immediately on recommending this fund and instead took a wait and see approach. My biggest concern was that large hidden costs can lurk in small cap international stocks as, for example, bid-ask spreads of buying and selling individual stocks within the ETF can be quite large.

So now that it's been around for a while, I thought I'd kick the tires and see if I'm ready to recommend this fund.

Vanguard FTSE All-World Ex-US Small Cap ETF (VSS)
With an expense ratio of 0.40 percent annually, it's not terribly more expensive than the VEU at 0.25 percent annually. According to Duane Kelly, Vanguard's Principal who oversees this portfolio, the fund represents the 10.8% of the international market cap missing in the VEU fund. Thus, to build a total international portfolio, you would use roughly 90 percent VEU and 10 percent VSS.

The fund holds about 2,500 different individual stocks, and all classes of this index fund total about $563 million. This compares to $8.8 billion for the VEU fund. The size of the fund is important, as any ETF must be large enough to support a liquid market when it comes time to sell.

While this is considered a small cap fund, the size of some of its holdings surprised me. Its largest holding, Crescent Point Energy Corporation, has a $8.5 billion market capitalization, while the top 100 holdings represent companies with over $2.3 billion or more of market capitalization. In fact, Morningstar characterizes the fund on the bottom of the mid-cap scale, rather than small-cap. Morningstar hasn't yet rated the fund, as it is too new.

Fund performance evaluation
According to data provided by Mr. Kelly, the average bid-ask spread of the VSS ETF was about 0.16 percent, which seems to be providing an adequate level of liquidity. Over the past year ending July 31, 2010, the fund returned 18.0 percent, a full 1.4 percentage points below the FTSE Global Sm-Cap ex US Index it tracks. This is a full one percent more than the 0.40 percent expense ratio.

Of this one percentage point differential, most of it is due to the items that tend to equal out over time. These items include the ETF trading at a premium or discount to Net Asset Value (NAV) and what is called fair-value pricing. Fair-value pricing adjusts the price of an international fund for events that took place after that international market closed, such as trading in the US markets.

My recommendation
I'm all for holding a global portfolio of stocks and owning international stocks according to market capitalization weightings. Still, I'm a little concerned that some of the shortfall between the index and the fund performance is due to this being an expensive part of the market to play in.

Nonetheless, I'm now willing to put one foot in the water and I'll adjust my international portfolio to include five percent VSS, about half of the full market cap weighting.

This is a major milestone for me as it's only the third fund to an all world equity portfolio. For someone living in the US, my new equity recommendations will be as follows:

Vanguard Total Stock Market ETF (VTI) 66.7%

Vanguard FTSE All World Ex US ETF (VEU) 31.6%

Vanguard FTSE All-World Ex US Small Cap (VSS) 1.7%
Total Equity 100.0%

Final thoughts
Putting 1.7% of your equity portfolio into any one fund isn't going to make or break your portfolio so, if you're hesitant, I'd wait a bit. But if you do buy a bit of this fund, make sure:

You understand this is likely to be a volatile fund.
Have the stomach to stay in throughout volatile periods.
Don't get greedy and buy more if it does well.

Finally, I'm recommending buying this fund via an ETF share class rather than through the mutual fund share class (VFSVX). That's because the mutual fund has a 0.63% annual expense ratio, a 0.75 percent fee to purchase the fund, and another 0.75 percent fee to sell. The fee is to pay for the costs of buying the underlying securities, so owning the ETF class avoids these fees.

MORE ON MONEYWATCH
BP Teaches Three Key Investment Lessons
Beating the Market - Legg Mason Manager Makes the Case
Contrarian Investing - Just Rebalance Your Portfolio

Allan Roth

Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

Twitter

More from CBS News