Emerging Markets in your SAA

Hi @Hockey Monkey

Thanks for your post it makes some timely points as I am currently considering adding a international small exposure ETF to my portfolio. My rambling thoughts around the topic as it relates to me, follows.

My touchstone for passive is as broad and low cost as possible. So firstly, let’s get of the chest the annoyance that we don't have local domicile access to VT for 0.08% as an all in one or a VSS for 0.11% for broad int small caps (including emerging). We have to do the best we can with what we have.

VISM is the best representation of the international small cap 'population' available to us. It covers approx 13-14% market cap of the 23 developed countries. The annual cost for this exposure is 0.32%.

Alternatively, you could 'sample' international small cap exposure with IJH or IJR for approx 0.07%

VISM is 60%+ USA exposure. If you do a calc to work out equal weight diversification. VISM country diversification is equal to 2.7 equally weighted countries. Obviously IJH and IJR are equal to 1. From a personal perspective most of my small company exposure is in Australia, so adding 1 more country to make 2 on an equal weight basis gives the biggest bang for buck on diversification impact– lifting to 3.7 would be nice but is it worth paying for?

IJH does have overlap with VGS, about 20% of IJH’s capitalisation is overlap. On a pragmatic level It doesn’t concern me. The overlap at the tail end of VGS and top end of IJH is the smallest step towards equal weighting. I’m almost a little attracted to equal weighting if I didn’t have to pay a premium for it so really not concerned about the overlap.

IJH has 400 stocks, IJR has 600 stocks VISM has 4000+ stocks, yet the reduction in company specific risk when modelling inclusion of each into my portfolio is basically the same. In other words, the existing portfolio is already diversified enough that adding 4000+ stocks makes virtually no improvement over adding 400. VISM’s country diversification does however move the needle slightly for systemic country risk.

I’ve basically landed at adding IJH. In theory I prefer to have exposure to the population of small caps via VISM. Pragmatically I am happy to take my exposure as a ‘sample’ via IJH for a 0.25% reduction in cost. IJH/IJR also have larger FUM and generally lower spreads than VISM.

The sample may differ from the population. But reasonable expectations would be the difference should not be too large. I don’t mind the USA legal framework for a place to do business for small caps and I don’t mind S&P’s financial viability selection criteria either, who knows the sample might vary to the upside. I’m not paying for that possibility but I’ll take it, knowing that it may also underperform.

End of the day, % of portfolio we are talking about and likely tracking error of IJH to VISM isn’t likely to cause me to change my mind at an inappropriate time. But if owning the whole haystack becomes cheaper down the track I might change my thinking.

Cheers

 

@dunno why the need for a small cap fund? I'm all for trying to capture the "All World Index", but do you need to hold both VGS and VISM / IJR for the diversification/re-balancing benefit?

If you're going with IJR then might as well keep the below in mind...

Ben Felix on the problem with small-caps (obviously from a factor perspective)


Leading to two points:
1) Without the sort for value and profitability in a small-cap fund, there is little point in trying to capture the size factor (i.e. the fund should ideally be a small-cap value fund)
2) There are no small-cap value ETFs in Australia. And of the ones available in the US, the "good" ones only cover the US market (e.g. IJS and VIOV - both track the S&P 600 Small-cap Value index which screens stocks for value and profitability)

 

@mtat I run Dimensional's Global Small Company Trust for Global Small, however it has underperformed compared to reference (MSCI Global Small ex AU) for a decade....and DFA is screening for value and profitability. I'm not even sure that SCV is worthwhile anymore, but I find it more interesting than LCV and will keep it for the very long term.

 

Of course, value overall has under-performed. I just find factors interesting (thanks Ben Felix), but the extra returns are truly not guaranteed (nothing in investing is).

My general view is:

1) Go with VGS or VTS/VEU or IWLD without an extra small/mid cap fund. Depending on what you go with you will have some exposure there, but the difference in returns won't be significant. And you have fewer funds to worry about.

Or

2) If you want to take on some extra risk, add a small-cap value fund. SCV may never make a comeback again, but if it does... you will likely be rewarded handsomely. And you can feel superior to typical market beta plebs, because you invest in factors!

 

Hi @mtat

I work on the 80/20 rule. VGS(or similar large cap developed market) is the 80% core and is vital diversification as far as I’m concerned. The 20% is Emerging and Mid/Small Cap and is somewhat optional depending on how determined you are to own the whole haystack.

I’m not trying to overweight mid/small from a factor perspective. Just bringing the current underweight position in my passive exposure back to par.

This is the Morningstar style box for for my current passive holdings.

I believe passive capitalisation is achieved at 70/20/10.


Because I’m not that fussed with getting the small cap exposure aligned with pure passive capitalisation, I’m happy to move the needle in the right direction with IJH as a sample representation and lock in the lower fee savings.

This is what IJH style box looks like


This is IJH (black line) vs the underlying Managed fund (red line) for VISM since inception.


S&P 400 which IJH tracks has a profitability filter as part of the index selection process.

I don't read anything into the IJH historical out-performance, it could turn around tomorrow. what I do take comfort from is that IJH is a representative sample of the passive broader population that VISM tracks.

I'm not chasing anything clever with my passive allocation - Just want broad, simple and cheap and am happy to be pragmatic rather than pedantic in the selections.

 

Yeah, I reckon it will struggle to beat cap weight after costs and tax but happy enough to roll the dice on that and feel special.

 

A long view of the Value factor.

If it aint broke it will be so sweet on the reversion.

 

Thanks for your reply, I must say much of this goes over my head as I'm still very much in the learning stage.

I had not realised how little VGS and IJH overlap. Loading the latest holdings into a database and running some queries

VGS 1547 holdings vs IJH 406
47 holdings in common making up 0.95% weight in VGS to 19.23% in IJH

Wouldn't there be an argument that IJH is more likely to correlate to large caps that IJR. In fact IWLD omits IJH altogether, holding only IVV and IJR for its US holdings

Another factor for me is that I'm already very heavily exposed to the US with VGS (68%) and an investment in my US employer (a privately held small cap sized company that is 10% of my portfolio). Currently my overall equities are 30% Australia, 50% US and 20% Ex-US. Replacing VISM with IJH or IJR is only going to make it even more concentrated over time.

Another option would be just drop small caps altogether and go 90/10 VGS/VAE

 

Interesting results

 

Interestingly the managed fund version of VISM was out performing VGS until this year

 

Personally for me no it's not worth going world small caps vs usa small or mid caps given the expense. I'd rather add something like global REITs, which some (somewhat flawed) research says is a proxy for SCV and high yield corporate debt. Or global infrastructure. Even if they cost 0.5% in fees, weighting evenly with IJH brings it down to costing similar to VISM. If you really want to reduce USA exposure then mix and match with other niche products. Betting against the USA is a big call though, particularly if you are (for good reason - sweet franking credits) way overweight Oz as many likely are including me. A 50/50 USA/oz mix is still underweight USA given its world market share.

I like this equal weighting aspect, and it was part of my decision to include IJH with my large cap USA exposure. I feel like its "taking money off the table" to put new money into IJH or IJR while letting existing USA large caps ride. I don't see any reason for me NOT to have equal weight between USA large, mid and even small caps given historical performance and equal fees. Will it help returns or drawdown wise? Maybe not. Will it help my SANF? Yes.

Probably not - but given the very low fee for IJH/IJR why not?

That assumes small cap value mean reverts. I'll happily take a 50/50 growth/value split with my mid and/or small caps. Maybe the size premium itself doesn't exist anymore either? Who knows. But I'll take the diversification.

Who knows? That's the problem with the talk of mean reversion. "SCV has outperformed since 1929 so it must mean revert back to outperforming" can just as easily be "SCV has outperformed since 1929 so it must underperform for a long time to mean revert back to equal long term performance with growth". If SCV is a risk premium, but index funds like the DFA ones now make it less risky, why should it outperform?

Depends on your definition of risk. If it's a 5 year investment time frame definitely. If it's a 40+ year timeframe and we base on historical returns than it's a higher expected return therefore less risk.

This is the key point on IJH and IJR. I read a lot into it before buying previously and kept liking the S&P index IJH uses more and more. It's almost a perfect split down the middle of value and growth due to that profitability filter. By contrast the Wilshire mid cap index is heavily weighted to growth over value. A 50/50 growth/value blend suits my style perfectly.

They both correlate very strongly (r>0.9) with large caps, with only minor differences in values. They are even more strongly correlated with each other. However, they still add diversification compared to large caps. Just look at the 1999-2003 period. Much of it is likely sector weighting, but also the global vs domestic market revenue. I think either is fine, but personally use IJH for reasons I've posted prior.

Me too. At 0.07% fees it's hard not to like!

Each to their own though. As long as you're investing consistently in broad indexes and not doing silly stuff like jumping in and out of the market most likely good things will happen. All of this small cap, emerging markets etc. is likely just the indexers version of stock picking. Trying to feel like we have control of an erratic, uncontrollable thing....

 

For me with VISM, it was essentially rolling my own VDHG without the 10% bonds and 40% VAS. Although, even then, I swapped out VGE with VAE to avoid the issues discussed in this thread

VGS - 76%
VISM - 12.5% (85%:14% MSCI ratio)
VAE - 11.5% which is 10% EM by MSCI definition including Korea but not Hong Kong or Singapore

Total MER 0.224% which would drop to 0.192% if I swapped VISM for IJH or $320 / year on a $1M portfolio. I expect Vanguard MER's to come down as soon as IWLD switches to direct replication.

Let's catch up in 30 years and see who was right Hopefully before then we get a VT equivalent and can just invest in that instead.

 

@Ross36 ; index funds don’t make SCV less risky. They make the factors more investable which probably reduces return. Who knows. The best factors are the ones yet undiscovered, safely peering through the rear view.

 

I take your point but I'm not sure on this historically. SCV is by nature almost the riskiest of the risky. Tiny companies you've likely never heard of that are unloved. In the past (ie. Prior to SCV factor being identified) investing in them was difficult, noone knew anything about them because there was no internet or news articles about them, they were easy to manipulate by wall street scammers etc. etc. More of a penny dreadful shoot for the moon than typical investment. So my interpretation is they were much more risky. Now with all the regulations in place to stop (...reduce anyway) insider trading, ability to easily diversify into them for peanuts (DFA funds) and ability if you are a direct investor to go to their webpage to read their AUDITED financial statements I'd think a lot of that risk is gone.

They are still likely riskier than large caps, but I don't think the risk premium should necessarily be what it was in the 1970s. Again though - I have no idea and SCV may well shoot the lights out going forward. Hence a balanced growth/value fund option is my choice.

 

I don’t believe taken on the whole the risk for the entire subset was different than now. I do believe though that once factors are known and easily investable that the factor premium is reduced in the medium term at least. That does not reduce risk, only expected premium.

Anyway, who knows?

 

Great article on small caps was recently published What's the deal with small caps? - Passive Investing Australia

 

MSCI China Enters Bear Market After Tech Selloff; Alibaba Slumps

Leading decliners include Alibaba, Tencent and Meituan

China’s most widely-followed stock benchmark tumbled into a bear market after a selloff in some of the nation’s biggest technology firms.

The MSCI China Index slid 3% Thursday, extending losses from its mid February high to more than 20%.

This is the second time the gauge has fallen into a bear market in a little over a year. Last March, major equity benchmarks slumped following the spread of the Covid-19 pandemic.

 

Interestingly there's not been a lot of difference in total return between the s&p500 and s&p400 or s&p600 over the last 15 years . Didn't look further back. Less than 1% pa. You'd need a significant weighting over a long period to have a material impact. Just an observation.

 

China is also 30% of iShares MSCI Emerging Markets ETF