Increase Your Diversification and Risk-Adjusted Returns

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Small cap stocks are companies with market capitalizations of between $300 million and $2 billion. With their increased volatility relative to other asset classes. these companies can offer investors higher returns at a greater risk. But generally, including small cap stocks in a diversified investment portfolio can be a great way to enhance long-term risk-adjusted returns.

Benefits of International Small Caps

International small cap stocks have greater upside potential than many blue chip stocks. Simply put, it’s easier for a $300 million company to become a $600 million company than a $16 billion company to become a $32 billion company. International small caps also enjoy a number of other competitive advantages over larger companies, such as the ability adapt to market conditions more quickly.

Aside from greater growth potential, international small cap stocks offer enhanced diversification. According to some studies. large cap stocks or indices tend to co-move, which mitigates the benefits of international diversification. In contrast, small cap companies do not exhibit the same tendencies and can therefore offer a significant diversification advantage to international investors.

Risks of International Small Caps

International small cap stocks also carry many risks. Unlike U.S. small cap stocks, international small caps can face unusual risks like nationalization, sudden changes to laws, or even state-sponsored competition. For example, China’s mining industry faced a shake-up when the country forced many smaller mines to close down in 2010 by implementing stiff new safety and environmental standards.

International investors know that not all stock markets trend upwards either. For instance, the Japanese Nikkei is still trading well-below its all-time highs, while other markets are still very young. The increased volatility exhibited by these small cap stocks therefore may not translate into higher returns over the long-run. As a result, investors should carefully consider the markets in which they invest.

Most Popular International Small Cap ETFs

There are many international small cap stocks, but most are off-limits to foreign investors. Since American Depository Receipts (ADRs) are typically reserved for large foreign companies, investors have only a couple options for buying international small caps. They can either open a foreign brokerage account and buy the domestic stocks or purchase exchange-traded funds (ETFs) that hold them.

Here are some popular international small cap ETFs:

• iShares MSCI EAFE Small Cap Index (NYSE: SCZ )
• SPDR S&P International Small Cap ETF (NYSE: GWX )
• WisdomTree International SmallCap Dividend Fund (NYSE: DLS )
• Schwab International Small-Cap Equity ETF (NYSE: SCHC )
• PowerShares FTSE RAFI Developed Markets ex-US Small-Mid Portfolio (NYSE: PDN )

How to Analyze International Small Cap ETFs

There are many different factors that investors should consider before investing in international small cap ETFs. But here are some important tips to consider:

• Consider the Country & Region. Domestic market dynamics impact small cap stocks more than large cap stocks. So, it’s important for investors to take a careful look at the economic performance, regulatory environment and any risk factors associated with countries or regions.
• Choosing the Right Time to Buy. Small cap stocks tend to outperform during bull markets, while larger stocks tend to outperform during bear markets. While it’s always a good idea to diversify, investors may want to consider these factors to diversify at the right time.
• How Much Does It Cost? ETFs charge management fees that cover their costs of buying, selling and managing a portfolio of stocks. Investors should consider these fees – which are expressed as a percentage called an expense ratio – before investing.