VSS: Low-Yielding Small-Cap Ex-US ETF Unattractive Despite Decent Total Return

~ by Snehasish Chaudhuri, MBA (Finance).

The last time I covered Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEARCA:VSS), during December, 2022, I found that this low-yielding small-cap equity fund used to generate a decent overall return over an extended period. Its portfolio was well-diversified both in developed and emerging markets, and significantly invested in sectors having high-growth potentials. There was concern over the future price performance of VSS, as small-cap equities were expected to witness low or negative growth had there been a global recession. At the same time, historical data reveals that smaller stocks do well post-recession and global funds further benefit from a falling dollar. Last time, I suggested a hold on this fund. With the passage of three months, I would like to reassess the investability of VSS by applying my "7 Factor Model for Evaluating Equity Funds."

By applying "7 Factor Model for Evaluating Equity Funds," I try to find out whether the stock qualifies with respect to some minimum requirements such as current market price of $5, assets under management ("AUM") of $200 million, yield of 4 percent, and diversification of its investments among eight major sectors - technology, financial, healthcare, industrial, consumer products, energy & materials, real estate and utilities. The remaining three factors are degree of discount from its current net asset value, risk of its portfolio, and sustainability of its current yield. These three factors ultimately help me to understand the attractiveness of the fund for both income-seeking investors as well as for growth-seeking investors.

VSS Provides an Option for Investing in Small-cap ex-US Equity Securities

Vanguard FTSE All-World ex-US Small-Cap ETF primarily invests in diversified value stocks of small-cap companies. This often-overlooked asset class has the potential of generating strong capital growth because these companies are also strong acquisition targets. This fund pays quarterly dividends, which have varied from $0.027 to $2.5 over the course of the past ten years. Its yield is quite low, but has been consistent. Throughout all these 10 years, yield ranged between 2 percent to 3.5 percent. However, during 2016 and 2021, the fund recorded an annual average total return in excess of 10 percent. Over the Long run, VSS thus provides investors a value investment option where they can gain through investing in publicly traded small-cap ex-U.S. equity securities.

Vanguard FTSE All-World ex-US Small-Cap ETF benchmarks itself against The FTSE Global Small Cap ex US Index and uses representative sampling technique to create its portfolio. FTSE Global Small Cap ex US Index is a market-capitalization weighted index that is a true representative of how the small cap stocks performed in various emerging and developed markets excluding the U.S. markets. Stocks from almost 50 countries are included in this index created during 1993 and is rebalanced every March and September. FTSE Global Equity Index Series ("GEIS"), which covers 98 percent of the world's equity market capitalization, works as a base for this small-cap equity index.

VSS Has a Well-Balance Portfolio Consisting Over Almost 4200 Small-Caps

Vanguard FTSE All-World ex-US Small-Cap ETF has a portfolio of almost 4200 equity stocks. As a result, a very small proportion of the entire fund is invested in each stock and not a single or small group of stocks are in a position to influence the performance of VSS. VSS's top 30 holdings comprise less than 8 percent of the entire portfolio. Two-thirds of its assets are invested in four best emerging markets globally as well as four developed markets spread throughout the globe. While the economies of China, India, South Korea and Taiwan are poised for high growth, markets in Japan, Canada, Australia and the United Kingdom are among the most stable and credible markets. The best thing is all these eight economies are having investment grade sovereign bond ratings, implying the fund has gone for less riskier equity stock markets.

Vanguard FTSE All-World ex-US Small-Cap ETF has a fully diversified portfolio that is invested in public equity markets of the global ex-U.S. region. I have a general liking for funds that invest a major percentage of their assets in four sectors - information & communication technology ("ICT"), financial, industrial, and healthcare - sectors possibly having above-average growth prospects in the coming decade. Innovative and revolutionary technologies are creating new benchmarks and compelling changes in industrial structure. Since the outbreak of covid-19 pandemic, demand for better healthcare facilities have been on the rise for the last three years, and will continue for a few more years. In this equity fund, this percentage is almost 55 percent. In a nutshell, this equity fund has invested in the right markets and in the right segments.

Lack of Information and Geopolitical Risks May Impact Investment Decision

Vanguard FTSE All-World ex-US Small-Cap ETF holds over $8 billion in assets with Vanguard Group, Inc. charging 7 bps in fees. Due to such a low expense ratio, investing becomes much cheaper and easier for investors who want decent returns but don't have the skill or time to pick individual stocks, especially the small cap stocks in international markets. However, a major hindrance while investing in such funds is the unavailability of performance data for these stocks. Presence of almost 4200 stocks also doesn't help. So, it's quite difficult to do some homework and then invest in such equity ETFs.

During my last coverage in Q4, 2022, I found that all the small-cap-equity funds have performed equally good or bad over the years. Post-pandemic, these small-cap-equity funds witnessed steady recovery and generated high growth till July 2021; and from the very beginning of 2022, these funds started witnessing a fall in their values. Three months back, most of such funds were trading somewhere near their pre-pandemic levels. The major markets in which VSS invested consisted of emerging markets like India, China, Taiwan, and South Korea, as well as developed markets like those in Canada, Japan, the United Kingdom, and Australia. All these countries have investment-grade sovereign bond ratings. However, all is not hunky dory. The Japanese and Canadian economies are slowing down. China and Taiwan are involved in a political conflict which has a possibility of translating into an armed conflict. All these factors do make an impact while considering an investment in VSS.

Investment Thesis

Vanguard FTSE All-World ex-US Small-Cap ETF is currently trading at $105.63, almost at par with its NAV. The scenario was almost the same three months back. This fund has a significantly large asset base and its portfolio is well-diversified among all the major developed markets and the largest growing emerging markets. Its low expense ratio enables investors to gain from such diversified holdings by bearing a very low risk. This equity fund seems to have invested in the right markets and in the right segments. Lastly, the annual average total return over the long run has been in double digits.

However, VSS has been consistently generating low yields within a range of 2 percent and 3.5 percent, which will most likely deter income-seeking investors. In absence of price growth, there is nothing left for investors. For the records, VSS generated a negative 21.5 percent total return during 2022. This year is not good either with a year-to-date return of 2.74 percent, which is almost equal to its average yield.

Going forward, I believe that Vanguard FTSE All-World ex-US Small-Cap ETF will continue to generate a low but decent yield and almost equal percentage of price growth over the long run. Economic slowdown and geo-political risks also loom large over future performance of this fund. Unfortunately, all these do not make a strong case for investment.

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