SCHC: Disappointing Returns, But Not Time To Sell (NYSEARCA:SCHC)

When it comes to investing in international small-cap stocks, investors have a choice between passive index-tracking strategies and actively managed funds. The Schwab International Small-Cap Equity ETF (NYSEARCA:SCHC) is an option for those seeking broad, low-cost exposure to the asset class.

Although both international stocks and small-cap stocks have generally underperformed the broader market for an extended period, this underperformance has resulted in attractive valuations, and we believe that shifts in long-term trends impacting the global economy could benefit these areas of the market.

However, we don’t believe investors have been compensated for the risk they’ve assumed with SCHC thus far, and a comparison to funds that take a more discerning approach to this area of the market highlights how a thoughtful, rules-based approach to filtering through this large investable universe can benefit investors’ long-term returns.

That said, the attractive valuations of small-cap international stocks, coupled with the potential catalysts provided by what could be several significant macroeconomic tailwinds, lead us to maintain a Hold rating on SCHC.

The Drawbacks of Passive Approach to Small-Cap International

SCHC tracks the FTSE Developed Small Cap ex US Liquid Index, which has no explicit profitability requirements for its constituents. This raises the risk of the fund holding a significant number of unprofitable companies, as many publicly traded small-cap businesses are unprofitable. The chart below from JPMorgan shows how the percentage of unprofitable businesses in a small-cap index, the Russell 2000, has trended over time – reaching 41% in the third quarter of last year.

In contrast, active managers have the flexibility to avoid money-losing firms and focus on higher-quality, profitable stocks. With over 2,100 holdings, SCHC is taking an extremely broad, index-like approach to the space. In our view, an active strategy could be more discerning in its stock selection while still providing ample diversification.

Don’t Fall for “Diworsification”

SCHC holds a whopping 2,176 stocks with only 5.7% of assets in its top 10 positions. We believe this level of diversification is a classic case of “diworsification” – over-diversifying to the point of impairing returns. We believe that actively managed funds can provide sufficient diversification with significantly fewer holdings while being able to make high-conviction bets on their best ideas, potentially improving returns for investors over time.

SCHC: Complementary Exposure At Attractive Valuations

International and Small-Cap Exposure

One of the key potential benefits of investing in SCHC is gaining exposure to international small caps – an area where we believe most investors are significantly underweight after a long period of underperformance vs. US large caps. With compelling valuations and the potential tailwind from global supply chains diversifying away from China, international small caps could be poised for a period of outperformance. We believe that small caps, which tend to be more domestically oriented, should benefit from the resultant uptick in in-sourcing.

Moreover, international stocks could see a windfall from a weakening US dollar, which has generally been on an upward trend over the last 10+ years. The chart below shows the US Dollar Index (DXY), which measures the value of the US dollar relative to a basket of six foreign currencies (the euro, Japanese yen, British pound, Canadian dollar, Swedish króna, and Swiss franc), over the last 10 years.

In our experience, currencies tend to mean revert over time, and when considered in light of the level of money printing undertaken by the Fed since the onset of the pandemic, we think this trend is poised to reverse in favor of international businesses which can benefit from a weaker dollar. A weaker US dollar can enhance international stocks by making their products more competitive, boosting their earnings when translated back into local currencies, and making them more attractive to US investors. As the dollar weakens, international stocks may experience increased demand and capital inflows, potentially leading to higher stock prices. For US investors in funds like SCHC, a weaker dollar could also enhance returns as foreign currency gains are translated back into US dollars.

Other Considerations on SCHC’s Exposure

The fund has meaningful exposure to Canada (over 20% of assets) and Japan (18%), and is generally overweight those countries relative to broad international indexes. Sector-wise, SCHC also has large allocations to industrials (22%), financials (11%), and materials (11%). This exposure should be complementary to many investors’ portfolios, particularly in an environment where US Tech stocks have dominated.

Attractive Valuations

According to analyst estimates, SCHC’s holdings trade at just 14x projected 2024 earnings and 0.9x sales, a significant discount to the S&P 500, which trades at 21x this year’s earnings and 3x sales. SCHC’s discount to US large caps is a result of the fund’s meaningful long-term underperformance relative to that area of the market, but may also provide investors with an attractive entry point in under-appreciated businesses which could be positioned to enjoy attractive long-term gains as a result of the trends mentioned above.

Performance

SCHC has delivered lackluster returns. As of 2/28/24, the fund had generated a negative 3-year annualized net return (-0.7%) and was compounding at just 4% and 3% over the past 5 years and 10 years, respectively. Moreover, while an analysis of the funds’ rolling 3-year returns highlights the similarity of its return profile to other passively managed peers such as the iShares MSCI EAFE Small-Cap ETF (SCZ) and the Vanguard FTSE All-World ex-US Small-Cap Index Fund ETF Shares (VSS), it also shows that a more discerning approach may have improved absolute returns.

For example, the iShares MSCI Intl Small-Cap Multifactor ETF (ISCF), which is a passively managed fund but uses a rules-based approached to maximize exposure to factors that have historically outperformed the broader market, has generally outperformed similar funds that don’t employ any additional filtering, particularly over the last three years as the volatility created by rising interest rates and increasing geopolitical tensions has created opportunities for active managers to capitalize on short-term mispricings.

SCHC: Unimpressive returns, but not time to sell

While SCHC offers broad, low-cost exposure to international small-cap stocks, we believe the fund’s overly diversified, index-hugging approach may not be the optimal way to invest in this space. The lack of profitability requirements in the index SCHC tracks raises the risk of holding unprofitable companies, and the fund’s extreme level of diversification could be a case of “diworsification” that impairs returns.

That said, international small caps are currently trading at attractive valuations and could benefit from long-term trends such as global supply chain diversification and a potentially weaker U.S. dollar. And although we believe an actively managed approach may be better suited to capitalize on these opportunities, long-term investors in SCHC shouldn’t give up just yet.

As a result, we are maintaining a Hold rating on SCHC.