Rules of the Game: Asset Allocation, Part 3

Continuing my mini-series on asset allocation (see Part 1 and Part 2), today I examine overseas small-cap stocks.

It stands to reason that small-caps outperform their larger cousins, when given time to percolate. Many smaller companies are newer, and have management teams that are nimble enough to respond to changing market conditions or just quickly implement new ideas. Indeed, plenty of small-cap firms, both in the U.S. and elsewhere, are essentially publicly traded family businesses. That means management can move fast, without a flotilla of committees to approve new actions.

Small-cap stocks are also, by definition, less liquid, which increases risk for investors with large holdings in a particular name. If they want to exit, it may be hard to find buyers at the price they want. For this, and other reasons, investors demand a risk premium for small-caps.

Even in the U.S., small companies don't have legions of investment banking analysts covering their shares. There just aren't enough shares available to interest large numbers of institutions. You'll also notice that it's often smaller, boutique investment banks that bring small-caps public. A company with a $300 million market cap won't be hiring Goldman Sachs (GS) as an underwriter.

When it comes to U.S.-listed American Depositary Receipts (ADRs), top performers include Noah Holdings (NOAH), Silicon Motion Technology (SIMO), Zhaopin (ZPIN), Grupo Aeroportuario del Centro Norte (OMAB), Grupo Financiero Galicia (GGAL) and WNS (Holdings) (WNS).

However, as I noted earlier this week in my column about foreign large caps, it can be difficult to invest directly in overseas companies when there is no ADR available stateside.

This problem is compounded with smaller stocks. As an asset class, it is distinct from both domestic small-caps and foreign large-caps, and as such, doesn't receive much attention in the financial media. This is understandable. With just a few clicks, you can buy BHP Billiton (BHP), PetroChina (PTR), China Mobile (CHL) or any number of popular ADRs. These companies are somewhat familiar to U.S. investors because of their size, so they get a bit of media attention.

But good luck trying to identify fast-growing small-caps listed on the Frankfurt, Mumbai, Tokyo or Taiwan stock exchanges. And even if you have superior research skills, you wouldn't be able to buy those stocks, anyway.

Enter international small-cap funds, such as the Vanguard International Explorer Fund (VINEX). For ease of use (as well as cost considerations), a vehicle such as this is the best way to gain exposure to foreign small-caps. The fund has an expense ratio of 0.36% -- pretty low for active management -- and invests in small- and mid-cap stocks from non-U.S. developed and emerging markets.

The list of VINEX's top holdings isn't exactly a "who's who" for Americans -- but that's the point. Heavily weighted stocks include Helvetia Holding, Smurfit Kappa Group, Glanbia, Storebrand ASA and Gujarat Pipavav Port. Yeah, not exactly the type of names in a run-of-the-mill American portfolio.

This is the type of investment that brings diversification to your overall strategy. It may seem like a bit of a "black box," especially if you are accustomed to doing exhaustive technical and fundamental research on your purchases. But again, that's exactly the reason for this type of investment. Diversifying into overseas funds gives you exposure to asset classes that you simply can't research or buy on an individual basis. 

At the time of publication, Stalter had no positions in any of the securities mentioned.