Summary SCZ has over 1500 holdings across the globe which appear to give it great internal diversification. The term “across the globe” might be overly optimistic since over 50% of the holdings are in two locations. The weakness for SCZ is that SCHC and VSS both offer materially lower expense ratios and more holdings for enhanced diversification. Since SCZ has a beta higher than 1, it has to be expected to generate fairly substantial returns. On top of the high beta raising required returns, SCZ also needs to be able to beat out SCHC and VSS to justify the high expense ratio. One of the funds I analyzed for exposure to international markets is the iShares MSCI EAFE Small-Cap ETF (NYSEARCA: SCZ ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. By reducing risk at the portfolio level investors can get their best shot at producing alpha. Expense Ratio The expense ratio for SCZ is .40% for both gross and net expense ratio. That may not seem bad for international small-cap equity and an ETF with 1555 holdings. However, investors should be aware that they also have options in the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) and the Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEARCA: VSS ). SCHC has an expense ratio of .18% and 1645 holdings. VSS has an expense ratio of .19% and 3352 holdings. It should be no surprise that I see SCHC and VSS as the strong front runners for this kind of portfolio exposure. In the interest of full disclosure, while I don’t have a position in any of these ETFs yet, I do have a pending limit-buy order on SCHC. That order is quite a ways under the current share prices and is only intended to activate if share prices start falling hard again. Geography The geography of the exposure is important in considering international equity options. The chart below demonstrates the exposure for SCZ. Japan and the United Kingdom only represent over 50% of the market capitalization of the holdings in SCZ. I’d like to see more exposure around the globe. This is international and I’m okay with excluding China since I’ve been bearish on their market for months, but I’d like to see a few more continents included. Aside from the concentration being so heavily focused on the top two options, I don’t see any other problems there. Sector Exposures The following chart has the sector exposures within the ETF: I’m not seeing this as a huge problem, but it seems interesting that the exposure is so heavily focused on a few categories again. If it were reasonably possible, I’d like to see better diversification across the industries as well as across the globe. International ETFs are usually plagued by having fairly high levels of volatility and more diversification within the sectors might reduce that volatility some. On the other hand, when financial markets exhibit significant stress factors, it is common for correlation levels to increase throughout international markets so even more diversification in the holdings might not make a material difference in the volatility. Building the Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to high yield bonds. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since the volatility on equity can be so high. However, the diversification within the portfolio is fairly solid. Long term treasuries work nicely with major market indexes and I’ve designed this hypothetical portfolio without putting in the allocation I normally would for REITs on the assumption that the hypothetical portfolio is not going to be tax exempt. Hopefully investors will be keeping at least a material portion of their investment portfolio in tax advantaged accounts. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA: HYS ) for high yield shorter term debt and the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) for longer term treasury debt. TLT should be useful for the highly negative correlation it provides relative to the equity positions. HYS on the other hand is attempting to produce more current income with less duration risk by taking on some credit risk. The Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. The iShares U.S. Utilities ETF (NYSEARCA: IDU ) is used to create a significant utility allocation for the portfolio to give it a higher dividend yield and help it produce more income. I find the utility sector often has some desirable risk characteristics that make it worth at least considering for an overweight representation in a portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard’s Vanguard S&P 500 ETF (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. Despite TLT being fairly volatile and tying SPY for the second highest volatility in the portfolio, it actually produces a negative risk contribution because it has a negative correlation with most of the portfolio. It is important to recognize that the “risk” on an investment needs to be considered in the context of the entire portfolio. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of TLT’s heavy negative correlation, it receives a weighting of 20% and as the core of the portfolio SPY was weighted as 50%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion SCZ is the most volatile investment in the portfolio when viewed in isolation as it has a volatility level of 18.7%. That problem is compounded by the high correlation between SCZ and the S&P 500. The combination leads SCZ to having a beta of 1.06% which is unfavorable. Under modern portfolio theory the only way to get risk adjusted returns on SCZ is for it to be outperforming the S&P 500 over the long run since it is increasing portfolio volatility. Will it outperform the S&P 500? I have no idea. The better question would probably be: “Will it outperform SCHC and VSS?” In that regard, I’m skeptical. It certainly could happen but SCHC and VSS have an advantage from having materially lower expense ratios which allow more of the returns to reach shareholders. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.