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ETFs open doors to dynamic small firms overseas

An employee sorts apples at a plant in Grojec, Poland.

Filip Klimaszewski/Reuters

Do you invest in Western multinationals? Think they give you exposure to emerging and international markets because they do business in those places?

You just might want to pay attention to which sport utility vehicle affluent Chinese families are driving these days.

That's what Tyler Mordy, president and chief investment officer at Forstrong Global Asset Management in Toronto, does. While the overall SUV market is growing in China, the big winners aren't the major global car companies. Sales of domestic Chinese-branded SUVs are up 30 per cent, compared with 12 per cent for foreign brands.

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"Globalization is a double-edged sword. There are new opportunities, but there is also new competition," Mr. Mordy explains.

Good to know. But how can individual investors buy into the smaller-cap companies that are playing a part in this shift?

After all, deciding to purchase shares in, say, Gopala Polyplast Ltd., a small, successful packaging company in India, means not only knowing the business exists but addressing concerns about liquidity and conducting plenty of research on market and country stability.

It also means giving up home-country bias. Only about a quarter of Canadians hold foreign investments in their portfolios, according to a 2013 Bank of Nova Scotia poll.

"I think a lot of people are genuinely uncomfortable investing in international markets because they don't feel they understand them. I find that clients and their advisors both feel that way," says Benjamin Felix, an investment adviser with PWL Capital Inc. in Ottawa.

But attitudes and comfort levels may be changing now that exchange-traded funds that invest in small-, mid- and micro-cap companies have come onto the scene. (ETFs track an index, commodity, bond or asset basket much like an index fund, although they trade like common stock on a stock exchange.)

ETFs are a game changer when it comes to gaining exposure to the global small-cap sector, Mr. Mordy says. "Without sounding hyperbolic, it has been a paradigm shift for the portfolio construction process," he says. "We've seen a whole wave of managers move from traditional stock-picking to picking global themes, trends, sectors and even countries."

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Individual investors are following suit. Mr. Mordy says he has noticed a different tone lately at his company's client events held twice a year. Recently, investors have been asking him more questions about China and emerging markets, for instance.

"If you think back 10 or 20 years ago, you typically wouldn't get that. You'd get questions like, 'What do you think of Apple stock?'" Mr. Mordy says.

A few examples of global small-cap ETFs are the iShares MSCI EAFE Small-Cap ETF with exposure to small public companies in Europe, Australia, Asia and the Far East, and Vanguard FTSE All-World ex-U.S. Small-Cap ETF, although this one includes a small chunk of Canadian holdings. With their high volatility and thus possibly high returns, small-cap ETFs can give diversification oomph to a conservative portfolio.

Selecting a country-specific ETF is another option for those wanting small- and micro-cap exposure overseas. Vietnam, with its relatively new, but maturing, capital market offers a range of offerings. The Vietnam ETF (VNM) is composed of 54 per cent small- and micro-cap stocks, for instance.

Poland's emerging economy is another option. The country has a large number of young households and favourable credit ratios. Because of a weak Polish zloty and a comparatively robust euro, European multinationals that outsource their manufacturing to Asia have started looking at Poland instead. Market Vectors Poland ETF (PLND) is a passive ETF that seeks to replicate the Market Vectors Poland Index, and consists of approximately 30 per cent medium, small and micro-cap companies.

Not all ETFs are created equal. Matthew Phillips, director of wealth management and portfolio manager for Richardson GMP Ltd. in Guelph, Ont., contends that while ETFs offer exposure in formerly out-of-reach markets for a low cost, "factor based" ETFs may be the way to go. These hybrid funds are tweaked so they don't simply going up and down with an index. They can offer better returns, or less risk, to the investor.

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Timing is important, too. Mr. Phillips, who adheres to a momentum investing strategy (buy high and sell higher), looks at what's happening in Europe and China and questions whether it's a good time to enter volatile markets on the downswing."I wouldn't just buy because they've gone down. Within the industry, we call that 'catching the falling knife,'" he says. "I can't tell you where the bottom is. I would much rather wait for the bottom to be found, and as things move higher, that's when you jump in."

But that would require active management, and Mr. Felix isn't sure whether highly volatile small-cap investing is appropriate for DIY investors – even those using ETFs – unless they're in it for the long term and can ride the waves. The trick is to consider global small-caps as just one part of an overall portfolio strategy and to get in early.

"There's never a bad time to start investing," he says. "As long as someone has designed a portfolio that's right for them in any market, then now would be a good time to be investing in small-cap international stocks."

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