Getting out of a headwind

What should replace the struggling smaller stocks in our exchangetraded fund portfolio?

We’re almost finished reviewing our MoneyWeek exchange-traded fund (ETF) model portfolio, and it’s our investment in UK small caps that looks the most troublesome, as we’ve analysed extensively in the last few articles. This investment is one of the “satellites” to our “core” of large-cap global equities and government bonds, intended to offer greater growth or protection against certain risks. Small caps were originally held for growth, but lately they’ve not delivered much of that.

We could hold on to our position in Vanguard FTSE 250 (LSE: VMID), on the basis that the UK is deeply out of favour and may eventually stage a strong recovery. But we have 10% of our portfolio in a single country of shrinking global importance with deep structural problems, and it’s not clear what the catalyst for improvement will be. As good companies are taken private, the market shrinks and the quality of what’s left declines. That’s a headwind for the index investor (unlike stockpickers who might benefit from takeovers).

Go global or change course?

If we think small caps are cheap, we could switch to a global tracker, such as iShares MSCI World Small Cap (LSE: WLDS). This has certainly done better than the UK (see chart). But we would be increasing our exposure to the US (about 60% of the index). Meanwhile, small caps are lagging large caps even in the US and they don’t look especially good value there: the MSCI US Small Cap is on a forward price/earnings (p/e) ratio of 19.

We could consider sectors that offer some kind of diversification. Many sector trackers don’t deliver what you expect (see issue 1193), but we’ve used SPDR MSCI World Energy (LSE: ENGW) before as inflation protection. Energy is the opposite of the hot tech sector that is driving markets: it is relatively cheap (forward p/e of 10.5) and tends to have relatively low correlation to the wider market. This is always on my watch list – but as I noted when removing it from the portfolio last year, this does not seem like the right energyprice environment to be strongly bullish.

We could look at alternative assets, such as infrastructure – a popular choice with many investors who want a steady income that should rise with inflation. Could it help us? One risk is growing political pressure about investors earning high returns from vital assets. Another is that higher interest rates crimp returns: infrastructure investments often use a lot of debt. But the immediate problem when you look at ETFs such as iShares Global Infrastructure (LSE: INFR) or SPDR Morningstar Multi-Asset Global Infrastructure (LSE: GIN) is that they don’t quite hold what we want. They are full of utility stocks and short of investments that simply earn rent-like returns from assets. Trailing returns of 3%-3.5% per year over five years are not compelling.

So nothing stands out amid the obvious asset classes. Instead, explicitly tilting this last part of our portfolio towards factors such as value or momentum might be the easiest way to target some different sources of return. We’ll look at a couple of options for this next week, as we wrap up our review ahead of the new tax year.