Young & Invested: Why this popular ETF might not be the best way to access the market
Investors often assume the cheapest ETF is the best option, but that may not be the case in one corner of the Australian market.
Mentioned: Vanguard MSCI Australian Small Coms ETF (VSO)
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 77
Australian small caps are back in the headlines. Depending on who you ask, they’re either positioned for a comeback, entering a new golden age ofmarketleadership, or simply enjoying their turn in the spotlight before everyone gets bored and goes back to talking about CBA.
The renewed attention is attributed to our small-cap market having significant exposure to the resources sector where there appears to be a growing enthusiasm around minerals and periodic whispers of a new commodity cycle.
As tempting as it is to make a sweeping prediction about the future of small cap performance and then delete this article if I’m wrong, that is not what we’re doing today. Many investors are looking for growth beyond the ASX’s largest names and naturally, some land on small caps.
Vanguard’s MSCI Australian Small Companies Index ETF (VSO) is the largest Australian small-cap ETF by assets under management. Despite being low cost, broadly diversified and delivering strong category-relative performance, I’ll be looking at why our analysts aren’t convinced that this is the best way to gain access to the market segment.
Vanguard MSCI Australian Small Companies Index ETF VSO
- Assets under management: $1.2 billion (AUD)
- Morningstar category: Fund Equity Australia Mid/Small Blend
- Morningstar Medalist Rating: Neutral
- Management fees and costs: 0.30%
- Benchmark: ASX Small Ordinaries (XSO)
VSO tracks the MSCI Australian Shares Small-Cap Index, which is designed to capture the smaller end of the Australian equity universe. MSCI defines this as the bottom 14% of free float market capitalisation.
Composition
The portfolio consists of ~190 stocks, with a median market capitalisation of $5.2B. Unlike broader ASX indices, no single position dominates the fund and the largest holding accounts for less than 3% of the total portfolio. A few familiar names include Bluescope Steel, Mineral Resources, NextDC and Ampol.
From a diversification perspective, our analysts believe the ETF does its job well. Investors receive broad exposure across the small-cap universe without taking on excessive company-specific risk, as the top ten holdings represent around 21% of the portfolio.
The index is concentrated around cyclical sectors such as materials, industrials and real estate. Notably, the sector composition of the broader small-cap universe has evolved significantly over time. Over 15 years ago, materials represented as much as 44% of the benchmark, but have now shrunk to ~29%.
However, this figure is still noticeably higher than the category average allocation to materials which is around 19%.
A broader issue
Investing commentary often purports several strategies to achieve outperformance, however I think there needs to be a reasonable discussion before diving into that.
Conclusions that support certain strategies often depend heavily on the starting point, end point and the benchmark chosen. Given enough data, it’s possible to build a convincing argument for almost anything.
That doesn’t mean the research highlighting the historical success of small caps is wrong. Rather, investors should know what market the research is based on. Just because one small-cap index has delivered strong long-term returns doesn’t mean another will produce the same outcome.
This is why understanding index construction is a crucial part of the bigger picture. The rules the index defines itself by will ultimately determine investor outcomes.
When people discuss the long-term benefits of small-cap investing, much of the evidence comes from global research that shows smaller companies have historically delivered higher returns than larger ones. Australia is somewhat unique in this sense. Our domestic small caps have generally struggled to replicate the same level of outperformance achieved by their international counterparts.
One reason is the scale of our market. Globally categorised ‘small caps’ are on average, two times larger than their Australian peers. To provide a clearer perspective, SanDisk, which is currently the largest constituent in the MSCI World ex-Australia Small Cap Index, is larger than any company on the ASX at ~240 billion USD. Comparatively, Vault Minerals, the largest constituent on the ASX Small Ordinaries has a market cap of 6.5 billion AUD.
The implication is that Australian small caps are often businesses that are much earlier in their lifecycle. Naturally, this creates the potential for extraordinary growth, but it also introduces greater earnings uncertainty, higher business risk and a larger dispersion between winners and losers.
Another factor that influences small-cap returns is our sector composition. The Australian small-cap market contains a large allocation to mining and materials companies. Many are junior operators still in the exploration or development phase, often generating little or no profit while relying on equity raisings to fund growth.
Global small-cap benchmarks look very different. The MSCI World ex-Australia Small Cap Index is primarily comprised of industrials and financials. Many of these are often established businesses with more predictable earnings streams.
In other words, it’s important to acknowledge that “small caps” are not a universal category. An Australian small-cap portfolio will look fundamentally different from a global one despite sharing the same label. Investors should be careful about applying conclusions from one market to another.
Fees and performance
One of this fund’s biggest advantages is its low fees. The ETF charges 0.30% annually, placing it among the cheapest options in the Australian small-cap category where the median fee is 1.44% p.a. Given the higher fees charged by many active small-cap managers, this introduces a significant cost advantage.
Fees are considered a strong predictor of future success and in many asset classes, active managers often struggle to overcome their higher costs and fail to outperform their passive counterparts in the longer run. Australian small caps have proven they might be an exception.
Over the decade to October 2025, VSO delivered annualised returns of 10.7%, slightly below the 10.9% average return generated by its active peer group. Though the gap is small, the broader point is despite the significantly higher fees, active managers have broadly been able to keep pace with the passive alternatives in this market segment.
However, if we look at the broader category of small cap funds (passive and active), VSO has outperformed over most time horizons. I think this highlights an important distinction to make.
The question isn’t whether VSO is a ‘good’ or ‘bad’ fund. By category standards, its low fees, broad diversification and long-term returns make it a perfectly reasonable option. The key question is whether an index is the most effective way to access the small cap market in the first place.
Why we rate this ETF neutral
Our analysts assign a Neutral Medalist Rating to VSO ETF. Importantly, this rating does not reflect concerns around implementation. We believe the fund tracks its benchmark efficiently and provides reliable exposure at a low cost. The issue lies with the underlying market itself.
Unlike large-cap Australian equities, the small-cap universe remains relatively inefficient. Many companies receive limited analyst coverage and attract little institutional attention. This creates opportunities for skilled active managers to identify mispriced businesses before the broader market catches on.
Active managers also have the discretion to avoid companies with deteriorating fundamentals, weak balance sheets or speculative business models, all things that a broad index fund generally won’t be able to avoid. As long as a company remains in the index, it must be owned regardless of quality.
This flexibility matters most in Australia where a meaningful portion of our small-cap universe consists of unprofitable or highly speculative businesses.
Another area where active managers have the advantage is when successful small companies grow into larger businesses. Active managers can continue holding these winners as they mature, whereas index funds are typically required to sell them once they graduate into a larger market-cap benchmark.
The result is that active managers have historically found it easier to outperform in Australian small caps than in many other market segments. Despite the higher fees involved, we favour an active management approach in this market segment.
