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International Small-Cap Funds Defy Global Equity Slide

Hidden gems and a focus on domestic economies have produced robust inflows and solid returns. Narrowing the risk gap.

As global equity benchmarks have skidded this year, many international small-cap funds that invest outside the U.S. have either held their own or shown positive returns. “Overall, international small-cap funds are doing better than the large-cap funds, no matter if they invest in growth or value. Clearly there’s some advantage to the smaller ones this year,” says Gregg Wolper, senior mutual fund analyst at Morningstar.

The relatively better performance of international small caps belies the notion that they are riskier than U.S. small caps, according to Roger Edgley, lead portfolio manager at the Wasatch International Small Cap Growth Portfolio, an international small-company growth fund. Edgley finds the perception of greater risk on the international level to be outdated. Small companies in emerging markets have “narrowed the gap” with U.S. small caps, while “the really good companies in Europe and Japan are now world-class.”

The ability of international small caps to defy a broader slide by international large caps is reflected in the equity indexes. The MSCI All Country World index, an all-cap benchmark that excludes U.S. equities, has declined 5.71 percent year-to-date as of September 21. By contrast, Morningstar’s Foreign Small/Mid Growth index has gained 4.29 percent year-to-date, while the return on the MSCI index for small companies outside the U.S. is close to even at –0.09 percent for the year.

Demand for international small caps has been boosted in part by net inflows from institutional investors. During the second quarter of 2015, investors shifted $970.9 million in assets into this fund category, according to eVestment, a Marietta, Georgia–based investment data firm. This marked the seventh consecutive quarter of net inflows. Over those seven quarters, investors boosted by $5 billion their net allocations to international small caps outside the U.S. Most of that gain in net inflows, $3.87 billion, occurred over the past four quarters.

Because there is a lack of research and only sporadic media interest in most international small companies, shoe leather investigative efforts can lead fund managers to hidden gems the markets have not yet discovered, which can provide solid returns over time. “It’s a huge opportunity set — almost every small-cap company outside the U.S.,” says Edgley. The $2.4 billion Wasatch International Small Cap Growth Portfolio typically holds stock in 80 to 90 firms, whereas the $455.9 million Wasatch International Micro Cap Portfolio has 150 to 160 names.

The universe for international small-cap companies is 17,000 names, each with less than $2 billion in market cap outside the U.S. in 45 developed and emerging markets, according to Robert Cresci, senior fund manager at the $120.1 million JO Hambro International Small Cap Equity Fund. “Our focus is on very high quality, very transparent companies, Cresci says. “If we can’t meet management and do a site visit, we won’t invest in a company. So nothing gets into the portfolio without doing that exercise.”

The right portfolio of international small caps can provide investors with a way to avoid the pitfalls of large-cap cyclicals, especially companies exposed to the slowdown in China, according to Edgley. “We’re getting more of the domestic economic exposure or theme — and it’s an interesting one — rather than owning something like Royal Dutch Shell, which is going to be highly correlated with Exxon,” he adds.

Wasatch prefers moderate growth stocks that pay dividends and offer a high return on capital: companies like YOOX Group, an Italian Internet retailer that made the cut for the fund’s portfolio. “We’re not looking for high-growth, shoot-the-lights-out type of companies. We like highly profitable, Steady Eddie types of companies with long duration,” says Edgley.

Wasatch’s investing strategy is reaping attractive rewards. The Wasatch International Small Cap Growth Portfolio returned 5.41 percent year-to-date as of September 22. Its five-year return is 9.62 percent, placing it in the top quartile in its fund category, according to Morningstar.

The interest in small caps may provide investors a way to diversify away from their exposure to international large-cap funds that have been weighed down by a rising dollar and that may be unlikely to snap back any time soon. “Some people are investing in international small caps because they believe these funds have a chance of bouncing back,” suggests Morningstar’s Wolper.

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