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Five Terrific Sources of International Spice

These fine foreign funds have more than their share of diversification value.

William Samuel Rocco, 11/25/2009

The exact portion varies from fund to fund and over time, but foreign large-cap offerings normally invest the lion's share of their assets in blue chips from developed markets. Funds that focus on foreign smaller caps and offerings that concentrate on emerging-markets stocks, therefore, make the best complements to most investors' core international holdings. And there are a number of good to great options in the foreign small/mid-growth, foreign small/mid-value, and diversified emerging-markets categories.

Of course, some investors have the resources to build a multi-fund international portfolio and thus have the freedom to supplement their core foreign holding with both a foreign small/mid-cap fund and an emerging-markets offering. Other investors are naturally drawn to one type of complementary international fund or the other, either because of their personal tastes or because of the composition of their foreign large-cap offerings. For example, those especially keen on the growth prospects in the developing world have considerable incentive to add a dedicated emerging-markets offering, while those who own a giant-cap-oriented core foreign fund with a large emerging-markets stake likely would choose a foreign small/mid-cap vehicle as their diversifier.

But investors looking to get exposure to both small/mid-size stocks and emerging markets in the same fund do have some good alternatives. Below are details on several such offerings.

AIM International Small Company IEGAX
This foreign small/mid-growth fund's managers readily consider emerging-markets opportunities as they pursue small firms with strong earnings potential, healthy financials, and reasonable valuations. Indeed, this fund currently has more than one fourth of its assets in emerging-markets names, and it frequently has more than the category norm of approximately 12% in such issues. And thanks to the strength of the managers' stock selection in both the developed world and the developing world, this fund has handily outpaced its average rival since opening in 2000. Its hefty emerging-markets stake and some of its other distinctive traits backfired in awful 2008, and this fund has been more volatile than most of its peers, but bold investors who are seeking an overseas diversifier have ample reason to give it a look.

Columbia Acorn International LAIAX
This fund is more temperate than most of its foreign small/mid-growth rivals in several respects. Managers Louis Mendes and Zach Egan insist that their picks have reasonable valuations as well as healthy growth rates, and they're more committed to issue, sector, and country diversification than most of their counterparts. However, while they do avoid making big bets on individual developing nations, they're quite comfortable building a big emerging-markets position overall. This fund has roughly one fifth of its assets invested in the developing world at present and has had similarly sizable stakes in the past. Mendes and Egan have executed their strategy well in a mix of climates, and this fund has earned strong risk-adjusted returns during their 6.5-year tenure. It also has an attractive expense ratio and is a good source of smaller-cap and emerging-markets exposure. PAGEBREAK

MFS International New Discovery MIDAX
This fund has a much bigger average market cap than the foreign small/mid-growth norm, partly because its managers will stick with a holding that became a large cap as long as they continue to like its fundamentals. But this fund still provides plenty of exposure to smaller caps. It also provides a significant amount of exposure to emerging-markets stocks--it currently has one fifth of its assets in such issues. The fund's managers look for high-quality companies with strong balance sheets and steady growth prospects that are trading at fetching prices. This fund has been less volatile than most of its peers and held up well in down markets. But it's no slouch when it comes to returns: It has comfortably outgained the category average over the mid and long runs, thanks to its managers' stock selection. It's worth serious consideration from investors who are looking for a relatively conservative complement to their core international holding.

T. Rowe Price International Discovery PRIDX
This foreign small/mid-growth fund offers quite a bit of diversification value. Skipper Justin Thomson focuses even further down the market-cap ladder than most of his peers. He pays ample attention to emerging-markets names as he focuses on firms with rapid earnings growth, robust sales growth, and strong returns on equity. This fund's average market cap tends to be about half the category norm, while its emerging-markets weight tends to be much heavier than the group average. (It's 19% of assets at present.) Thomson has produced superior results with this fairly bold approach in this year's surge and most other rallies, so this fund boasts impressive long-term returns. And although it certainly has had its rough spells, it hasn't suffered much more volatility than its average peer overall. Its relatively modest expense ratio is another plus. Risk-tolerant investors who are looking to add some pop to their international portfolios should check this fund out.

Templeton Foreign Smaller Companies FINEX
This fund is more adventurous than most of its foreign small/mid-value peers in a number of ways. Lead manager Brad Radin goes wherever the best bargains are and buys stocks in bunches as he looks for companies that are cheap relative to their assets or projected earnings. He favors relatively small firms and doesn't hesitate to buy in emerging markets. Indeed, this fund's average market cap is roughly one third the group norm of $2.4 billion and its emerging-markets position is triple the category average of 10% currently. These bold traits caused the fund to suffer even more than its typical peer in the late 2007 to early 2009 worldwide meltdown, and they're likely to lead to additional rough spells. But Radin has guided this fund to spectacular gains in this year's rally, and while he has only been at the helm for a couple of years here, he has earned strong returns with the same strategy during his 11-year tenure at a similar Canadian offering. This fund is a good international diversifier for hard-core value investors.

Conclusion
These five funds do come with three caveats. First, funds that focus on foreign smaller caps are explosive by nature, and those that pay extra attention to emerging-markets issues are taking on additional risk. Thus, even the more moderate members of this quintet require a real tolerance for volatility. Second, overseas small- and mid-cap stocks have posted spectacular gains in the rally that began in March of this year--and their emerging-markets counterparts have fared even better. Huge upswings often lead to sharp downturns. This means that investors should be sure they have realistic short- to mid-term expectations for these funds. And third, it's capital gains distributions season. Therefore, investors who are shopping for taxable accounts should check to see if the fund they're interested in is slated to make a distribution and, if so, wait until after the fact to make their purchase.

William Samuel Rocco is a senior fund analyst at Morningstar.

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