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Alternatives for American Funds Fans

Good small- and mid-cap funds that can take the place of Smallcap World.

Greg Carlson, 06/05/2007

A version of this article appeared in the May issue of Morningstar's American Funds Fund Family Report, our monthly newsletter dedicated to helping American Funds investors find superior long-term investment opportunities. To review a risk-free trial issue, click here. All figures are as of May 15, 2007.

Investors looking for dedicated exposure to U.S. and non-U.S. small- and mid-cap stocks within the American Funds lineup have just one choice: American Funds Smallcap World SMCWX. Every other equity fund from American has at least 75% of its assets stashed in large caps. And while it's true that both asset bloat and large caps' arguably more appealing valuations (after small caps' seven-year rally) have something to do with that heavy emphasis on behemoths, those funds have long invested that way. Even in March 2000--just as the bull market peaked and smaller, cheaper stocks began their run--just two of American's 15 equity and balanced funds (other than Small Cap World) invested more than 45% of their equity portfolios in small- and mid-cap stocks.

The dearth of other smaller-cap options at American hasn't been a big negative for investors--Smallcap World has performed respectably--but I think investors can do better. True, Smallcap World's long-term returns look good both in its current category--world stock--and relative to the funds in its former home, the small-growth category. However, neither category is an ideal fit, given the fund's focus on smaller firms all over the globe. When pitted against other world-stock funds with average market capitalizations under $2 billion, Smallcap World looks rather middling over the past five, 10, and 15 years.

Granted, the fund will likely look somewhat better versus that subgroup when growth stocks return to favor, but I think the fund also faces significant challenges going forward--starting with its $22 billion asset base. The fund's expanding girth has necessitated the addition of two portfolio managers since December 2002, bringing the total number if skippers to seven, according to publicly available information. As a result, the fund's list of holdings has gotten longer--it has increased about 70% over that span to a recent 581 equity positions, which may dilute future returns. Furthermore, the fund's size makes it difficult to establish meaningful positions in small-cap companies without swamping their shares and creating liquidity concerns. For example, of the fund's dozen largest U.S. holdings, its advisor owned at least 10% of the outstanding shares of five of them--and this fund was by far the largest (or sole holder) of four of those companies. Plus, the fund may own larger-than-10% positions in non-U.S. names. Its advisor isn't required to report these stakes in SEC filings as it is for its positions in U.S. stocks.

Look Beyond American
Fortunately, investors can find smaller-cap alternatives outside of American Funds that provide broad diversification and solid returns. True, it's difficult to find other world-stock funds with a similar focus to recommend--they're few and far between, and the only one I'm truly comfortable with, Templeton Global Smaller Companies TEMGX, closed to new investors at the end of April. However, investors can still find good, available choices that cover U.S. and non-U.S. smaller-cap stocks; they'll just need to buy a pair of them. Because U.S. equities compose roughly half of all stocks' market capitalization, I'd suggest a 50/50 split between a U.S. and non-U.S. fund. Following is a rundown of my favorites. I'm listing primarily broker-sold options, but I've included no-load offerings, too, for clients who own American Funds through retirement plans or use fee-only advisors.

It's worth emphasizing that I'm not recommending that investors bulk up on their exposure to small- and mid-cap stocks, whether domestic or international. In fact, given smaller firms' dominance in recent years, some portfolio rebalancing may be in order. But I think pairing a good domestic-stock fund with a good foreign-stock fund is a sensible alternative to Smallcap World.PAGEBREAK

U.S.-Stock Options
Columbia Small Cap Value II
COVAX
This small-value fund is one of the few accomplished options in its category that remains open. (It's relatively small at $600 million.) And while Columbia was tied up in the market-timing scandal, the firm has done a superb job of cleaning house, cutting fees, and instituting effective compliance systems. This fund's duo of Christian Stadlinger and Jarl Ginsberg, who have run it since its 2002 inception, opt for companies with lower valuations that have made some progress in turning around their fortunes, rather than deeply troubled fare, and won't shy away from so-called "growthier" sectors such as tech. Thus, their fine record isn't simply a product of value stocks' recent dominance. The fund is modestly priced, too.

Masters' Select Smaller Companies MSSFX
A collection of five talented subadvisors working independently lend this no-load fund its appeal. Each constructs a compact portfolio of his best nine to 15 ideas. The fund is less than four years old, but most of the skippers own superb long-term records. It has thus far landed in the small-growth corner of the Morningstar Style Box, but that's due to the managers' contrarian approaches in the face of small-value stocks' continued rally, as well as the value-oriented skippers' big cash stakes. That tack has proved costly thus far--the fund lags its benchmark, the Russell 2000 Index--but I think its prospects are bright. I also like that the fund's advisor has pledged to keep its size quite modest.

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