Good small- and mid-cap funds that can take the place of Smallcap World.
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
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
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.
Columbia Small Cap Value II
Masters' Select Smaller Companies