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Four Ideas for Exposure to Foreign Small Caps

Most of the good ones are closed--but not all.

Russel Kinnel, 05/08/2007

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition. Fund Analyst Picks are available on Premium Morningstar.com.

No doubt about it, foreign small-cap funds have had an amazing run. A global small-cap rally and a falling dollar have led to outstanding returns for foreign small-cap funds, and that has spurred many to close the doors to new investors. In fact, all of our foreign small/mid-value and foreign small/mid-growth Fund Analyst Picks are closed.

As a result, I'm fielding a lot of questions about where one can turn for a good foreign small-cap fund. I've come up with a few ideas, but first I have to share a big caveat. Whenever an asset class has such hot returns that funds are closing left and right, the savvy investor steers clear. It usually means that the securities are due for a correction, and it always means the risks of a correction have gone up considerably.

Moreover, you don't have to own a fund dedicated to foreign small caps to have some exposure there. Check any foreign or world-stock funds you own and you might find they have a meaningful slug of small- or mid-cap stocks. However, if you don't have any foreign small-cap exposure and plan on holding for 10 years or more, I can see some merit in establishing a small position in foreign small caps.

With that in mind here are few ideas that you might want to consider.

T. Rowe Price International Discovery PRIDX
When T. Rowe took sole control of its foreign asset-management wing about seven years ago, it kept its managers but lost its analysts. As a result, T. Rowe has been in rebuilding mode, and overall its foreign funds have been decent but not as good as its domestic funds. It has made progress, however, and management has done a fine job here. The fund has modest costs (not easy to find in foreign small cap) and a sound strategy, and it is diversified so that it tones down the volatility of a high-risk asset class, though it's still pretty volatile.

Polaris Global Value PGVFX
This fund isn't all small caps and it isn't all foreign, but it still has a big chunk of its portfolio in small caps. It actually follows an all-cap strategy and has a fair amount in large, mid-, and small caps. I like the fact that its asset base is modest and costs are reasonable. Manager Bernard Horn Jr. has done a great job of blending quantitative screens with fundamental value analysis. He equal weights roughly 75 stocks that make up the portfolio in much the way other quant funds will because such funds have faith in their process more than any one stock. The fund has performed well since its 1998 inception.

DFA International Small Company DFISX
This fund actually is a pure foreign small-company fund. The catch is that you probably can't get in. It is for institutional investors and individual investors who go through a select group of planners who are dedicated to indexing and even attend DFA's seminars. If you can get in, though, the funds are great. The idea is to essentially use a passive indexlike strategy but to make money on trading by acting as a provider of liquidity. In other words, it keeps overall exposure in line with the broad small-cap market but will buy or sell in bulk in order to get a better price. Because foreign small caps can be rather illiquid, many foreign small-cap funds start off with a big disadvantage on trading costs. Simply having lower trading costs and expenses has led this fund to strong returns.

Hartford International Small Company HNSAX
This fund is more of a gamble than the above funds. The reason is that costs and the track record aren't as good. The expense ratio is 1.58% on this 2-star fund. However, the good news is that the current management team from Wellington has only been at the helm since 2006. Given Wellington's strong firmwide track record, it's easy to imagine relative performance perking up. And if it does, that should attract assets and then expenses would likely come down a bit.

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