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Morningstar Fund Spy

Bottom Quartile, Eh? I'll See You in Court
The news that a fund firm is being sued for underperformance might make some of you rejoice. It shouldn't. Although it's tempting to side with the alleged victim (Unilever's pension fund) against the big, bad fund company (Merrill Lynch's Mercury Asset Management), a Unilever victory in this British court case would likely have negative consequences for U.S. mutual-fund shareholders.

According to reports in the Financial Times and The Wall Street Journal, the crux of the case is this: Unilever says it signed a contract with Mercury that stipulated Mercury wouldn't lag an undisclosed benchmark by more than three percentage points for any four consecutive quarters. Mercury did, and Unilever sued. The pension fund is asking for 100 million pounds (about $165 million) in damages.

Here's why I'm not cheering for a Unilever victory. At the most basic level, it would encourage the dangerous bull-market sentiment that investing should be risk-free. If your fund thrives, you win; if it doesn't, you sue. Second, it would accelerate the trend toward "closet indexing." If lagging a benchmark can land fund managers in court, all the more reason for them to simply ape the benchmark. (Without lowering fees, of course.) Last Sunday's New York Times ran an article showing how widespread this trend already had become even before the court case hit the news.

A successful Unilever suit also would encourage shareholders to judge fund managers on short-term performance. In its response to the suit, Mercury points out that before this rough 12 months, it had provided Unilever with nine years of fine returns.

The fourth potential consequence is perhaps the most insidious: Should Unilever win a large judgment, U.S. fund firms would likely react by taking out insurance against a similar judgment against themselves. Don't be surprised if the cost of the premiums is borne by fund shareholders.

Small Stocks, Large Questions
International small-cap funds have posted incredible returns over the past 12 months. Does that mean it's time for you to jump in? I can't provide that answer; nobody knows the "right" time to get into certain part of the market, though plenty of people are willing to guess. But I can tell you that if you want to buy a foreign small-cap fund, simply choosing one of the best performers is not the way to go.

One reason is that the manager who racked up that record might be gone. Nothing puts a shine on your resume like a 70% return, so it's not surprising that managers at two of the most successful international small-cap funds recently changed employers.

Tracy Stouffer, the key member of the team that led Federated International Small Company ISCAX to the best three-year return in the entire foreign-stock category, left that fund this summer; she now runs Founders Passport FPSSX. Her replacement, Leo Vila, has experience with the fund, but there's no telling if he can duplicate her success.

Similarly, Pilgrim International Small Cap NIGRX lost two members of its team to Loomis Sayles a few months ago. Another of their colleagues at Nicholas-Applegate (the firm that subadvises the fund) also departed. Unlike Stouffer, John Tribolet and Alex Muromcew were not the lead managers of the Pilgrim fund, but between the defection of these managers and the sale of Nicholas-Applegate's retail business to Pilgrim, the managerial situation at Pilgrim International Small Cap isn't as stable as one would like.

So why not go with one of the biggest and oldest of these funds--Oakmark International OAKIX? Or its sibling, Oakmark International Small Cap OAKEX? No manager changes to worry about here: David Herro and Mike Welsh are still in charge of both funds. But to own these funds without going crazy, you must be firmly committed to the managers' deep-value approach. The out-of-favor stocks they own can struggle for long periods before justifying the managers' faith. Herro and Welsh also invest hefty sums in emerging markets. So don't expect a smooth ride.

There's no reason these funds can't continue to succeed, though. The same goes for other leaders in the group, such as American Century International Discovery TWEGX (but are you comfortable with a momentum strategy?) or Acorn International ACINX (though with a $2 billion median market cap, it's as much mid-cap as small). But clearly, the standard advice to investigate carefully before you buy goes double for these adventurers.

Stat du jour
Oakmark International Small Cap's return in 1997's fourth quarter:
-23.9%