Don't Give Up on These Three Foreign Funds

In a January Fund Spy column, we wrote about five prominent international funds that had delivered less-than-inspiring relative performance in 2005. We figured shareholders of those funds--not to mention other curious observers--would be wondering why those funds hadn't capitalized on the great foreign-market rallies as effectively as had so many of their peers. Were those laggards still worth holding on to?

Here, we'll look at three more international funds whose shareholders face the same dilemma. Of course, we should immediately point out that investors should never judge any fund simply on one year's worth of performance. Only over much longer periods can a manager and fund be fairly assessed. Yet there's nothing wrong with a watchful shareholder trying to figure out why a fund performed as it did even over shorter stretches, especially if its results are notably strong or weak in relation to its competition. After all, doing so can help assure that shareholders fully understand the fund's strategy and how that approach should respond to various market conditions--knowledge that is crucial if one is to feel comfortable owning the fund over the long haul. And in some cases a look at poor short-term performance can lead to the discovery of deeper problems or changes that do make the fund less attractive to own.

Moreover, this exercise also provides a framework that readers can use to evaluate the performance of their own funds, not only over the period in question but over longer, more significant periods as well.

In the case of these three funds, the investigation yields an interesting result. As it turns out, each of them either has a reasonable explanation for the disappointing performance or otherwise provides reason for optimism that an improvement could be on the way.

 Templeton Foreign Smaller Companies 
This fund has managed to post a 15% gain over the trailing 12-month period through March 15, 2006. Although that kind of return earned consistently over the years can make an investor quite well-off, under the circumstances it's not impressive at all. The foreign small/mid-value category average over that stretch is a hefty 21.6%; this fund's return lags behind 90% of its compatriots in that group.

Prior to 2005, this fund had a more respectable, if not spectacular, record. Just as important, we consider the Templeton organization to be one of the more reliable options in the international arena. So what's the story here? Should the recent underperformance be taken as a red flag?

No, it shouldn't be. There are legitimate explanations for the result, and--a key factor--they reflect the long-held beliefs and strategy of the fund's managers and of Templeton. First, the fund had a far-below-average stake in the Japanese market. That alone would have held the fund back, as Japan was the strongest big market in 2005, and even after a recent slowdown, the trailing 12-month average for the Japan-stock category is a full 10 percentage points higher than that of the Europe-stock group. A miniscule energy stake also didn't help.

While the fund certainly could have performed better, these explanations provide some reassurance. Templeton has been wary of Japan for many years now, and the managers continue to argue that the share prices of most Japanese companies reflect unrealistic expectations. And the portfolio is more value-oriented than its average category peer--which also reflects Templeton's long-held investment philosophy. That tilt cost the fund, as small growth has topped small value by a huge margin over the past 12 months.

The lead manager here, Tucker Scott, only took over that role in 2005, but he's no newcomer; he first joined the team as comanager in early 2000. Meanwhile, recognizing that it can't totally ignore its underperformance here, Templeton has reorganized its analyst staff, placing more emphasis on dedicated small-cap research. While we aren't putting a "buy" on this fund, it's worth watching, and shareholders definitely need not jump to sell it in favor of a more appealing small-cap rival (which, given how few of them remain open to new investors, wouldn't be easy to find anyway).

 USAA International (USIFX)
This fund lags more than two thirds of its foreign large-growth rivals over the trailing 12-month period. That's not as severe an underperformance as those of the other two funds listed here, and the fund is off to a strong start in 2006. But given that it also trailed behind the MSCI EAFE Index in its past three calendar years, shareholders might be wondering if the time has come to bail.

The answer here, too, is no. One reason is that managers of this fund have more experience than it might appear at first glance. They took over this fund in 2002, but one of them, David Mannheim, has run  MFS Global Equity (MWEFX) for more than a decade, and his record there is strong. That fund has beaten about two thirds of its world-stock peers over both the trailing five-year and 10-year periods and has topped the MSCI World Index by meaningful margins in both periods as well.

In 2005, USAA International--like  Templeton Foreign Smaller Companies --was held back, relatively speaking, by its underweights in Japan and energy (though it wasn't as lacking in them as Templeton was). And as for lagging EAFE, all growth-oriented funds have had a handicap in keeping up with that blend-oriented index in the past few years as large-growth stocks have lagged large-value. It's not that this fund is blameless for missing out on the full potential of 2005's rallies. Rather, given Mannheim's long-range record, the fact that the fund's volatility level is much milder than those of most peers, and the likelihood that shareholders have embedded capital gains in their position, it's far from clear that selling the fund now would be a wise move.

 Wasatch International Growth (WAIGX)
This foreign small/mid-growth fund is in a somewhat different position than the previous two. First, it's closed to new investors. Second, its lackluster performance not only in 2005 but in the prior two years would, indeed, have been a signal to sell, for a variety of reasons. But then, in November 2005, the fund replaced its manager--whose aggressive approach simply had not produced acceptable results--and revised its strategy, and that changed the picture.

Now that the fund has new management and strategy, shareholders sitting on substantial capital gains in taxable accounts should stand pat unless they truly want to get out of the foreign small-cap arena entirely. And it's likely that most are sitting on substantial gains, for despite a bottom-quartile ranking over the trailing three-year period through March 15, the fund has posted a remarkable 37% annualized return over that period.

Even if it were open, we wouldn't recommend that new investors buy into this fund right now, given that its new managers don't have much in the way of prior records on a similar funds. Moreover, this fund's expense ratio is dauntingly high. But the chance of a turnaround under new managers using a less-risky strategy--plus the very small number of attractive foreign small-cap alternatives still open--make holding on a reasonable decision. Keep a close eye on it and see how things play out. You can always sell in the future if you're still not satisfied.