Small- and Mid-Cap Alternatives for American Funds Fans

A version of this article appeared in the May 2007 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. Fund Family Reports on Fidelity and Vanguard Funds are also available.

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 2007. 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 comprise 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, because many American Funds shareholders buy their funds that way. But I've included no-load offerings, too, for those who own American Funds through retirement plans and manage their own fund portfolios, 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.

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 --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.

 Heritage Small Cap Stock (HRSCX)--This fund employs two subadvisors. Growth skipper Bert Boksen has run half of the fund since 1995, and boasts a fine record at mid-growth charge Heritage Diversified Stock (HAGAX). Two managers just took over the other, more value-oriented half of the fund in January 2007, but they previously did a bang-up job in a four-year stint at  Pioneer Small Cap Value , and Hertiage has a history of good manager selection. This fund resides in the small-growth category, but it's far more valuation-sensitive than most rivals. A small asset base and 1.24% expense ratio bolster its appeal.

Foreign-Stock Options
 Columbia Acorn International (LAIAX)--I've long admired this Columbia subsidiary's growth-at-a-reasonable-price philosophy and a team structure that allows analysts to focus on the same industries for many years. (And so would American Funds' fans.) The fund has grown to a hefty $4.8 billion, but the telltale signs of asset bloat haven't appeared: The number of holdings hasn't changed much, its already-modest portfolio turnover hasn't declined, and the team hasn't moved up the market-cap ladder. What's more, the fund has delivered solid results with below-average volatility.

 T. Rowe Price International Discovery (PRIDX)--This foreign small/mid-growth no-load fund takes a more aggressive tack than the fund above; manager Justin Thomson and his crew won't shy away from small companies and emerging markets and have posted big gains in rallies. But they've also shown a knack for reigning in their bets in a sufficiently timely fashion to keep the fund afloat in difficult environments. Thus, the fund's record is stellar during Thomson's nine-year tenure. I'd like to see this fund close soon, but T. Rowe has generally done a good job with fund closures, and the fund's 1.24% expense ratio is appealing.

 Putnam International Capital Opportunity (PNVAX)--Putnam's market-timing issues and subsequent personnel turnover made me wary in the past, but its long-accomplished international team has recovered from the loss of its two most senior managers, and Putnam has taken big strides to become a more shareholder-friendly shop. I think the fund's approach is a sensible, prudent one: The managers focus on companies with solid competitive advantages that generate strong returns on capital. While the fund's recent returns, relative to its foreign small/mid-value rivals, look just so-so, a willingness to pay up a bit for companies with solid profit growth has held it back in value stocks' rally.