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ETF Specialist

Passive vs. Active: Debating International Small Caps

Passively managed funds are a viable option thanks to low fees.

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An important decision investors make is whether to use an active or passive strategy in a particular segment of their portfolio. Passive investing is popular for more "efficient" areas of the market, but less-efficient areas, like international small-cap stocks, are thought to provide active managers more opportunities for outperformance.

Passive and Active
An examination of all mutual funds from the Morningstar international small/mid-cap categories (value, growth, blend) shows that the categories are littered with underperforming funds. We created a data set of all actively managed mutual funds in Morningstar's international small-cap growth, value, and blend categories from the beginning of 2001 through the end of May 2014 and calculated the group's average alpha relative to the MSCI EAFE Small Cap Index. Alpha can be an indication of the unique skills a portfolio manager brought to the table. Three-year return data (from June 2011 through May 2013) was used. The average alpha produced by the active funds over the past three years was 0.02, or almost zero. An investor picking from the broad list would have a less-than-50% chance of picking an outperforming fund. However, it is important to note that the international small-cap categories are somewhat heterogeneous. Funds can invest only in developed markets, or include a slice of exposure to emerging markets. Regional exposure, in addition to stock selection, drives return. In years when emerging-markets stocks outperform, funds with exposure to the region will have a boost to return relative to the category regardless of their stock-picking skill.

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Abby Woodham does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.