International small-cap stocks have beaten their large-cap global counterparts in recent years, following a trend of small-cap dominance in the U.S. Though international small-cap funds have been on a roll, benefitting from this strength, investors should still be selective since they have failed to beat their benchmark as a group.
We chose two S&P/Citigroup indices to compare the performance of international large-cap and international small-cap stocks. The S&P/Citigroup PMI (Primary Market Index) World ex-U.S. represents international large-cap stocks excluding the U.S., while the S&P/Citigroup EMI (Extended Market Index) World ex-U.S. is the small-cap version of that index.
The EMI has beaten the PMI not only on a year-to-date basis as of August 31, but for the one-, three-, and five-year periods as well. The EMI has done so by a wide margin, as shown in Table 1 below.
The international small-cap funds in Standard & Poor's database, however, have generally failed to beat the EMI index. We reviewed 126 funds, including multiple share classes. The group's average return trailed the index in the year-to-date, one- and three-year time frames, but did outperform in the five-year period. As a group, these funds beat the large-cap PMI during all four time periods.
International small caps also have compared favorably to U.S. small cap-stocks, which have outpaced U.S. large caps in recent years. The EMI beat the S&P Small Cap 600 index in the year-to-date, one- and three-year periods, although trailed the 600 during the five-year period.
We decided to screen for international small-cap funds that outperformed the EMI for the one-, three- and five-year periods ended August 31. Though nine funds met the criteria, five had minimum initial investments of $1,000,000 or more. The four remaining funds, which had sharply lower minimum initial investments, are listed in Table 2.
For funds that have been in existence for less than five years, four beat the index in the one- and three-year periods, and are listed in Table 3. The funds in both Table 2 and Table 3 are all ranked in order of their one-year returns. Currently, Standard & Poor's recommends only a 10% allocation to foreign stocks overall.
One thing to bear in mind is that international small-cap funds tend to have high expense ratios. The average for the funds we reviewed was 1.89%, with more than 40% of them charging over 2.0%. Though higher expense ratios in this asset reflect higher research costs, lower cost options exist. For instance, Vanguard International Explorer (VINEX), which charges just 0.73%, missed the cut in our screen based on its three-year annualized return, but not by much. However, the fund closed to new investors on August 19 in response to strong and rapid cash flows.
That should be a warning sign, since international small-cap funds have had strong returns. Instead of chasing past performance, investors should temper their expectations in the near term, keeping in mind that international small-cap stocks can be much more volatile than their larger-cap brethren, andthat valuations in the sector are not as compelling as they were. But for the long term, funds in this asset class can be attractive for the diversity they offer.
