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International Small-Cap Managers Beat Index

NEW YORK ( TheStreet ) -- Investors have been dumping active managers and shifting to index funds. Academic studies have encouraged the migration, finding that most active managers trailed benchmarks. But there is a glaring exception to the rule. According to research by Standard & Poor's, 82% of active small-cap international mutual funds topped their benchmarks during the past five years. S&P says that outperformance doesn't seem like a fluke. "This is not a one-year phenomenon," says Aye Soe, director of index research and design for S&P Dow Jones Indices.

Index proponents may scoff at the findings. Vanguard founder John Bogle and other purists have long argued that the average active manager cannot possibly top benchmarks. Reason being: Funds have become so big that they account for virtually the entire market. Inevitably, half of the funds will be above average and half below, but the high fees of active managers drag the average performance down below benchmarks.

This argument may hold for funds focusing on the big U.S. stocks of the S&P 500. But the case breaks down in the market for international small caps. The mutual funds in the international small-cap category account for $64 billion in assets, according to Morningstar. That's just a speck in a market with more than $3 trillion in assets. In such a giant pool of stocks, there is room for skilled managers to spot bargains and outperform the average. "International small cap is an overlooked asset class," says S&P's Soe.

Harold Sharon, international strategist of Lord Abbett, says that it is hard for active managers to gain an edge with U.S. blue chips because there is a flood of information. It is common for a prominent company to be followed by dozens of analysts. But of the 42,000 international small caps, only 17% are followed by two or more analysts. The rest receive little or no coverage. As a result, many stocks are mispriced.

Will mutual funds soon flood into international small caps? Probably not. Sharon of Lord Abbett says that managers overlooked international small stocks as the fund industry evolved. In the 1980s, most mutual funds focused only on U.S. large caps. Then in the '90s, investors who sought greater returns began embracing funds that emphasized small U.S. stocks. Inspired by trends in U.S. stocks, portfolio managers introduced a wave of international funds that focused exclusively on small caps. During the past decade, growth in small-cap international funds was disrupted because aggressive investors had shifted their attention. "To get growth, investors jumped to the emerging markets and skipped international small caps," says Sharon.
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