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Where to beat the market: Small-cap foreign funds

| Saturday, April 6, 2013, 9:00 p.m.

BOSTON — An annual scorecard of mutual fund performance is in, and it's generating more of the negative headlines that fund managers have become accustomed to in recent years.

The key finding: Two-thirds of managed U.S. stock funds failed to beat the market in 2012, according to S&P Dow Jones Indices. For all their stock-picking skills, the vast majority of managers couldn't claim an edge over low-cost index funds and exchange-traded funds that seek to match the market.

It was the sixth time in the last 10 years that average annual returns of managed funds fell short of the market's overall performance. Faced with such persistently disappointing results, it's understandable that an investor might consider giving up and rely exclusively on index funds.

But look deeper into the latest annual scorecard, and there's a positive takeaway for investors. Funds specializing in stocks of small foreign companies have beaten their market benchmark year after year.

In 2012, 85 percent of this small group of funds posted larger returns than an S&P index of stocks from foreign developed countries. Returns for the five dozen funds in the international small-cap category averaged 21.7 percent, compared with 15.4 percent for the index.

It wasn't a one-year fluke. Ninety percent outperformed over three years, and 79 percent over five years.

Those results are far better than the long-term numbers for other stock fund categories, suggesting that international small-cap is the go-to category for market-beating fund performance.

“It's kind of like an overlooked child,” says Aye Soe, an S&P Dow Jones Indices researcher who authored the company's latest scorecard. “There are lots of opportunities there, and active managers can find them.”

How they do it

Stocks of small companies based overseas generate less attention from investment managers and stock analysts than the big U.S. names in the Standard & Poor's 500 index. That under-the-radar status creates greater opportunity to find stocks that are underpriced relative to their earnings potential.

That's reflected in the wide variations in returns among small-cap international stocks. The gap between the best and worst performers is typically larger than in other market segments.

“That creates more opportunity for active managers to add value,” Soe says.

Winning picks

A couple examples of top-rated small-cap international funds, and stocks that have generated strong recent returns:

Franklin International Small Cap Growth (FINAX) found a gem in Jumbo SA, which was recently the fund's third-largest holding. Shares of the Greece-based retailer of children's products have surged 43 percent over the past 12 months.

For Invesco International Small Company (IEGAX), a key contributor has been Total Energy Services Trust. The Canadian energy services company is a longtime holding, and the stock has more than doubled over the past five years.

One word of caution: Investors who don't have the stomach for volatile returns might want to avoid international small-cap funds. Sharp ups and downs are more likely with foreign stocks than with the U.S. market, especially among small-caps.

Other fund categories

But for consistency in generating market-beating returns, international small-cap funds stand out. Last year, just two out of 13 categories of managed U.S. stock funds posted average returns better than their market benchmarks. The two: funds specializing in large-cap growth stocks, and funds investing in property-owning real estate investment trusts. But going back over 3 and 5 years, the vast majority of funds in both categories failed to beat the market.

Among managed U.S. stock funds last year, 66 percent failed to beat a broad measure of the market, the Standard & Poor's Composite 1500. Although that may sound bad, it's a marked improvement from the 84 percent that underperformed in 2011. The last year that a majority of managed funds beat the market was in 2009.

Such poor numbers are a key reason why investors have been pulling their money out of managed funds in recent years. Among all U.S. stock funds — the majority of them managed funds, rather than index products — withdrawals have exceeded deposits for six years in a row.

Last year, investors withdrew a net $95 billion from managed large-cap stock funds, according to Morningstar. In contrast, a net $61 billion was deposited into large-cap index mutual funds and ETFs.

Mark Jewell is AP personal finance writer.

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