Foreign Small Caps: Choose Actively Managed Funds or ETFs?

Exchange-traded funds have proliferated like rabbits. You can now buy these funds, which trade like stocks and track a particular index, for most types of investments. After slicing and dicing the U.S. market into plenty of niche ETFs, financial firms have sharpened their knives to carve up overseas markets in a similar fashion.

Amid the wide selection, one newly minted ETF may be worth a look. In late April, State Street Global Advisors launched SPDR S&P International Small Cap (symbol GWX). It holds stocks of companies in developed markets with market capitalizations below $2 billion. Countries with the most stocks in the fund include Japan, U.K., Canada and Australia. Managers aim to mimic the performance of the S&P/Citigroup World Ex US Cap Range

Investors have plenty of reasons to want international small-company stocks in their portfolios. Thanks to globalization, large-company stocks in the U.S. and overseas have differed less in overall performance than in the past. These giants are more dependent on global economic health than the fate of their local market. The more synchronized returns have taken away one major advantage of international investing, which is to generate returns less tied to the U.S. market. Returns of overseas small-company stocks, however, are less correlated to the returns of U.S. large-company stocks.

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Other international small-company ETFs exist. WisdomTree was the first to launch an ETF that invests in a broad portfolio of international small-company fare in June 2006. WisdomTree International SmallCap Dividend (DLS) has an expense ratio of 0.58% and is tilted to stocks that are dividend payers. And there are plenty of ETFs that concentrate on the stocks of a particular country or region, such as Japan or emerging markets.

Yet ETFs may not be the best way to invest in international small-company stocks. If there's one area where active management works, it's in picking small-company stocks, no matter if they are U.S. or foreign. Why? The markets for the small fry are less efficient than the markets for large-company stocks. That gives managers more opportunities to find hidden gems that beat the benchmarks.

Selecting the right actively managed fund is tricky. Since international small-company stocks overall have posted impressive results for many years, most of the best funds in this category are closed to new investors. Other funds are so bloated with assets that their size will be a drag on future returns, and some funds have new managers at the helm.

Among the actively managed small-cap funds, T. Rowe Price International Discovery (PRIDX; 800-541-6066) stands out as a solid choice. Lead manager Justin Thomson targets stocks of firms with market capitalizations between $250 million and $3 billion. Thomson, who has run the fund since 1998, wants companies with accelerating sales and earnings growth rates. He trolls for stocks in both developed and emerging markets with a preference for countries with favorable regulations that protect small companies. To limit risk, he buys stocks of fast-growing small companies that sell at reasonable prices. Over the past five years, International Discovery has returned an annualized 26% through April 30, which beat the average fund that invests in foreign small-company stocks by three percentage points per year. And the fund has a below-average expense ratio of 1.24%.