News

(Reuters) – When it comes to picking funds, most investors would do themselves a favor by ignoring stock picking altogether.

Nearly 70 percent of all actively managed U.S. equity funds lagged their respective benchmarks over the last five years, according to a report by S&P Dow Jones Indices. About 92 percent of small cap growth funds, for instance, underperformed the S&P Small Cap 600 over that time period, while 78 percent of large-cap core funds fell behind the benchmark S&P 500. No wonder, then, that 27 percent of domestic actively managed equity funds merged or shut down over the last five years.

International small-cap equity funds was the lone category in which portfolio managers consistently added value for investors, the report showed. About 79 percent of funds in the category beat their benchmark over the last five years, compared with 26.3 percent for international stock funds as a whole.

The reason appears to be simple. With fewer analysts covering small international companies, individual portfolio managers are more likely to have an informational advantage over the broad market.

“It comes down to efficient markets. When you are looking at a large cap company, there are going to be dozens and dozens of analysts poking around the company,” said Jeff Tjornehoj, head of Lipper Americas Research.

“But with small caps, especially overseas, you tend to have situations where a portfolio manager may have the most informed opinion about what a stock price means in relation to the company’s potential earnings,” he said. Lipper is a unit of Thomson Reuters.

Funds in the international small cap universe also appear more likely to take larger positions in companies that have small weightings in the benchmark index, said Aye Soe, a director at S&P Dow Jones Indices, who authored the report.

HOW TOP FUNDS ARE INVESTING

Portfolio managers of top-performing international small-cap funds say that the large number of potential companies makes it easier to find attractive options.

“It’s difficult for the market to be efficient in such a large asset class,” said Josephine Lewis, a portfolio manager of the $60 million Harding Loevner International Small Company fund. “It’s up to more niche players who are going to be doing fundamental analysis to come in there.”

Lewis’s fund screens about 10,000 companies around the globe, compared with 3,405 companies in the S&P Developed Ex-U.S. Small Cap index, she said, looking for companies with strong balance sheets and consistent profits.

Lewis is significantly overweight in healthcare, industrials and consumer staples companies and underweight financials and energy companies. Her fund has returned an annualized 7 percent over the last five years, which was 4.6 percentage points more than the average fund in the category, according to Lipper data.

Lewis often looks for companies with strong brand names and other lasting competitive advantages. The fund’s top holding, Super Group Ltd, a maker of instant beverages and snacks, jumped 114 percent over the last year as its sales grew at a rate more than double that of its competitors. The Singapore-based company, whose brands include Cafe Nova, Owl and Coffee King, sells its instant beverages and snacks in over 50 countries, with a significant portion of revenues coming from emerging market countries in Asia. Lewis said she likes the company, which has a $1.7 billion market-cap, because of its brand name and its premium product pricing.

She has also been adding to her position in German apparel retailer Gerry Weber International AG. The company, which Lewis calls “the Chico’s of Germany” because of its focus on upper-middle-class women, is up 17 percent over the last year thanks in part to a 15.7 percent jump in fourth-quarter earnings. The $2 billion market cap company announced plans in January to expand its presence outside of the euro zone in Russia, the Middle East and North America.

For the $847 million Wasatch International Growth fund, it attributes its outperformance to a well-timed bet on Japan and a focus on consumer companies. The fund increased its allocation to Japanese stocks to 11 percent in 2012 from 6 percent in 2011 and has benefited from a 42 percent jump in the Nikkei 225 since October.

The fund, whose annualized return of 8.9 percent over the last five years made it the top-performing fund in the category, is especially interested in companies that use their Web presence to build market share, said Linda Lasater, a senior equity analyst who works on the fund.

One recent addition to the firm, for instance, is Domino’s Pizza Group PLC, Britain’s biggest pizza delivery company. The company’s shares are up 35 percent over the last year, and it plans to expand in Germany, Switzerland, Luxembourg and Liechtenstein. In addition to the company’s strong cash flow, Lasater likes that over 50 percent of the company’s UK sales come from online orders.

“You get better data, you can target the customers better, and costs are lower because you have more accurate orders,” she said.

Another fund holding, CarSales.com LTD, holds a “basic monopoly” in Australia’s online classified ads service, Lasater said. The company, which has a market cap of $2.2 billion and announced plans last month to buy nearly 20 percent of competitor iCar Asia Ltd., is up 66.8 percent over the last year.

“People constantly underestimate how much more migration there is from print to online,” Lasater said.

Along with the Wasatch and Harding Loevner funds, other top-performing funds in the category include the $446 million Westcore International Small-Cap Fund, which gained an annualized 8.7 percent over the last five years, and the $822 million Franklin International Small Cap Growth fund, which gained 7.7 percent a year over the time frame.

(Reporting By David Randall; Editing by Jennifer Merritt and Leslie Adler)