At least four large pension funds this year are creating, or considering, separate accounts for investing in small-capitalization non-U.S. stocks. Reports of two others - Ameritech Corp. and U S WEST Inc. - could not be confirmed.
The use of this new asset class should continue to gain favor as funds raise their foreign allocations, some consultants believe. Stephen Nesbitt, senior vice president of Wilshire Associates, Santa Monica, Calif., sees some confusion now in the marketplace between emerging markets and foreign small-capitalization stocks, but he foresees interest in non-U.S. small-cap stocks eventually - perhaps in "three to five years" - replicating current interest in small U.S. stocks.
Large public funds have spearheaded the interest in setting up separate accounts for small-cap foreign stocks. Reza Vishkai, international research director of Rogers, Casey & Associates, said if the "large public funds put 10% to 15% of assets overseas, they couldn't just hire eight to 10 EAFE managers because they'd just end up with an index" replication.
This year, among the funds that have hired, funded or searched for managers of such mandates are: the Rhode Island Retirement Systems, Providence, which hired Dunedin Fund Managers for an $84 million account; the Municipal Fire & Police Retirement System of Iowa, West Des Moines, which hired Philippe Investment Management and Pictet International Management each for $20 million international small-cap accounts; and the San Francisco City and County Employees' Retirement System, which, at last report, was still searching for international small-cap stock managers. In addition, the Pennsylvania State Employes' Retirement System, Harrisburg, expects to hire an additional small-cap manager as it expands its current allocation.
(Officials of Ameritech and U S WEST either had no comment or did not respond to Pensions & Investment queries on this story.)
This year, Edinburgh, Scotland-based Dunedin Fund Managers landed three of its now-six U.S. clients for international small-cap separate accounts. The firm has seen interest percolate in the last year or so as clients "recognize that there are a lot of opportunities" in that sector that has not reached "its full value," said Mary White, Dunedin's marketing manager of client services.
Morgan Stanley Asset Management, New York, has seen "almost as much demand" for non-U.S. small-cap investments "as we can accommodate," said Gail Hunt Reeke, a principal and international business manager of the firm. However, Morgan Stanley is "carefully controlling the flow of money into those investments because of limitations on" the availability of stock in that sector, she said. The firm offers separate international small-cap investing through two commingled funds, an ERISA trust and an institutional mutual fund; assets in both total about $250 million.
Because of rising demand for non-U.S. small-stock investments, Morgan Stanley Capital International, producer of the Europe Australasia Far East Index, is considering setting up a non-U.S. small-stock index, but that could not be confirmed. In the near future, Goldman Sachs & Co., New York, plans to create separate midcap and small-cap non-U.S. equities indexes.
Investor interest was cited as the incentive.
In recent years, the performance of non-U.S. small stocks evidently hasn't been the most compelling draw. For instance, the FT-Actuaries' medium-small cap Europe & Pacific Stock Index, in U.S. dollar terms, gained 13.81% for the six months ended June 30, compared with 9.42% for the large-stock counterpart; but for the three years ended June 30, the small-medium stock index advanced by an annualized 11.12%, vs. an annualized 12.24% for the large stock index.
According to Morgan Stanley's Ms. Reeke, interest in the foreign small-cap segment stems from the relatively limited research on this wide array of stocks; this, in turn, affords greater pricing inefficiencies than might be found among larger-cap stocks. Pension funds increasingly are finding this attractive because many already have gained experience with broad international investing. Now, more are seeking ways to diversify their growing foreign investments and enhance returns.
Now about 18 months old, Morgan Stanley's non-U.S. small-cap funds have also performed well. "For the six months ended June 30, our international small-cap funds are both up over 13%," Ms. Reeke reported.
The performances of separate small- and medium-cap foreign stock accounts hasn't yet wowed the Connecticut Trust Funds, Hartford. The approximately $11 billion fund added those two accounts in 1990. The result: "Until recently they have not performed well, although relative to their benchmarks we had no complaints; the sectors have only recently emerged," said John Winchester, a principal investment officer.
Nonetheless, the fund believes the sectors will add value over the long term. About two years ago, it even added to the accounts to lift them to their "appropriate exposures," he said. Connecticut now invests $77 million in its non-U.S. midcap account and $76 million in its overseas small-cap account.
The slightly more than $3.3 billion Rhode Island Retirement Systems hired Dunedin as an offshoot from its search last year for a Pacific Basin equities manager. According to Barbara Schoenfeld, deputy treasurer/general counsel, Dunedin had applied for the Pacific Basin account. But in studying its application, it became clear the firm excelled in international small-cap investing generally, including in the Pacific Rim. As a result, Rhode Island split the account, hiring Scudder, Stevens & Clark as its Pacific Rim manager and Dunedin for international small-cap investing.
The $13.5 billion Pennsylvania State Employes' fund will expand its holdings in international small-cap stocks as part of a larger overall increase in its international exposure - to 10% of total assets from 5.5% now. Of the additional allocations, 80% will be invested in the broad international equities portfolio and 20% in international small-cap.
Why is the fund expanding its non-U.S. small-cap holdings? "We think there are investment opportunities there. It's a less efficient part of the market and active management can add value to it," said Peter Gilbert, chief investment officer.
"We've been in it awhile and it's produced good results for us," he added.