International small-cap stocks have enormous potential to be the next hot asset class, according to plan sponsors and money managers.
Institutional investors that invest in international small caps include:
* The $950 million City of Hartford, Conn., pension fund, which recently gave $25 million mandates to FTI Institutional for the international small-cap value strategy and Arnhold and S. Bleichroeder Advisers Inc., New York, for international small-cap growth;
* Pennsylvania State Employees' Retirement System, Harrisburg, which has a total of $797 million in international small-cap investments. The $20.4 billion fund has $413 million with Merrill Lynch Investment Managers, New York; $196 million in an international small-cap mandate with Pictet Asset Management, London; and a $188 million international small-cap mandate with Henderson North American Partners, New York;
* General Electric Co., Stamford, Conn., which has a significant amount of its $54 billion pension fund's $13 billion international equity portfolio invested in international small cap equities;
* American Airlines Inc., Fort Worth, Texas, which recently put $40 million of a $400 million international equity allocation managed by Templeton Investment Counsel, Fort Lauderdale, Fla., into small caps;
* Fortis AG, Brussels, which has a $250 million international small-cap mandate with Standish Mellon Asset Management, Boston; and
* Case Western Reserve University, Cleveland, which recently put $10 million into an international small-cap fund run by Morgan Stanley Inc. out of London.
Ferreting out
"We've always believed there's times to be in small and midcap stocks," said William F. Quinn, president of AMR Investment Services Inc., which runs the American Airlines pension fund. He added that Templeton had come to the fund with the suggestion to put part of the mandate into international small-cap stocks. "We like to have managers who can ferret out opportunities wherever they may be," said Mr. Quinn.
William Rose, treasurer of Case Western Reserve, said the university's $1.3 billion endowment invested in international small-cap stocks "for many of the same reasons we're overweighted in small-cap value stocks domestically. He believes that "small caps will outperform large caps, and although value has outperformed for a number of years, we think there's more to come."
Kathleen Palm, treasurer of the city of Hartford, said the pension fund recently did an asset allocation study that showed the fund could get better diversification if it invested in international small-cap stocks.
Managers, understandably, are happy to be telling the small-cap story. "The international small-cap universe is underresearched, underowned and undiscovered," said Margaret Lindsay, an executive vice president with Fiduciary Trust Co. International, New York, and manager of an international small-cap growth portfolio. Sister firm Templeton Investment Counsel offers an international small-cap value strategy.. The investment offerings of the two firms are offered through the FTI Institutional platform.
"We think there's a lot of value out there," said Judy Studer, senior vice president for international equities at GE Asset Management, Stamford, Conn., which manages the GE pension fund as well as money for outside clients.
"The same arguments that can be made for small-cap stocks in the U.S. can be made for small-cap stocks internationally," she added. "There are not a lot of analysts following the asset class, and it's a very inefficient asset class."
Bottom-up pickers
Most money managers who offer an international small-cap product are bottom-up stock pickers, including GE, FTI Institutional, Morgan Stanley, Standish Mellon, Pictet and Driehaus Asset Management, Chicago.
"We're 100% active bottom-up stock pickers," said Daniel LeVan of Standish. "We take it to an extreme and don't do much country research," he added. Year-to-date through Dec. 16, Standish's international small-cap fund was down 20 basis points, compared to its benchmark, the Salomon Smith Barney Emerging Markets Index, which is down about 8%.
"We're hoping by year-end we can squeeze a positive performance number out of the fund," said Mr. LeVan.
"The level of interest now in international small-caps is greater than we've ever seen," said Margaret Naylor, senior portfolio manager with Morgan Stanley. "A number of consultants in the U.S. have worked to inform themselves and their clients about the asset class," she added. Most of Morgan's approximately $1.2 billion in international small-cap money is in two separate mutual funds - one of which is a dedicated ERISA fund - and a number of segregated accounts, according to Ms. Naylor.
Morgan's International Small Cap A mutual fund had a return of -3.71% for the first 11 months of 2002, compared with -7.77% for the Morgan Stanley Capital International Europe Australasia Far East small-cap index.
"American pension funds are looking at opportunities to do more diversification, and the international small-cap asset class is coming up on their radar screens," said Michael McLaughlin, senior investment manager and portfolio manager with Pictet. The firm has $540 million under management in its international small-cap strategy.
"International small-cap stocks offer the same diversification that international large-cap stocks offered 20 years ago," said Rob Hearn, chief marketing officer of Pictet. He pointed out that international large-cap stocks have become more closely correlated to U.S. stocks but small caps are less closely correlated and offer diversification of investments and risk.
Always important
Lawrence Borsanyi, director of marketing at Arnhold & S. Bleichroeder, said, "Small-cap investments have always been a very important part of our strategy," although the firm also invests in midcap and some large-cap stocks.
"In the international arena, many small-cap stocks have been ignored by investors in the late 1990s because they were no longer in the benchmark," he added.
"We are value investors and we gravitate where we find the best values - it's primarily been in small caps and midcaps in the last few years," he said.
Arnhold & S. Bleichroeder offers a mutual fund, First Eagle SoGen Overseas Funds, which has returned 8.66% annually over the last five years. It was originally a retail fund but now offers an institutional class of shares targeted to institutions that want to invest from $1 million to $50 million. "A lot of endowments and foundations have come into that class of shares over the last 12 months," Mr. Borsanyi said. There are now 56 investors, mostly small pension funds, endowments and foundations, with assets in First Eagle funds.
"Everybody should be looking at this asset class," said GE Asset's Ms. Studer. She pointed out that many asset allocation studies don't include international small-cap stocks in their reports.
