A new report from Standard & Poor’s finds that investors who turn to actively managed funds or exchange-traded funds for their international holdings aren’t getting their money’s worth and suggests that they would be better off buying passive index funds.

But other experts say that there is still a strong argument to be made for using active management.

The S&P Report, called the SPIVA U.S. Scorecard, which also evaluated the performance of active vs. passive management for domestic funds and for bonds, found that in the international sphere over the past year 70% of global equity funds, 75% of international equity funds, 81% of international small-cap funds and 65% of emerging markets funds underperformed their benchmarks.

As a group, active managers fared even worse over a three- or five-year period, says Todd Rosenbluth, S&P’s director of ETF and mutual fund research.

“It gets worse over the longer term,” he says. “Over the past three years, 65% of actively managed funds underperformed in the broad international category, and 61% underperformed in the emerging markets category, while over five years, 70% underperformed in the broad international fund category, and 68% of actively managed emerging markets funds underperformed their benchmarks.”

The one area where active management seemed to do better is international small-cap, Rosenbluth says.

True, over the past year active management didn’t do so well in small-cap either, with 81% of actively managed funds underperforming, but he says that over the three- and five-year periods, these actively managed funds outperformed their benchmarks, at 57% and 54%, respectively.

“I think that this may be because it is hard to cover small international firms well, so if you are a manager who does do it well, even finding good companies that aren’t in the indexes, you have a better chance of outperforming the index,” he says.

'START OUT AT A DISADVANTAGE'

But Gerard Cronin, a portfolio adviser with Advisor Partners, says financial advisors shouldn’t let the S&P study deter them from recommending actively managed international funds to their clients.

“First of all, you need to remember that an index has no fees, so managed funds start out at a disadvantage, and also the past three to five years have been good ones for equity markets, including international equity markets, and that means there are fewer losers to avoid, which is where active managers can really add value,” he says.

Where active management can really do best, as shown in the S&P study’s findings, is small-caps, Cronin says.

“That’s where it’s possible for active managers to get better information. If the manager is expending the resources to look at companies that analysts are missing, they can find the diamonds in the rough,” Cronin says.

“With the large-cap international companies, we do recommend advisors go with the passive funds,” he says.
In that regard, Cronin says that his firm likes Oakmark’s International Small Cap Fund (OAKEX), managed by David Herro.

With a Morningstar three-star bronze rating, this fund is up just 2.57% for one year but has shown average annual gains of 13.78%, 9.73% and 9.02% over the past three, five and 10 years, respectively.

Rosenbluth agrees that the fact that a majority of active managers of international funds aren’t beating their benchmarks doesn’t mean that there are none who don’t.

“This study shouldn’t stop advisors from picking active managers, but it should make them very careful about picking them,” he says.