International funds made up of small- and mid-sized companies may be a victim of their own stellar success, according to The Wall Street Journal.

While international funds comprised mainly of large-cap stocks have delivered an average annual return of 29% in the past three years, international small cap funds have delivered 39%.

In the past five years, 59 international small-caps delivered returns of 16% per year, according to Chicago-based analyst, Morningstar, while international large-caps gained 9%.

Their success has made these funds so popular, that some are now closing to new investors, who are pouring in more money than the funds can manage.

"When a group of funds attracts so much money in new flows that the funds are forced to close, that's often a sign that these funds have reached their peak," said Dan Lefkovitz, an analyst for Morningstar. "The more money that these managers have to put to work, the more this dilutes their ideas," he said.

In fact, 12 of the 25 international small-caps ranked among the top, according to Morningstar, have closed.

International small and midsize funds consist of companies with an average market value of  $1.8 billion, and no more than  $5 billion.  Robust returns have driving the prices of these funds up so high, many no longer consider them a good deal.

"Clearly, these funds are riskier in that there's going to be more volatility," said Harold Evensky, a financial adviser at Evensky & Katz Wealth Management in Coral Gables, Fla.

The fragility of these funds was exemplified in January, when Japanese regulators raised questions about Internet company Livedoor. The firm's former president and four other executive were accused of submitting fraudulent financial forms and violating other laws. Japanese investors, many of whom used borrowed money to invest in the company, sold off shares in other small companies to repay their loans. As a result, stocks across Japan plunged.

"Anyone involved in the Japanese market was affected in some way by Livedoor, said Justin Thomson, a portfolio manager with Baltimore-based T. Rowe Price International Discovery Fund. Although his fund held no Livedoor stocks, his Japanese Internet holdings suffered. 

The mergers-and-acquisitions sweeping Europe and Japan, thereby boosting small company stocks, will continue, according to Thomson.

Evensky, whose firm managed $500 million, advises clients to keep up to 25% of their international portfolio in smaller stocks.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.