Managers Sound Warning on International Small-Caps

We've all heard the saying, "What goes up must come down," and that is precisely why fund managers are becoming increasingly cautious on foreign small-cap stocks, MarketWatch reports.

For the past several years, small- and mid-cap foreign stock mutual fund returns were impressive, as they rose by an annualized 40.7% over a period of three years, according to Morningstar. This is precisely why a growing number of portfolio managers are becoming cautious about these stocks.

Their strong performance has attracted large inflows, causing some of the better funds to close their doors to new money. For example, the Artisan International Small-Cap Fund and the Fidelity Small-Cap Fund have recently announced that they would close to new investors.

Nathalie Degans, co-manager of Morgan Stanley International Small Cap Fund, believes that managers are right to believe that small caps cannot continue the extraordinary gains of the past few years. However, she also noted that small-cap stocks are very much affected by economic cycles, meaning, "As long as the economies do fine," she said, "we should expect small-caps to do reasonably well."

Some managers note that it is, in fact, possible that international small-caps will defy the odds and have blockbuster gains again, but the likelihood is that at some point it must end.

"At some point it's going to end," said Bill Rocco of Morningstar. "Ask yourself, 'Am I going to stick with this for the long term? Can I handle the risk? 

Meanwhile, many managers have turned to Japan and Asia's emerging markets.

"The fact that small-cap stock coverage in Japan remains somewhat spotty means there are greater opportunities for uncovering small-cap gems," said Howie Schwab, a portfolio manager at Driehaus Capital Management.