StreetWise: Next hot sector: Global small-cap

If the numbers are accurate and the financial services industry’s big thinkers are right, international small-cap equities will be among the hottest performers over the next five to 10 years.

Based on a survey of economic forecasters conducted by the KPMG Investment Consulting Group, the annualized 23% return by U.S. equity markets over the past five years is not the kind of performance we should expect over the next five years.

“Even with the steadily growing economy, respondents are expecting the U.S. equity market to return 9.1%, annualized, over the next five years,” according to KPMG.

The good news is, over the next five years, international small-caps are expected to be second only to venture capital in terms of performance, with a predicted annualized return of 13.1%.

The sector is expected to produce an annualized return of 12.5% over the next 10 years, placing it third behind venture capital (15.1%) and emerging-markets equity (13.9%).

One mutual fund that appears to be positioned ahead of the curve is the Ivy International Small Companies Fund. The no-load version of the fund has risen 52% over the past 12 months. That compares to a 3% gain by the MSCI EAFE Index over the same period.

“This just shows you that risk and return tend to be related over long periods,” says Sheridan Reilly, chief investment officer of international equities at Ivy Funds in Boca Raton, Fla.

“It’s a risky area, and one should expect higher returns for that trade-off.”

The fund, which launched in January 1997, was co-managed until earlier this month with Henderson Investors in the United Kingdom. On Nov. 15, Henderson took over management of the fund’s $20 million. Henderson also subadvises the Ivy European Opportunities Fund.

Before shifting all the assets of the International Small Companies Fund to Henderson, the Ivy team was taking a value approach to the portfolio while Henderson took a more aggressive approach.

As Mr. Reilly points out, value investing doesn’t have to apply strictly to old blue chips.

“We like earnings, but some of the most important things are not necessarily earnings,” he says.

“Management and their ability to control costs and execute their business plan is really key.”

Mr. Reilly says that for a lot of companies, the most life-threatening problems begin when they start to achieve a level of success.

“They get out of their business plan, and that’s when they really need a good management.”

That said, the entire portfolio is now in the hands of Henderson. Ivy will now turn its attention more toward a large-cap universe.

“Long term, we’re here in Florida, and we’re not going to focus our attention on international small-cap,” Mr. Reilly says.

As part of Ivy’s general shift over the past six months toward the larger-cap stocks, the company’s large-cap international offering was expanded to include value, growth and blend portfolios. And last week, the Asia Pacific and China Fund, which had $6 million in investor assets, was merged into the Pacific Opportunities Fund, which now has $22 million in assets.