Stock markets around the world fell in the second quarter of 2010, driven by a jittery global investment community that perceived slowing global growth. The abundance of government debt in several countries caused the eurozone to significantly underperform the rest of the developed regions. Small-cap stocks in the European region declined more than in other regions during the quarter. Further evidence of turmoil in Europe was seen in the decline of the euro relative to the U.S. dollar during the quarter. The single currency region faces both economic and political challenges going forward.

For the second quarter of 2010, the Fund’s S&P® Developed ex-U.S. SmallCap benchmark had a double-digit negative return. The large dispersion between country returns, which existed in the first quarter, continued in the second. The Greek stock market posted the largest decline, as stocks fell by 30.3%, on average, while the Japanese market was a relative bright spot, with stocks falling by 4.0%. All ten economic sectors posted negative overall returns for the quarter, with energy being the worst performing sector with a decline of 16.2%. Consumer staples (-6.5%) and telecommunications services (-7.3%) showed relative strength for the quarter. Financials (-11.8%) trailed the overall Index.

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The International Small-Cap Fund trailed relative to its S&P benchmark for the quarter, as solid outperformance through the first ten weeks of the quarter disappeared in the late quarter sell off. Security selection showed relative strength in six of ten sectors, with consumer discretionary and health care leading the way. As the sentiment in the market turned negative in the latter part of the quarter, the more cyclical sectors, such as industrials and materials, became a headwind for the Fund’s performance.

Security selection in the industrials sector lagged relative to the Index, as Virgin Blue Holdings Ltd. (0.3% of the Fund) lowered its profit guidance. The Australian low-cost airline reportedly expects fares to drop as a result of a rapid deterioration in leisure travel both domestically and abroad. The stock fell by 62.1% for the quarter. Additionally, commodity prices began a downward march as investor appetite and money flows to commodity funds declined. Canadian mining company Quadra FNX Mining, Ltd. (0.9%) fell 39.8% as revenues were pressured by the decline in the spot price for metals.

The defensive sectors of the Fund mitigated some of the negative impact from more cyclical sectors, with particular strength in consumer discretionary and health care holdings. Japanese generic drug producer Towa Pharmaceutical Co., Ltd. (0.5%) was up by 28.0% for the quarter. The company posted solid fourth quarter operating results as gross margins remained high and investors continued to believe that government-sponsored generic drug incentives would boost long-term sales. Relative performance in the consumer discretionary sector was also strong, boosted especially by Avex Group Holdings, Inc. (0.5%), a producer and seller of DVDs, videos, and music CDs. The company announced better than expected earnings guidance based on an aggressive plan to cut costs and its stock price rose by 37.1%. Other top contributors to relative performance included U.K.-based Aggreko PLC (0.8%). The manufacturer of mobile electricity generators benefited from large contracts with both the Vancouver Winter Olympics and the World Cup and was up by 17.9% for the quarter. Electronic equipment manufacturer Alps Electric Co., Ltd. (0.8%) reported better than expected operating margins due to lower costs and higher automotive electronic component demand, and experienced a 25.9% increase for the quarter.

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