Benchmarking Canadian Small Cap

Benchmarking Canadian Small Cap

In a previous CH Minute, linked here, we looked at how CH Financial monitors our real estate asset investment managers using a global REIT (real estate investment trust) fund as a benchmark. To recap, a benchmark in investing is a passive index that tracks a similar set of securities within a specific asset class. So, an index for real estate will be an index-based REIT fund. In this article, we look at another important asset class that we own for our clients, especially those willing to take on more risk within their portfolio, namely Canadian small-cap stocks.

What is Small Cap(italization)?

In Canada, a small-capitalization (small-cap for short) stock is a company that trades publicly on the Toronto Stock Exchange (TSX) and has a total market value of $2.0 B or less. Traditionally this has been where the best performance can be found in the Canadian stock exchange, but the volatility (as one measure of risk) is considerably higher. While it is true that we at CH do not believe that volatility in itself is necessarily risk we do understand that it can be hard for clients to stay invested if their portfolio becomes too volatile. The risk in such situations is selling out of a position because an investment is down, and never getting the chance to make that loss back.

So, what does this have to do with how we use the Canadian small-cap benchmark? Put simply, when we are taking on higher levels of risk for our clients, we want to know that our management teams are not only being active, by outperforming that index, but that they are doing so with less volatility, making it easier for our clients to stay invested in that asset class.

We also want our managers to stay invested in a company if they still believe in it even as it has grown so much that it is no longer technically a small-cap company. This would result in the fund “punishing” a stock for being successful. The problem with an index, in this case, is that it will be forced to sell its biggest winners periodically as they grow too large to fit the definition of the index.

Which Benchmark Do We Use?

We currently use two small-cap funds in the Canadian space: the IA Clarington Canadian Small Cap Fund and the NCM Small Cap fund. Historically, several our clients invested in the BMO Enterprise fund, but this fund is closed to new investors. The index that we use for benchmarking is the iShares Canadian Small-Cap benchmark (known by its ticker XCS) that has traded on the TSX since 2008.

As our clients know, we use rolling 5-year performance numbers to monitor how a fund has been doing recently and rolling 10-year numbers to test the consistency and stability of our funds. Taken together these can produce a good picture of how the manager has performed over time. Given the volatility of this asset class, taking this long-term view has been especially useful.

The other reason we want to take a longer-term view, especially in the small-cap space, is because of what is known as “survival bias”. Survival bias is when an index looks better than it is because as companies drop substantially (or go bankrupt), they are removed from the index. The owner of the index loses as this benchmark is being forced to “sell” the now worthless security.

How Do Our Managers Stack Up?

The rolling five and ten-year performance numbers for XCS are 6.7% and 4.3% respectively. This five-year number has been helped a lot by the performance in 2021 and into 2022 as energy and commodity prices have risen dramatically, and this index is very heavily weighted in oil, gas, and mining stocks. In fact, up until the end of 2020, this index was essentially flat, meaning owners of this benchmark had broken even from 2008 to 2020. Not surprisingly this has made Canadian Small Cap frustrating and therefore an avoided sector for many investors, especially those who have underperformed, and lost money over the last 5 and 10 years.

Each of our managers, by contrast, has had consistently positive 5-year and 10-year rolling rates of returns. This does not mean that they have made money every single year, but it has made it easier for clients to remain invested, and to then reap the outsized profits that have come in good years like 2021 and so far in 2022.

 Performance 5-YR 10-YR This table indicates fund performances up until the end of February 2022 (all numbers are net of fees).

As we can see all the funds have comparable rates of return to the index over 5-years and dramatically higher returns over 10-year periods.

XCS 6.7 4.3
BMO Enterprise 7.3 11.4
IA CDN Small Cap 5.9 8.8
NCM Small Cap 6.8 5.7
 Standard Dev. 5-YR 10-YR Regarding volatility, the results are even more dramatic. This table is measuring the standard deviation of each fund. Note that high numbers indicate higher volatility, meaning bigger swings up and down.
XCS 23.0 19.2
BMO Enterprise 17.6 10.4
IA CDN Small Cap 17.2 13.4
NCM Small Cap 20.6 16.5

Here we see that our fund managers have been 25% to 50% less volatile than the index. This level of outperformance has been a huge benefit for our clients since they get to participate in the upside of this investment space without having to experience the much wilder ride of the index.

Conclusion

This edition of the CH Minute is intended to help our clients better understand how we use benchmarks to measure both the performance and risk levels of our fund managers. The example of our small-cap managers was selected both because of the overall level of riskiness of this type of investment. It also shows how reducing volatility and risk can help our clients enjoy the rewards of taking on this additional risk.

As always, we welcome any questions or comments.

 

All the best,

Brian Trafford, Chief Investment Officer

& Your CH Financial Team

403-237-6570

hi@chfinancial.ca

 

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