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Small Cap: A Big Opportunity

By: Steve Orlich & Ted Whitehead

The diversification of a portfolio can be enhanced with the addition of small cap equities. Steve Orlich and Ted Whitehead, of MFC Global Investment Management, show how they offer the potential for capital appreciation.

Practically every successful largecap company started as a small business at one time or another. That’s why small cap equities offer investors the potential for greater capital appreciation.

Imagine if one had the foresight to have invested in WestJet Airlines when it was only $4.17 dollars per share in July of 1999 (adjusted for splits). The company now trades at over $24!

In spite of this, some investors continue to be wary of small caps, most often based on their perception of high volatility.

However, the addition of small cap stocks to a portfolio serves to increase return over the long term without the expected increase in volatility. This is because the diversification of the overall portfolio is improved through the addition of small caps. The large and small cap markets differ by more than simply the size of the companies involved – and these differences are behind the diversification power of small cap stocks.

Investors have first-hand knowledge of the benefits they derive from holding a diversified portfolio of Canadian, U.S., and International equities and bonds. Many have also benefited by investing in both value and growth stocks.

By not allocating a portion of their equity portfolio to Canadian small caps, many investors are missing out on a great opportunity to increase returns and reduce risk. This added benefit is derived from the lower correlation between small cap stocks and other equity asset classes typically included in a diversified portfolio. Adding securities with lower correlations to a portfolio works to decrease the volatility of returns over time, without necessarily giving up any performance.

Similarly, citing the same principle, one can potentially increase returns over time, without any associated increase in volatility. Analysis shows that allocating 20 per cent of an equity portfolio to Canadian small cap stocks provides increased returns, without increasing volatility, at every given level of risk.

Every Portfolio Can Benefit

To illustrate the benefit of diversifying with small cap securities, we constructed a number of hypothetical portfolios. The findings of our analysis are illustrated in the Chart, ‘The Diversification Benefit of Canadian Small Cap Equities.’

We began our analysis with an already well-diversified portfolio, consisting of Canadian, U.S., and International large cap equities, equally exposed to value and growth styles, with foreign content constrained to adhere to the foreign content limits for registered accounts. To keep this first example straightforward, we ignored fixed income and manager effects, focusing only on the appropriate index returns.

Using portfolio risk/return optimization techniques, we built an efficient Aggressive Portfolio that can be expected to return 8.52 per cent with a standard deviation of 13.52 per cent over an 18-year period.

We found that by modifying this welldiversified equity portfolio to include a weight of 20 per cent in Canadian small cap stocks, the expected return increased to 8.72 per cent for the same level of risk, thereby earning an additional 20 basis points of return on an annualized basis over the 18-year period studied. In our analysis, this allocation of approximately 20 per cent was the optimal weight. It is interesting to note that, despite these findings, most investors have a much lower exposure to this asset class in their equity portfolios.

In order to further test the validity of this exercise, we built a Growth Portfolio, again assuming a well-diversified portfolio and ignoring manager effects. We distinguished it from the Aggressive Portfolio by including a 20 per cent exposure to fixed income. Again, we found that return was improved with no associated increase in volatility when 20 per cent of the equity component was invested in Canadian small cap stocks. In other words, our analysis implied that 20 per cent of the 80 per cent invested in equities, or 16 per cent of the total portfolio, should be held in small caps. By incorporating small caps in our example, the expected return increased from 8.08 per cent to 8.24 per cent over the 18- year period, with a standard deviation of 11.55 per cent in both cases.

The Diversification Benefit of Canadian Small Cap Equities

This 20 per cent weight is a useful ruleof- thumb. Our analysis shows that optimal portfolios for every possible risk level would benefit over the long term from having 20 per cent of the equity component invested in Canadian small caps.

The sophisticated mathematics that form the foundation of modern asset allocation modelling make a compelling case for the addition of small caps to a portfolio. Certainly, it is the lower correlation of Canadian small caps with other asset classes that is behind their diversification power. Why is the correlation with Canadian large cap stocks lower than might be expected?

One of the most noticeable differences between Canadian large and small cap stocks is that the small cap arena is more heavily skewed toward consumer and cyclical stocks. This is evident in comparing the holdings of the BMO Nesbitt Burns Small Cap Index (NBSCI) and the S&P/TSX Composite Index. The small cap index has a combined exposure to consumer and cyclical stocks that is more than 27 per cent greater than that of the large cap index. These differences in sector weights help to explain why small cap and large cap indices will often act quite differently under the same macro-economic conditions. Cyclicals, as indicated by their name, experience ups and downs through an economic cycle. When the economy is growing strongly, cyclical stocks will outperform. The Canadian small cap index, heavily cyclical, will tend to outperform the large cap index in this environment.

It is also helpful to understand more about the types of companies that are categorized in these sectors. Consumer and cyclical stocks can consist of both mature and new industries. The steel industry, though mature, is dominated by small companies such as Russell Metals.

A newer industry with no comparable large cap company is the water purification industry. Canada has two small cap companies with two different technologies: Zenon Environmental and Trojan Technologies. The small cap world tends to be populated with companies that are in new industries, which focus on product innovation or newuse applications and which often have lower barriers to entry. Software and biotechnology companies typically fit into this category.

If you lack exposure to small caps, you are likely missing investment opportunities in important and growing segments of the Canadian market.

The Canadian small cap index is also much less heavily weighted toward interest sensitive companies relative to the Canadian large cap index. This one sector alone represents a 28 per cent variance between the two indices. Examples of interest sensitive companies include utilities and financial service companies.

The large cap interest sensitive sector is dominated by the five large Canadian banks and tends to have a higher than average dividend payout policy. In contrast, the interest sensitive sector in the small cap market is represented by niche players. Home Capital, for example, is a mortgage lender to non-typical clients.

Given the large exposure to the interest sensitive sector in the large cap index, small cap diversification serves to smooth performance during periods that do not favour interest sensitive stocks.

Achieving These Results

Our analysis demonstrates the diversification benefits of holding small caps in a portfolio. But how should an optimal position in Canadian small caps be implemented?

The first decision is whether to implement the exposure using active or passive management. While all fund managers attempt to beat the market, not all can achieve this in a given year. Yet, we know that some managers can persist in earning above-average returns over several years. The benefits of active management are most evident where market inefficiencies exist. The Canadian small cap market is one such market and, so, selecting a strong active manager can result in outperformance by several percentage points above and beyond the index.

A 20 per cent equity weight in Canadian small caps appears to be an optimal allocation. It is quite common, given the relatively concentrated Canadian market and the varying policy definitions of what constitutes small cap within customized mandates, for Canadian equity fund managers to hold a mix of small and mid (and occasionally even some large) cap stocks in their portfolios. This makes it critical to carefully analyze your portfolio’s underlying holdings to get an accurate reading of your allocation to small, mid, and large cap stocks.

Institutional investors undergo rigorous analysis at the portfolio level as part of the normal course of practice. For the individual investor participating in a Defined Contribution Pension Plan, building retirement portfolios by combining a number of investment options, this proves more challenging. In these cases, DC pension plan sponsors may wish to offer employees a selection of asset allocation funds on their investment platform, giving them access to a product with the potential to provide an optimal asset mix of both assets and managers.

As our analysis demonstrates, investment portfolios can be improved through the additional diversification provided by small cap stocks. In many instances, larger Defined Benefit plans have already incorporated this strategy successfully. Unfortunately, smaller DB plans have generally not considered using small cap diversification. Given that a 20 per cent allocation to small cap in the equity component of a portfolio can enhance performance with no accompanying increase in volatility, even DB plans as small as $10 million can incorporate this approach quite successfully, particularly utilizing active management.

Steve Orlich is assistant vice-president and portfolio manager, responsible for managing asset allocation portfolios worldwide, and Ted Whitehead is vice-president and senior portfolio manager, Canadian small cap equities, for MFC Global Investment Management.

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