A sense of history will help to interpret small cap return rankings

By Dan Hallett, CFA, CFP on April 11th, 2013

When asked recently to examine a portfolio manager’s track record, I was reminded of how careful one must be with performance rankings.  In this case, I was assessing the strong five-year run of a Canadian Small/Mid Cap Equity manager.  It didn’t take long to see that knowing the evolution of today’s small/mid cap mandates is critical to making an informed assessment.

Evolution of Income Trust Mandates

The first investment funds mandated to invest in real estate investment trusts, royalty trusts and business trusts were launched between 1996 and 1998.  As tech stocks melted down post-2000 and income trusts (and most non-tech equities) posted strong returns, fund companies lined up to launch income trust funds.  This spawned the income trust class of funds and institutional mandates.

But as 2010 ended so too did income trusts’ tax advantage.  Accordingly all funds and mandates formerly categorized as income trust products were placed either alongside dividend funds or with small-to-mid cap equity funds.

Impact on Performance Comparisons

Depending on the particular fund or product under examination, you could draw very different conclusions on otherwise similar portfolios and performance levels.  When looking at retail mutual funds, for instance, old income trust funds are now in one of three categories – i.e. Canadian Dividend & Income Equity, Canadian Small/Mid Cap Equity or Canadian-Focused Small/Mid Cap Equity.  (It’s interesting to note that some institutional databases continue to track a Canadian Income Trust class of products.)

For those looking at returns over the past five years, all of this background is relevant because two factors are skewing the performance comparison today.

Former income trust mandates generally had a policy to buy the three aforementioned types of income trusts.  And by policy, many of these could not buy regular small cap stocks that did not fall into one of the trust buckets.  Once income trust funds moved into regular categories, their returns get compared with other types of portfolios without any similar policy restrictions.

And this is relevant because performance over the past five years has been very different for these market segments.  Shares of domestic small company stocks, for instance, have posted a 2.3% annualized gain for the five years through March 2013 (based on data from S&P Dow Jones Indexes).  The much broader S&P/TSX Composite Index sports the same five-year performance.

By contrast, stringing together returns from the old TSX Income Trust Index and the current S&P/TSX Equity Income Index shows returns of 7.9% per year.  The Dow Jones Select Canada Dividend Index gained 6.3% per year over the same five years.  (All performance figures are total returns.)

Proper Benchmarking

While this is hardly a scientific test it does imply that over the last five years, having had exposure to dividend-payers has been a much more influential factor than whether you had exposure to bigger or smaller companies.  In other words, those comparing former income trust funds to a dividend benchmark will draw very different conclusions than benchmarking those same mandates against small cap stocks.

Bissett Canadian High Dividend-A is a small/mid cap equity fund that has returned 9.1% annually.  This return looks stellar compared to the 2.3% annualized return for Canadian small cap stocks.  While the fund has outperformed its more suitable “equity income” benchmark, the outperformance is much less striking.

Similarly, Dynamic Equity Income is a former income trust fund but is classified alongside Canadian dividend funds.  Its annualized total return of 7.7% leads to a very different assessment, with outperformance of the DJ Select Dividend Index but sub-par returns compared to the Equity Income index over the past five years.

This is just one of many examples demonstrating the importance of looking beyond the numbers.  Sometimes one benchmark will apply throughout a fund’s history – whether or not it matches its current classification.  Other times a more customized benchmark will be needed to reflect a portfolio’s changing investment policy over time.

Making this assessment requires a portfolio’s original investment policy or stated strategy (and subsequent changes), a full performance history and periodic holdings going back several years.  In other words, understand how a performance record was achieved – something my HighView partners and I live and breath.  Failing to do so could lead to false insights.