A solid option for exposure to mid- and small-cap stocks

IShares S&P/TSX Completion ETF charges one of the lowest fees in the category.

Alex Bryan 23 October, 2018 | 5:00PM

 iShares S&P/TSX Completion ETF (XMD) pairs well with funds that track the S&P/TSX 60 Index. While it isn't perfectly representative of its active peers' opportunity set, it effectively diversifies risk and is one of the cheapest options in the category, which gives it a durable edge. It earns a Morningstar Analyst Rating of Bronze.

This fund invests in most of the significant Canadian stocks not included in the large-cap-focused S&P/TSX 60 Index. That sweeps in some large-cap stocks, as well as mid- and small-cap names, though the portfolio nets out in mid-cap territory. It offers better sector diversification than rival iShares S&P/TSX Small Cap ETF, which, together with its inclusion of large-cap stocks, should help reduce volatility.

This is a market-cap-weighted portfolio, which promotes low turnover and reflects investors' collective views about the value of each holding. It also pulls the fund toward the largest stocks in its target market segment, giving it a larger market-cap orientation than most of its peers. In fact, the average market cap of the fund's holdings is about twice the category norm, so it may not keep pace when the smallest stocks outperform. Despite its broad reach, the fund leaves out some of the smallest names from the dedicated S&P/TSX Small Cap Index, many of which are among the market's riskiest and least-profitable firms.

While the fund's 0.61% management expense ratio is high by index fund standards, it is among the lowest in the category and well below the 1.21% median for non-commission-based funds, which should translate into strong category-relative performance over the long term. That said, the fund's performance hasn't stood out over the trailing 10 years through August 2018. During that time, it lagged the category average by 48 basis points annually, partially because of its greater exposure to basic materials stocks.

This portfolio is designed to complement index funds that track the S&P/TSX 60 Index. However, it would be cheaper to own  iShares Core S&P/TSX Capped Composite ETF (XIC), which charges a razor-thin 0.06% management expense ratio, than holding XMD and  iShares S&P/TSX 60 ETF (XIU) (0.17%) separately.

Fundamental view

Because this is a completion index fund, the composition of the S&P/TSX 60 Index influences the composition of this fund's portfolio. The committee that maintains that index targets 60 large-cap stocks that approximate the sector composition of the S&P/TSX Composite Index, which represents the broad Canadian stock market. But the S&P/TSX 60 Index does not follow mechanical rules or a set reconstitution schedule, so it can be difficult to anticipate changes. This fund gets the leftovers from that selection process, which includes a handful of large-cap stocks, but the majority are small- and mid-cap names.

Smaller-cap stocks have tended to be more volatile and less profitable than their larger counterparts, as they are less likely to enjoy durable competitive advantages. Their sector tilts can also contribute to their higher volatility. The basic-materials sector represents a much greater portion of the Canadian small- and mid-cap market than it does in the large-cap segment, and financial-services stocks have much less influence here. That said, the fund has less exposure to the volatile materials sector than the S&P/TSX Small Cap Index, and greater exposure to financial-services stocks. The fund also excludes some of the smaller and less profitable stocks from that dedicated small-cap benchmark. Its holdings also tend to generate average returns on invested capital, similar to the category norm.

This is a well-diversified portfolio that includes more than 180 stocks, the top 10 of which represent about a fifth of the portfolio. It is also well diversified across sectors, which each represent less than 20% of the portfolio. Because of its market-cap-weighting approach and inclusion of some large-cap stocks, the fund has a larger market-cap orientation than most of its peers. This should help mitigate volatility, but could also put the fund at a disadvantage when the smallest stocks outperform.

As a broadly diversified market-cap-weighted portfolio, the fund's performance probably won't rank among the best or the worst in the category over short horizons. But its cost advantage gives it a durable edge that should help its performance over the long term. It is also always fully invested, so it has a smaller-than-average cash drag, which can help its category-relative performance during market rallies but hurt during downturns.

Market-cap weighting allows market prices to drive the composition of the portfolio. This approach effectively harnesses the market's collective wisdom about the value of each stock. While the market may not always get prices right, it has been difficult for active managers to consistently beat the market. This fund's lower management expense ratio should give it an edge over its active counterparts over the long term.

About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.