This good-in-theory ETF is lousy in reality

The benchmark behind this small-cap ETF from iShares is problematic enough to earn a Negative rating.

Christopher Davis 25 April, 2017 | 5:00PM
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A flawed benchmark and poor track record earn  iShares S&P/TSX Small Cap Index (XCS) a Morningstar Analyst Rating of Negative.

XCS tracks the S&P/TSX Small Cap Index, which weights its constituents by float-adjusted market cap and includes stocks with market caps of $100 million-$1.5 billion. Because the fund’s market-cap boundaries are fixed, the number of holdings can fluctuate widely depending upon prior market conditions, either because rising markets push the index’s largest constituents above the $1.5 billion upper boundary or because falling markets push midsized names into small-cap territory or the smallest names below the $100 million lower boundary. The number of holdings has fluctuated between 180 and 280 since a significant 2007 methodology change. The largest 10 holdings make up less than 20% of assets. Even with one of the purest small-cap portfolios in the category, its holdings rank among the most liquid. The index rebalances quarterly and reconstitutes annually in June.

XCS fully replicates the index holdings. Reflecting the Canadian small-cap market, XCS is heavy on basic materials stocks; its 36% weighting is the category’s second-highest. And while its 17% energy stake is on par with the category norm, its holdings are more volatile than average, effectively magnifying its stake. Thanks partly to these sector biases, the fund has a strong tilt toward lower-quality names. It has the second-lowest concentration of companies with quantitative moats in the category and among the highest levels of fair value uncertainty, as measured by Morningstar equity research.

Research from as far back as 1981 has documented small caps’ historical outperformance in the U.S. stock market. Academics argued that smaller names outperform larger ones to compensate investors for added risk. Subsequent research has identified a small-cap premium in other developed markets and in emerging markets. However, evidence for this premium in Canada has been in short supply in recent decades.

To be sure, small-cap performance indicates investors have recognized small caps’ greater risk. Since its January 1987 inception, the BMO Small Cap Blended Index has been 20% more volatile (as measured by standard deviation) than the large-cap-dominated S&P/TSX Composite Index. However, investors haven’t been compensated for taking added risk. Since inception, the BMO Small Cap Blended Index has returned 7.6% annually, versus 8.2% for the large-cap dominated S&P/TSX Composite Index.

This is not to say Canadian investors should dismiss the possibility of a small-cap premium altogether. Although academic research has had little to say about the subject in the Canadian context, a 2003 paper indicated small caps outperformed large caps in Canada from 1960 to 2000. The small-cap premium can lay dormant for long stretches, and it is possible the future for the asset class may be brighter than its past.

The big problem with small-cap indexes may not be market cap but the quality of its constituents. AQR develops this idea in a cleverly named paper “Size Matters, as Long as You Control Your Junk,” where it found superior small-cap performance in 23 of 24 developed markets, including Canada, after accounting for the lower-quality firms. With its heavy reliance on commodity producers, the TSX Small Cap Index scores poorly on traditional metrics of quality like return on invested capital, which ranks among the lowest in the category. Having the ability to avoid low-quality names gives active managers a significant advantage over small-cap indexes.

No matter the prospects for small caps, the TSX Small Cap Index poorly represents the asset class. Rather than holding a fixed share of the investable Canadian market universe--say, the smallest 5% or 10% by market cap--the index includes stocks within a fixed market cap range of $100 million-$1.5 billion. This means the extent to which the index reflects the small-cap universe fluctuates with the market conditions as the number of companies considered small-cap by index standards decreases in rallies and vice versa. Active managers don’t face the same restrictions. As its name implies, the Canadian small/mid-cap equity category isn’t as pure as the index; its current upper market-cap boundary is approximately $4 billion, and the category median market cap, at $2.7 billion, more than twice the TSX Small Cap Index’s. Such flexibility has long been a virtue, as mid-cap stocks have fared better than either large or small caps during the past two decades.

To be sure, when commodities rally, or lower-quality stocks dominate, XCS has fared relatively well. Over the long term, however, performance has been poor, with its 0.9% annualised return since its May 2007 inception lagging the median fund in the category by nearly 3 percentage points annually.


By the standards of a market-cap-weighted index fund, XCS is relatively pricey, with a management expense ratio of 0.65%. However, it is relatively affordable next to active rivals; the median Canadian small/mid-cap fund sold without an embedded trailing commission levies a 1.34% MER. This advantage grows further once trading costs are taken into account: XCS' TER clocks in at a minuscule 0.01%, versus 0.19% for the category median. The TER only includes brokerage commissions, not implicit costs like bid-ask spreads and market-impact costs. Implicit costs are often higher in harder-to-trade, less-liquid stocks. XCS’ focus on the most-liquid small-cap names likely means its implicit costs are lower than its actively managed rivals, most of which hold less-liquid names.


Neutral-rated  iShares S&P/TSX Completion Index (XMD) is the only other passive option in the category, though its focus is on mid-caps and larger small caps. It tracks the S&P/TSX Completion Index, which includes TSX Composite holdings not held in S&P/TSX 60 Index, which is monitored by a committee tasked with ensuring its sector makeup reflects the Canadian market. Because some large caps aren’t included in the TSX 60 Index, a smattering end up here. While the strongest-performing small caps are jettisoned from XCS at a relatively low $1.5 billion threshold, investors here can hold them until they grow into mega-caps, where the return potential is relatively low. The portfolio is better diversified by sector and less-skewed to lower-quality names. Performance has been middling, despite the relative strength of the mid-cap stocks that comprise the better part of the portfolio.

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Christopher Davis

Christopher Davis  Christopher Davis is Director of Manager Research at Morningstar Canada.

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