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

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.

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About Author

Christopher Davis

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