The benefits of small-cap stocks, namely diversification and potentially higher returns, are widely documented based on data dating back almost a century.
This article is a journalistic opinion piece which has been written based on independent research. It is intended to inform investors and should not be taken as a recommendation or financial advice.
The data clearly links market outperformance to excluding unprofitable growth stocks and tilting towards value, tasks well within reach for Canadian investors through exchanged-traded funds (ETFs), which are able to hold and trade baskets of hundreds or thousands of small-cap stocks and diversify investors far beyond what any one individual could achieve.
As evidence mounts for a burgeoning turnaround in the asset class, with top institutions such as RBC, Macquarie and Raymond James compiling the key evidence for us, the time to start or reassess your exposure to small-cap stocks is now.
How to choose the best small-cap ETFs
- Make sure your risk tolerance matches up with what small-caps have to offer.
- Choose trusted ETF providers with significant assets under management.
- Compare ETF specs and investment mandates with your financial goals.
- Situate yourself on the active/passive divide.
- Think through your sell strategy.
1. Make sure your risk tolerance matches up with what small-caps have to offer
The first step investors should take towards investing in small-cap stocks is figuring out if personal risk tolerance aligns with the riskiness of the asset class as a whole.
We can conceptualize the risk of small-cap stocks by looking at the MSCI World Small Cap Index, which tracks a basket of more than 3,800 stocks in developed markets. The index has generated an annual return of 7.6 per cent over the past 20 years, while requiring you to withstand a standard deviation of 18.06 per cent over the past decade, meaning that your investment could fluctuate by an average of about one fifth of its value in any given year.
Averages are, of course, deceiving, as evidenced by the index’s maximum yearly return of 57.8 per cent in 2003 emerging from the Dot Com Bubble, and maximum drawdown of 61.35 per cent in 2007 during the Global Financial Crisis.
Would you feel comfortable losing more than 60 per cent of your money in a single year? And do you have the time horizon to potentially buy more ETF shares at depressed prices, or at the very least hold onto those you own, for the potential decade plus it may take for small-caps to recover?
If you think you’re well-equipped to withstand the psychological turmoil of a massive drawdown, you should be prepared to invest in small-cap stocks in excess of their market share to ensure they can make a difference in your portfolio. As a proxy, VEQT, Vanguard’s All-Equity ETF, holds just over 14 per cent of assets in small and medium-small companies, meaning that exposure in excess of that figure would begin to pull weight in terms of overall return.
2. Choose trusted ETF providers with significant assets under management
Once your settle on an allocation percentage, you need to make sure you’re doing business with a fund provider with a reputation worth trusting over the long term.
While there’s no official list to make this process easy, there are many trusted sources for financial news and commentary, including Money, Kiplinger, Morningstar and The Globe and Mail, that have made their recommendations clear, highlighting providers such as:
- Vanguard, which cares for US$11 trillion in assets and has made a habit over the decades of lowering fees and cutting costs to optimize investor returns.
- BlackRock, the planet’s largest asset manager at US$12.5 trillion, which rivals Vanguard in terms of the lowest-cost equity exposure around.
- Avantis, a specialist in factor investing, including small-cap and value stocks, with more than US$82 billion in assets under management.
- Dimensional Fund Advisors, an operation focused on low-cost index investing with data-driven tilts based on company size, profitability and value that have proven to maximize returns over an investing lifetime. Avantis was founded by former Dimensional executives.
What these investment houses have in common are the marks of high quality, including a long-term track record, a rigorous approach to data and the backing of billions of investor dollars, all of which reinforces operational longevity and de-risks your own investment.
Other notable names worth considering that fit this bill are Fidelity, Global X, TD and Bank of Montreal.
3. Compare ETF specs and investment mandates with your financial goals
Now that we have a universe of funds to choose from, we must consider the details of each fund of interest to make sure an investment is aligned with your financial goals.
To illustrate this process, let’s suppose the money you’re investing in small-cap stocks is meant for retirement in about 20 years, and that you have enough job stability to believe you won’t need to sell the stocks before then. Under this scenario, an essentials checklist should include:
- An assessment of after-fee returns, favoring funds that more than pay for what it costs to own them.
- An assessment of portfolio diversification, avoiding funds with overconcentrated positions that may put you at risk of steeper drawdowns compared to investing across the industry and geographical spectrum.
- An assessment of strategy, favoring data-driven, long-term approaches with low turnover ratios that keep costs low and conviction high.
- An assessment of longevity, favoring funds that have proven their ability to make money throughout the economic cycle.
- An assessment of assets under management, which are important because every ETF must hit a critical mass before earning enough revenue to merit its place on the parent company’s books. While this figure is not part of regulatory disclosure, data from ETF.com shows how a fund charging a 0.2 per cent management expense ratio will only be breaking even on annual costs with $100 million under management.
Should your financial goals change, you’ll need to re-allocate funds in the small-cap sleeve of your portfolio accordingly. Move to lower-risk assets such as bonds and cash, if a spending need within five years or less arises, or simply diversify into more market-capitalization-weighted exposure, if you decide small-cap volatility is just a little too much to bear.
4. Situate yourself on the active/passive divide
Every ETF investor, small-cap or otherwise, should take a stand in the never-ending debate about whether active or passive investing is the optimal way to go.
Active investing is the practice of picking stocks positioned to outperform their broader market, whether that’s the TSX, S&P 500 or some other index, based on financial metrics and product and industry analysis. Active ETFs often carry higher fees to reflect the research required.
Passive investing, on other other hand, entails owning the aforementioned broader market, opting for its total return, averaged out between also-rans and leaders of the pack. These ETFs often carry lower fees than their active counterparts, because instead of making judgement calls on prospective companies, the fund manager’s sole concern is the by-rote task of trading the portfolio in line with what its benchmark index dictates.
Here’s the rub: Over the long-term, passive investing is the clear winner when it comes to returns, trouncing active strategies to an embarrassing degree, with only 2.35 per cent of active Canadian stock funds outperforming the TSX over the past decade.
That said, more niche asset classes, including small-cap stocks, are often thinly traded and farther removed from the spotlight of analyst coverage, increasing the chances of a meticulous management team discovering winning stocks the broader market is missing. Avantis and Dimensional are shining examples of this, alongside a handful of other active ETF providers outperforming the TSX (20.68 per cent) and S&P 500 (14.38 per cent) year to date.
5. Think through your sell strategy
Our fifth and final step to optimize your exposure to small-cap stock ETFs is to determine how best to go about selling your shares when you need the cash.
Given that small-caps rank near the top of the high-risk/high-reward spectrum, you may find yourself contending with wide bid-ask spreads that call for spreading your sell orders across a few days or weeks, encouraging a lower average price than you could achieve by selling it all in one day. This strategy is of course dependent on doing business with a broker that offers commission-free trades, including Questrade, Wealthsimple and Canada’s Big Six banks.
You will also have to pay attention to the tax laws governing the account you hold your small-cap ETF shares in. In Canada, there are three primary accounts worth knowing about:
- The Tax-Free Savings Account or TFSA, which allows you to keep all investment gains subject to yearly contribution limits.
- The Registered Retirement Savings Plan or RRSP, which allows you to deduct every dollar contributed from your taxable income and grow your investments tax deferred. Withdrawals are taxed as income and subject to minimum distributions beginning in the year you turn 71.
- The Taxable or Non-Registered Brokerage Account, requiring you to pax taxes on all gains, though you may deduct capital losses from capital gains to lower what you owe.
Regardless of the account you choose, make sure to consult with a financial professional, bound by fiduciary duty, to dot your i’s and cross your t’s before settling on a plan and putting money to work. This would ideally be an independent, fee-only financial planner, whose income does not depend on convincing you to buy funds that pay them asset management fees.
Now that you have a solid framework to source small-cap ETFs, buy them for your portfolio and liquidate them to fund your life goals, all that’s left to do is compare funds until you find those best suited to your particular financial situation.
May your research be fruitful and your returns differentiated.
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Stockhouse does not provide investment advice or recommendations. All investment decisions should be made based on your own research and consultation with a registered investment professional. The issuer is solely responsible for the accuracy of the information contained herein.
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