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On Small-Fee Small Caps
Update In the July issue of the Canadian MoneySaver I wrote about the Barclay's iUnits iG10 exchange-traded fund (ETF), which trades under the XGX symbol. In November Barclay's Global Investors Canada proposed major changes to that fund's investment objectives. The proposal, subject to approval by unitholders, would see the fund henceforth aim to match the performance of the Scotia Capital Markets Universe (SCMU) bond index instead of the ten-year Canada bond. The fund's name would also be changed to "iUnits Canadian Bond Broad Market Index Fund". The purpose of the change appears to be to take advantage of the SCMU index's historically better performance in times of rising interest rates. However, to be fair, it is also true that the iG10 ETF has suffered from a relative lack of investors. The fund has not been as successful at attracting assets as the five-year iG5 ETF, which is unaffected by these changes. From a frugal perspective the change will increase costs slightly, with the fund's MER rising to 0.30% from 0.25%. No doubt this increase reflects greater anticipated trading costs associated with managing what will be a much more diverse portfolio. Of course the fund will still be much cheaper than actively-managed bond funds. The appearance of a well-diversified Canadian bond index fund should be welcome news to all investors since very few actively-managed bond funds have been able to match the performance of the SCMU index. As a rule self-directed frugal investors should stick to fixed-income funds that charge no more than a 1% MER. For equity funds on the other hand the MER maximum should be about 2%. Over time the savings from selecting a good low-cost fund will add up. Fortunately there are many funds that charge modest MERs. These are generally offered by boutique firms or firms with large pension operations such as Saxon, Phillips Hager & North, and Beutel Goodman, to name but a few. For the rest of this article, I focus on the small-cap equity fund offered by Calgary-based Mawer Investment Management, which offers a number of good low-fee funds. Mawer New Canada Over the past fifteen years the Mawer New Canada fund has returned an average of 15.5% annually, outperforming both its peer group and the BMO Nesbitt Burns Canadian Small Cap (NBSC) index, which returned 8.3% annually over the same period. The fund's relative performance has been even stronger over the three and five years periods, during both of which it added nine percentage points to the index's average annual performance. Managed by Martin Ferguson since 1998, the fund's $155 million in assets are invested mainly in shares of smaller Canadian companies with less than $500 million in market capitalisation. The fund's essential style is bottom-up growth-at-a-reasonable-price (GARP) with a value bias. Mr. Ferguson looks for money-making companies that are undervalued (on a discounted cash-flow basis), financially sound, and are in the right part of their business cycle. In selecting small-cap companies Mr. Ferguson places a particular emphasis on their managers' abilities and wealth creation track-records. Although companies are selected strictly on their own merits, top-down economic considerations also play a role in determining individual and sector weights. The need to manage the greater risk associated with small-cap stocks is reflected in exposure guidelines of no more than 5% for individual stocks and 20% for industry sectors, and in Mr. Ferguson's commitment to constructing a broadly diversified portfolio. The fund usually holds between fifty and sixty stocks. Once purchased, a stock is held in the fund's portfolio for the long term unless the company's fundamentals change for the worse, its stock becomes too expensive, or a better opportunity comes along. The fund's average 24% turnover suggests that stocks are typically held for about four years. It is noteworthy that when the opportunity arises the fund will sell to lock in a capital loss. The result being that the fund has made no significant distributions to unitholders since 2001 and has therefore been almost 100% tax efficient (on a pre-liquidation basis) since then. At the end of the third quarter the fund held fourty-seven stocks and a 3.2% cash position. The top three sectors were industrials (32%), energy (24%), and consumer products (23%). These weights have not changed significantly over the past few years, which reflects Mr. Ferguson's continued positive view of these sectors. The fund's top three holdings at quarter end were Russel Metals (RUS), Transat A.T. (TRZ), and CHC Helicopter (FLY). The fund has been moderately active lately. IAMGold (IMG) and Thunder Energy (THY) were sold in the third quarter while Esprit Exploration (now the Esprit Energy Trust (EEE)), ZCL Composites (ZCL), and Harris Steel (HSG) were added. The fourth quarter has so far seen the purchase of two IPOs. Asked about his best recent pick, Mr. Ferguson points to BW Technologies, a gas-detection equipment maker which the fund purchased for about $8 and held for almost five years before it was sold to a takeover for $36 during the second quarter. The current top holding, Russel Metals (RUS), also gets mention as a favourite stock, having nearly quadrupled since it was purchased. Looking to disappointments, fireplace maker CFM Corporation (CFM) was sold at essentially its purchase price during the third quarter after an ill-fated foray into barbecues weakened a previously solid balance sheet. Mr. Ferguson also takes his lumps when it comes to Norwall Group (NGI), a residential wallpaper maker. The stock was purchased at the right time in the company's business cycle, but the secular timing was wrong as the entire North American industry has been shrinking. The fund continues to hold Norwall, which trades at about $2 down from an $8 purchase price. Going forward Mr. Ferguson is very positive about the prospects of small-cap stocks in the long term. However, in the short term he foresees a period of slowing economic activity that will limit the sector to single-digit returns. As with all Mawer funds, the New Canada fund can be purchased through dealers or brokers with a $5000 minimum initial investment. However, when purchasing directly from Mawer the minimum rises to $25,000 for residents of Alberta and Saskatchewan, and to $100,000 for those in British Columbia, Manitoba, and Ontario. Residents of other provinces have no option but to go through a dealer. Over the long term, the Mawer New Canada fund has demonstrated a consistent ability to significantly outperform. Moreover, the fund's much lower historical volatility compared to the NBSC index is a testament to the effectiveness of Mawer's approach to risk-management. Nevertheless, because of the greater risk involved with small-cap investments this fund should only make up a fraction of a well-balanced portfolio. It is suitable for slightly more aggressive frugal investors who appreciate a bargain MER of 1.46%. In the News Fidelity Investments Canada recently announced cuts to the management expense ratio (MER) of all of their funds. The MER is the fraction of assets that investors pay annually to cover a fund's management and operating costs. The cuts announced amount to about twenty basis points for equity funds and thirty basis points for fixed-income funds. This is welcome news even though it is probably a marketing tactic intended to appeal to investors who currently hold units of Fidelity's deferred-sales-charge (DSC) funds. A significant portion of those assets is poised to emerge from the seven-year redemption period, after which the investors concerned will be free to shop around for a better deal and to redeem their Fidelity holdings without penalty. In brief, Fidelity has effectively announced that starting January 10, 2005 it will charge a lower annual MER but only once sales fees have been paid off. Holders of front-end load units, for which the sales fee is paid at the time of purchase, will therefore see an immediate cut in their MER. However, holders of fund units purchased with a back-end load (DSC units) will only experience a drop in MER after the end of the redemption period. At that time their units will automatically be converted to lower-fee front-end load units. So an investor buying a back-end load Fidelity fund today, with a seven-year redemption period, won't benefit from the MER reduction until 2012. (Fidelity has also announced a new low-load option with a two-year redemption period, but few details have been offered.) Explicitly mentioning the relation between MER and sales fees is welcome because it gives investors a better understanding of what they're paying for. It also appropriately places the sales fee burden on those who have not yet paid it in full. For cost-conscious investors interested in purchasing a Fidelity fund the choice is clear. Prior to the announced changes the front-end load option was already preferred (with the proviso that such funds should be purchased through a discount broker who will waive the load). Lower MERs now make this choice an even better one. It can only be hoped that other fund companies will follow Fidelity's lead in lowering fees and improving the transparency of the fee structure. The announced MER cuts notwithstanding, it continues to be the case that from a frugal perspective Fidelity's funds are expensive overall. The Fidelity True North fund, for example, will now sport a 2.35% MER, which is lower than the median 2.55% MER for Canadian equity funds but well above the 2% maximum recommended above. On the fixed-income side, the Fidelity Canadian Bond fund will see its MER drop to 1.36%, again lower than the median for Canadian bond funds but far above the 1% level which frugal investors should consider a maximum. For reference, recent median MERs for different fund classes are shown in the accompanying table. Remember that keeping fees to a minimum will help ensure that more of your money continues to work for you.
Carl Wolfe, PhD Jan 2005 |
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