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Déjà vu
It's 1996 all over again - sort of

Strong performance by dividend, small cap, and resources funds are drawing huge cash inflows. The combination of big returns and bigger inflows is causing ballooning assets - so much so that dividend and small cap funds have been closing over the past year. This should sound familiar, but the same fate may not be looming this time around for small cap funds.

Then (1996)

If you were in (or if you were following) the fund industry back in 1996, you'll recall that falling interest rates, a strong economy, and rising oil and gas prices juiced returns in funds positioned to benefit from such trends. After one of the quickest rate hikes in history in 1994, rates resumed their long-term descent. This was a shot in the arm for dividend funds and other interest sensitive investments.

Plus, a rebounding economy gave a boost to commodity prices which not only spurred resource funds, but also Canadian small cap funds (many of which were resource heavy at that time).

As a result, funds like BPI Canadian Small Companies, BPI Dividend Income (each was merged after CI bought BPI), Dynamic Dividend, GGOF Monthly Dividend Income, and Marathon Equity (now Northwest Special Equity) were closed to new investors. The reasoning: Bulging assets in a relatively thin market meant capping new sales was necessary to prevent size from adversely affecting performance.

And this made sense. The dividend funds that closed invested primarily in preferred shares. The preferred market was a small and shrinking universe of securities. It remains a relatively illiquid market today.

Canadian small cap stocks are a tiny market segment (in dollar terms) even though they have long accounted for hundreds of individual companies. So, capping new sales made sense.

Back then, the capping of funds also coincided with peaks in small caps and dividend funds (in absolute terms) - at least for awhile.

Now (2004/05)

Interestingly, many of the same closures have occurred over the past year, and continue today. Since the tech bubble began deflating, resources, small caps, and high yield equities have prospered.

Among others, recent fund closures include Bissett Small Cap, GGOF Monthly Dividend Income (which re-opened in 1998), Mawer New Canada, Northwest Special Equity (which also re-opened subsequent to its 1996 capping), and Resolute Growth. All except GGOF are small cap funds. And with the run such funds have had over the past five years, it begs the question: Does the capping bode ill for such funds' near future?

The run back in 1996 for small caps was followed by a very rough four year patch for small caps. And dividend funds suffered - at least in relative terms - as the late 1990s infatuation with all things 'large cap growth' gathered momentum. Plus, many value-oriented managers began to get concerned about valuation levels - as is happening today.

While the spring of 1997 brought about a fairly brisk decline, the rebound was equally quick; we now know that it took four years before any big declines began. Also, 1996-1997 was witness to a number of stock scandals in names like Bre-X, Cartaway Resources, and YBM Magnex. So, the early-to-mid 1990s small cap outperformance was in part illusionary (except for those that sold at or near the peak).

The small cap recovery of 2000-2004, however, was really the reversion to some sense of normalcy after the unprecedented performance gap between big and small companies during the late 1990s tech boom.

In short, don't expect small caps to fall apart. There are many companies not well represented in the small cap indexes. Plus, small companies are in better financial shape compared to the more speculative days of past rallies. However, no broad area of the market is cheap today - except, perhaps, microcaps - a situation that argues strongly for prudent diversification.

But as small cap funds grow, it becomes more difficult to maintain outperformance. So, be glad if one of your chosen funds closes. It's usually a good move. And while fund capping only happens after a strong run, this isn't necessarily a sign that the fund's near-term future is doomed.



Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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