When asked recently to examine a portfolio manager's track record, I was reminded of how careful one must be with performance rankings. In this case, I was assessing the strong five-year run of a Canadian Small/Mid Cap Equity manager. It didn't take long to see that knowing the evolution of today's small/mid cap mandates is critical to making an informed assessment.
Evolution of Income Trust Mandates
The first investment funds mandated to invest in real estate investment trusts, royalty trusts and business trusts were launched between 1996 and 1998. As tech stocks melted down and income trusts (and most non-tech equities) posted strong returns, fund companies lined up to launch income trust funds. This spawned the income trust class of funds and institutional mandates.
But as 2010 ended so too did income trusts' tax advantage. Accordingly, all funds and mandates formerly categorized as income trust products were placed either alongside dividend funds or with small-to-mid cap equity funds.
Impact on Performance Comparisons
Depending on the particular fund or product under examination, you could draw very different conclusions on otherwise similar portfolios and performance levels. When looking at retail mutual funds, for instance, old income trust funds may be in one of three categories - i.e. Canadian Dividend & Income Equity, Canadian Small/Mid Cap Equity or Canadian-Focused Small/Mid Cap Equity. (It's interesting to note that some institutional databases continue to track the Canadian Income Trust products.)
For those looking at returns over the past five years, all of this background is relevant for two reasons because both factors are skewing the performance comparison today.
Former income trust mandates generally had a mandate to buy the aforementioned types of income trusts. And by policy, many of these could not buy regular small cap stocks that did not fall into one of the trust buckets. Once income trust funds - really restricted smaller cap funds - moved into regular categories, their returns get compared with other types of portfolios without any similar policy restriction.
And this is relevant because performance over the past five years has been very different for these market segments. Shares of small company stocks, for instance, have posted a 2.3-per-cent annualized gain for the five years through March, 2013 (based on data from S&P Dow Jones Indexes). The much broader S&P/TSX Composite Index sports the same five-year performance figure.
By contrast, stringing together returns from the old TSX Income Trust Index and the current S&P/TSX Equity Income Index shows returns of 7.9 per cent per year. The Dow Jones Select Canada Dividend Index gained 6.3 per cent per year over the same five years. (All performance figures are total returns.)
While this is hardly a scientific test it does imply that over the last five years, having had exposure to dividend-payers has been a much more influential factor than whether you have exposure to bigger or smaller companies. In other words, those comparing former income trust funds to a dividend benchmark will draw very different conclusions than benchmarking those same mandates against small cap stocks.
Bissett Canadian High Dividend-A is a small/mid cap equity fund that has returned 9.1 per cent annually. If compared against a small cap benchmark, this return will look stellar compared to the 2.3-per-cent annualized return. While the fund has outperformed its more suitable benchmark, the outperformance is much less striking.
Similarly, Dynamic Equity Income is a former income trust fund but it classified alongside Canadian dividend funds. Its annualized total return of 7.7 per cent leads to a very different conclusion, with outperformance of the DJ Select Dividend Index but a bit below the Equity Income index over the past five years.
This is just one of many examples demonstrating the importance of looking beyond the numbers. Sometimes one benchmark will apply throughout a fund's history - whether or not it matches its current classification. Other times a more customized benchmarking solution will be needed to reflect a portfolio's changing investment policy over time.
Making this assessment requires a portfolio's original investment policy or stated strategy (and subsequent changes), a full performance history and periodic holdings going back several years. In other words, understand how a performance record was achieved - something my HighView partners and I live and breathe. Failing to do so could lead to false insights.
Dan Hallett, CFA, CFP, is director of asset management for HighView Financial Group and a contributor to thewealthsteward.com.