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Most commentary about the U.S. stock market has an understandable focus on the big-cap technology stocks that dominate the major indexes, so many investors are probably unaware of a quiet revival in the small-cap sector recently.

During the 12 months to Aug. 10, the Russell 2000 Index, a broad measure of U.S. small-cap stocks, is up 22.7 per cent compared with a gain of 16.2 per cent for the big-cap S&P 500 Index.

According to investment-industry gurus, there is a simple explanation for this newfound enthusiasm for the sector: Smaller companies are more dependent on the domestic U.S. market than big multinationals and so they are less exposed to the negative consequences of current and potential trade wars initiated by U.S. President Donald Trump. As a result, investors now see them as more attractive and have bid up prices.

If this is correct, then the same logic should apply to the Canadian stock market. After all, smaller companies are probably less affected if negotiations on the North American free-trade agreement turn ugly and may in fact benefit if import tariffs protect their domestic market. But the Canadian market indexes are sending the opposite message: the big-cap S&P/TSX Composite Index is up 8.3 per cent in the past 12 months, while the S&P/TSX Small Cap Index is up only 4.7 per cent and the S&P/TSX Venture Composite Index is actually down 8.6 per cent over the same period. So, are Canadian investors missing the boat, or is there some other explanation for the divergence in small-cap index returns?

After a 40-year career managing small-cap value portfolios, I have observed that small-cap index relative performance is often simply a result of the fact that small-cap indexes look nothing like their big-cap equivalent in terms of their industry sector profile. The situation is particularly extreme in Canada. With sector returns over the past 12 months ranging from minus-9 per cent for utilities to plus-33 per cent for health care, performance differentials between indexes are just as likely to be a result of industry weightings as any other factor.

For example, most investors are aware that the S&P/TSX index is dominated by banks and other financial institutions with an overall weight of 33.5 per cent. The next three groupings are energy at 19.9 per cent, materials (resources) at 11.1 per cent and industrials at 10.3 per cent. In total, these four sectors make up 75 per cent of the index, even though there are 11 categories for the whole index.

There are not many small-cap banks, so it will come as no surprise to discover that the S&P/TSX Small Cap Index, which covers TSX-listed companies in the market cap range of $100-million to $1.5-billion, contains only a 6.4-per-cent weighting for this sector. Materials make up 27.2 per cent, energy 24.5 per cent and industrials 11.7 per cent. For this index, the big outliers versus the Composite index are a dramatic underweight in financials and a significant overweight in materials.

The Venture Composite Index has a negligible weighting in financials at 3.1 per cent and, as expected, a solid 45.2 per cent in materials, given its role in financing junior mining exploration companies. I was surprised to see that the Venture Index has a 17.4-per-cent exposure to the health-care industry when the Composite index weighs in at only 1.2 per cent. On scrolling through the list of constituent companies in this sector, I noted quite a few with “cannabis” in the company name, which begins to make sense. Presumably they will move to the consumer staples or consumer discretionary grouping when the product becomes legal.

To illustrate the effect of these industry over/underweights, the average difference between the small-cap industry weighting and its large-cap benchmark is as follows: Russell 2000 at 3.5 percentage points, S&P/TSX Small Cap Index at seven percentage points, and the S&P/TSX Venture Composite Index at 10.9. In other words, all of the small-cap indexes differ in terms of industry profile from their big-cap benchmark with the Canadian versions especially deviating. This should not come as a surprise when almost two-thirds of the Venture index is made up of resource and health-care stocks.

As a result, it may be reasonable for U.S. investors to interpret a difference in the returns between the S&P 500 and the Russell 2000 index as indicating investor preference for small- versus large-cap stocks because the industry composition of these two indexes is not too dissimilar. In Canada, it takes more of a leap of faith to draw any size-related conclusions from the index performance, especially when we look at the Venture Composite.

None of this implies that the published small-cap indexes are not capturing the small-cap effect: the S&P/TSX Small Cap index clearly covers the appropriate universe. But an investor in an index fund or exchange-traded fund (ETF) that purports to mimic a small-cap index should realize that he or she will also be exposed to a huge industry or economic-sector effect which may dominate the returns. This is a situation where a mutual fund with a diversified portfolio may be the preferred choice, as long as the fees are not excessive.

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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