Use small-cap ETFs to modify a Couch Potato

Q: I haven’t ever seen recommendations from MoneySense regarding small-cap stocks. Do you have any suggestion for what percentage of small caps one might add to a modified Couch Potato ETF portfolio?

— Kelly

A: Researchers have known for decades that stocks of small companies (so-called “small caps”) have historically outperformed the stocks of large companies over the very long term. While most of the research has focused on the U.S., there’s also evidence that small caps have outperformed in many other countries, including Canada. So why not include a couple of small-cap ETFs in a Couch Potato portfolio?

So long as you understand the trade-offs, adding small-cap stocks to your portfolio may be just fine. But before you do, give some thought to whether it’s worth the additional challenges.

ETFs tracking small cap stocks almost always have higher management fees than the plain-vanilla funds in the traditional Couch Potato lineup. And if you’re considering Canadian small caps, be aware that the space is denominated by resource companies, leading to very poor diversification. For example, the iShares S&P/TSX Small Cap Index ETF (XCS) has a management expense ratio of 0.62%, about 10 times higher than that of a broad-market Canadian equity ETF, and has more than 25% of its holdings in the materials sector (which includes mining) and another 25% in energy.

Small-cap stocks, by their nature, are also more volatile—indeed, this additional risk is one of the reasons they have delivered higher returns. They tend to fall more sharply during a market downturn, and then rebound more swiftly. Most investors have a hard enough time with the roller coaster of the broad market, so piling on more risk is only appropriate for battle-hardened investors with nerves of steel.

Finally, although small-cap stocks have outperformed over the very long term (at least in the U.S.), there is no guarantee that premium will continue in the future. Most of the outperformance in the historical data came before about 1980, and since then small companies have become easier to research and trade, which may have removed some of their risks, and therefore lowered their expected returns.

If you still want to add small-caps to your portfolio, I’d suggest a target of one-fifth of your equity allocation. In other words, if you have a balanced portfolio with 60% equities, you might consider making that 48% large-cap stocks and 12% small caps.

—Dan Bortolotti, CFP, CIM, associate portfolio manager with PWL Capital in Toronto

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