Small-capitalization stock indices have been lagging large-caps in recent years, but many active small-cap portfolio managers have reaped impressive returns by venturing beyond the boundaries of their benchmark.

“Small-cap managers can look for stocks in a lot of different places, as there is a much bigger universe to choose from; whereas a lot of large-cap Canadian managers tend to fish in the same spots,” says Dan Hallett, vice president and principal with HighView Financial Group of Oakville, Ont.

According to a recent report issued by Toronto-based Russell Investments Canada Ltd., the S&P/TSX small-cap index was mired in negative territory in 2014, dropping by 2.3% – far behind the healthy 10.6% gain registered by the S&P/TSX composite index – marking the fourth straight year that small-caps lagged the broader index.

However, Russell’s survey of 40 small-cap equities portfolio managers found that many of them are performing far better than their benchmark, with a median return of 5.8% in 2014, roughly 818 basis points (bps) ahead of the S&P/TSX small-cap index. For the fourth straight year, the median small-cap manager returns were higher than their benchmark index, and 83% of these managers beat the benchmark in 2014.

In the large-cap arena, in contrast, only 55% of large-cap managers beat their benchmark, the S&P/TSX composite index.

In Canada, the small-cap index is heavily weighted in energy and materials stocks, and the small-cap managers that outperformed were lightly exposed to these sectors. Recently, the small-cap index had a 31% weighting in materials and 12% in energy, making it even more resources-heavy than the S&P/TSX composite index, which has 21% in energy and 11% in materials.

“It’s less about the [benchmark] index when assessing small-cap performance and more about performance relative to peers,” says Kathleen Wylie, head of Canadian equities research for Russell. “The data strongly support the value of active management in small-caps – and a greater opportunity to beat the index than with large-caps.”

Looking longer-term at the past decade, an average of 57% of large-cap managers beat the S&P/TSX composite index’s annual return, with the median portfolio manager roughly 80 bps ahead of the index’s return per year on average for the 10-year period.

In the small-cap arena, an average of 74% of small-cap portfolio managers beat their benchmark index on a yearly basis for the same period, with the median manager ahead of the benchmark by 680 bps a year on average.

During the same 10-year period, the median small-cap manager was ahead of the median large-cap manager in Canada by 286 bps a year, despite the fact that the small-cap benchmark index lagged significantly during the decade. The S&P/TSX small-cap index had a 10-year annualized return at the end of 2014 of 2.5%; the S&P/TSX composite index’s annualized return was 7.6%.

Anything can happen during short time periods, Hallett says, and a period of at least 20 years gives a more realistic comparison of small- and large-caps.

Data provided by Chicago-based Morningstar Inc.-owned Andex charts show U.S. small-cap stocks outperforming every other investment category in the 64 years between 1950 and 2014, with an average annual gain of 13.6% in Canadian dollars, beating the 11% return for large-cap stocks, 7.5% for long government bonds, 6.9% for five-year guaranteed investment certificates, 5.7% for 90-day Canada treasury bills and 3.8% for inflation (as measured by the consumer price index).

The difference is even more dramatic when comparing the value of US$100 invested. That sum would have grown to US$248,768 if invested in U.S. small-caps during the 64-year period since 1950, and to US$60,150 if invested in U.S. large-caps (based on an average annual return advantage of 2.6% for small-caps). However, the worst five-year period for U.S. small-caps was an average annual loss of 14.1%, almost double the worst five-year average loss of 7.5% for large-caps.

“For diversity, having a small-cap manager in your lineup is a good thing,” Wylie says. “Performance will swing more, but there is added value in the long term. It’s important to assess the stock-picking skills of the individual manager – there is a huge range of returns.”

Wil Wutherich, president of Montreal-based Wutherich & Co. and portfolio manager of Steadyhand Small-Cap Equity Fund (sponsored by Vancouver-based Steadyhand Investment Funds Inc.), says he never takes a point of view on the index; his approach is bottom-up.

“We look for companies with better than average balance sheets and growth prospects, and a dedicated management team producing products or services where demand is steady and sustainable,” Wutherich says.

The Steadyhand fund’s holdings have a market cap of $50 million to $5 billion, and the average currently is $1.2 billion, Wutherich says. He likes to run a concentrated portfolio of 15 to 20 names, so each holding can have a strong impact on returns; the fund currently holds 17 stocks.

Wutherich also likes to hold firms for as long as a decade, and he’s had a few in his portfolio for longer than that, including U.S.-based retailer Hibbet Sports Inc., which the Steadyhand fund has held for 13 years.

With small-caps, the quality of company management is particularly important, as one individual can make a big impact on a firm, he says: “The importance of management is huge with smaller companies. It’s like comparing a small sailboat to a giant freighter. If the captain takes his hand off the tiller for a second, the sailboat can veer off course quickly.”

Aubrey Hearn, vice president with Toronto-based Sentry Investments Inc. and lead manager of Sentry Small/Mid Cap Income Fund, has minimized volatility in the Sentry fund by focusing on small firms that are leaders in their respective industries, with strong free cash flow and the potential to pay growing dividends, although some holdings may not yet be paying dividends.

Although small-caps have a reputation for volatility, the Sentry fund’s performance has been rewarding – and less bumpy – than that of the large-cap S&P/TSX 60 index. As of April 30, 2015, Sentry Small/Mid Cap Income had an average annual five-year return of 18%. “We focus on owning good businesses, not risky high-fliers,” Hearn says.

For the year ended April 30, the top-performing small-cap fund was Pender Small-Cap Opportunities Fund, sponsored by Vancouver-based PenderFund Capital Management Ltd. Its gain was 38.1% for the 12 months.

The Pender fund was closed to new investors in January 2015. But David Barr, chief investment officer at PenderFund, says small-cap stocks are included in other PenderFund portfolios.

“As value investors, we try to figure out what a company’s cash flow will look like in three to five years,” says Barr. “With resources stocks, it’s difficult to predict the underlying commodity’s price, which means we tend to have low exposure to the [sector]. Last year, resources stocks were down, and we avoided the downdraft.”

Small-caps, due to their small size, can grow at 15% to 20% a year, while bigger companies can’t achieve the same percentage gains, Barr says. Small-caps also tend to be subject to less research by analysts, leading to greater inefficiencies in pricing and more undiscovered opportunities.

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