Several of Canada’s top performing small-cap funds have closed their gates to new entrants, shrinking the opportunities for investors looking to put new money into this sector. But with small-caps’ potential for sparkling returns, advisors and their clients should not pass by the slightly diminished selection, although they must dig a little deeper to find top funds that are still available.

“The choice is narrowing in the small-cap field,” says Rudy Luukko, investment funds editor at Morningstar Canada. “The purer the small-cap play the less capacity the funds have to keep on accepting new assets while maintaining their edge in performance.”

The Morningstar Canadian small- cap equity fund index boasted an average annual compound return of 13.3% for the five years ended April 30, far better than the return of 8.6% for the regular Canadian equity fund index. Only 49 of the 77 small-cap funds tracked by Morningstar have a five-year track record.

One of the latest hot performers to close down is Norrep II, sponsored by Hesperian Capital Management Ltd. of Calgary. The fund, which closed in March, boasts a three-year average annual return of 39%. Other good small-cap funds that closed within the past few years but continue to richly reward unitholders who got in before it was too late include Norrep Fund, Bissett Microcap, Bissett Small Cap, Resolute Growth, and Mawer New Canada. Although not officially classified as small-cap by Morningstar, Mackenzie Cundill Recovery Fund, Front Street Special Opportunities, and Sprott Opportunities Hedge Fund LP also have a preference for small companies and have raised the drawbridge within the past few months, and Beutel Goodman Small Cap closed about a year ago.

In most cases, the shuttered funds reached a size at which the managers felt that further inflows could impair their ability to invest in a concentrated portfolio of small and sometimes illiquid companies. The tipping point varies by manager.

For example, Front Street Capital Inc. of Toronto announced in February that it was closing Front Street Special Opportunities, when assets in the various versions of the fund were about $152 million. Norrep II was closed in March when small-cap assets in the fund and others run by the same manager hit the $400 million level. Bissett Microcap, part of the fund family of Toronto-based Franklin Templeton Investments Corp., was initially closed in 2000 when it hit $65 million in assets. It reopened for a brief few months after the September 2001 terrorist attack on New York’s World Trade Center, when the stock market declined and fund redemptions increased, closing again in 2002.

“After the 9/11 attack valuations became very attractive,” says fund manager Chris Fernyc, vice president and portfolio manager with Bissett Investment Management in Calgary. “Some people were redeeming while others wanted in. Rather than sell good securities to meet redemptions, we let the two activities offset each other.”

Fernyc says the reason for putting a lid on small-cap funds relates to the limited liquidity of small-cap stocks. In the micro-cap category, he’s choosing from a universe of companies with a market capitalization of less than $200 million. He wants to focus on his best ideas by running a concentrated portfolio of 35 companies. But he doesn’t want to end up owning too much of any one company’s outstanding stock or it becomes difficult to buy and sell without pushing around the price.

“We could have taken in more money and invested in bigger companies, but we want to maintain the integrity of the investment mandate, and maximize long-term returns for the investors who have supported the fund,” says Fernyc. “You don’t want to change the structure and strategy, but if the fund gets too big you’re forced to either put twice as much into each investment or to hold more companies. Owning 150 companies is a bad hedge, and doesn’t lead to superior performance.”

Randy Oliver, president of Hesperian Capital and manager of the Norrep family of funds, says that when fund assets are small he is able to invest in companies that fall under the radar screen of financial analysts, and it’s easier to find undiscovered gems. Once analysts on the Street become aware of a stock, it comes under greater scrutiny and is less likely to be available at a significant discount to its underlying value.

@page_break@When Norrep had $30 million in small-cap assets, Oliver says he could conceivably have invested in 30 companies with a market cap as small as $10 million, and take a 10% or $1-million position in each company. At $300 million in assets, he had to look at companies with $100 million in market cap to achieve the same effect, and there’s a lot more competition beating the bushes at that level, he says. The challenges increase as the funds grow.

“It’s harder to outperform the competition as we get bigger, but we expect our methodology will continue to give us an edge,” Oliver says.

His plan is to continue to invest in micro-cap companies with a market cap of less than $100 million, but they will no longer be able to make up the majority of the Norrep small-cap portfolios. He expects a realistic mix could be 20 microcap names, and then another 25 small-cap companies, with a market cap of up to $1 billion.

“We still want to invest in the companies with $20-, $30- or $40- million market caps in which you can be sure there is no analyst coverage, but it’s harder to get a position as our size increases,” Oliver says.

In February, the $240-million Northwest Specialty Equity Fund sponsored by Toronto-based Northwest Mutual Funds Inc. , announced it was reopening after being closed for a year. But it is solving the problem of fund size and limited small-cap opportunities by moving a portion of its assets and management responsibilities from subadvisor Deans Knight Capital Management Ltd. of Vancouver to Montrusco Bolton Investments Inc. of Montreal. The former lead portfolio manager, Deans Knight, gave up about $150 million in assets, but still manages about one-third of the portfolio. New incoming money will go to Montrusco. Reapportioning the investment responsibilities in this way allows Deans Knight to continue to manage an appropriate level of assets for its small-cap style, while sharing the management of Northwest Specialty Equity. The fund will be capped again when assets reach $500 million.

“Even with the fund closed for a year, it has continued to grow from capital appreciation,” says Wayne Deans, portfolio manager and co-founder of Deans Knight, who has managed the fund for 11 years. “We like to invest in companies with a market capitalization of less than $1 billion, and by staying small we can fish around in that area. If we get too big, we can’t do the best job for clients.”

As Dean’s comments indicate, shutting the fund to new investors is sometimes not enough to keep a well-managed small-cap fund small enough to maintain superior returns. Hesperian’s Oliver calculates that if small-cap assets in the Norrep funds grow another 30%, even without new money they will be greater than $520 million. Although there are always some redemptions in every fund, he says they have averaged about 11% a year — not enough to counteract investment growth. (The yearly average for the past seven years is close to 15% for all types of funds, according to the Investment Funds Institute of Canada) . Oliver says the funds may establish a policy of paying out a cash dividend to unitholders if necessary to keep the funds at a reasonable size.

Fernyc says there are still enough decent ideas out there to support his investment style, and he isn’t considering alternatives such as cash distributions at this point. He says there are ongoing fund redemptions at Bissett small-cap funds equal to about 15% of assets a year, and there’s always the possibility of less-than-stellar years in terms of performance.

“The market won’t go up forever, and, if it does check back, the redemption rate could go higher,” he says. “The combination could bring down the size of the fund.”

Although several top performing small-cap funds have closed, there are some attractive opportunities out there, according to Morningstar senior analyst David O’Leary. These include Saxon Small Cap, Ethical Special Equity and Clarington Canadian Small Cap. The Clarington Canadian Small Cap Fund, sponsored by Toronto-based Clarington Funds Inc., and Ethical Special Equity Fund, sponsored by Vancouver-based Ethical Funds Inc., are both managed by Calgary-based QVGD Investors Inc. They have similar, although not identical, profiles and jointly won the award for Canadian Small Cap Equity Fund of the Year at the 2005 Canadian Investment Fund Awards.

There are also some funds that may not be officially classified as small-cap, but are “opportunistic” and exercise a preference for small-cap stocks. Among these are Northwest Specialty Growth, Sceptre Equity Growth and Talvest Millennium Next Generation.

“There have been no discussions about closing our small-cap fund, although that could change,” says Robert Tattersall, executive vice president of Toronto-based Howson Tattersall Investment Counsel Ltd. and manager of the $300-million Saxon Small Cap for more than 20 years. The fund achieved an annual average return of 11.7% since inception in 1985 and a 30.7% average for the past three years.

“We’re a no-load fund, and don’t get the big surges of activity when it’s RRSP season or when a huge office full of brokers suddenly gets behind one fund. What’s detrimental to success is having huge flows of money in and out of the fund over which you have no control, and our flows tend to be slow and steady,” Tattersall says.

Irwin Michael, president of Toronto-based I.A. Michael Investment Counsel Inc. and manager of the ABC funds, is grateful for the removal of the 30% foreign content restriction on RRSP-eligible funds for expanding the world of opportunities just as the Canadian market’s selection of sufficiently liquid small-caps was starting to look skimpy for his growing funds.

“The Canadian small-cap market is extremely thin, but we have developed expertise in the U.S. market since we started ABC American Fund in 1996,” says Michael, whose four ABC funds each require a minimum investment of $150,000.

“We’re still finding things to buy in Canada, but we must scratch harder. The ability to look elsewhere increases the opportunity.” IE