Are You Ready For a Venture?

March 30, 2011

As I discussed in Monday’s post, an American ETF provider launched the Global X S&P/TSX Venture 30 Canada ETF (NYSE Arca: TSXV) on March 17, the first index fund pegged to Canada’s junior stock exchange. iShares has announced that it will launch its own the S&P/TSX Venture Index Fund (XVX) in the coming months.

These new ETFs give Canadian index investors an opportunity to access a whole new market that was previously off-limits to anyone who wasn’t willing to trade individual stocks. But before you decide to add one of these funds to your portfolio, understand what you’re getting into.

A risky Venture

The Venture exchange is a play on commodities. If you think the broad Canadian market is poorly diversified, it has nothing on the Venture market. All 30 of the companies in TSXV are involved in either mining or energy (oil and gas). So don’t make the mistake of thinking that this fund gives you broad exposure to small companies in all sectors of the economy.

These are really small companies. It’s a stretch to call these companies small caps — all but the largest Venture-listed companies are micro caps (worth less than $300 million), and TSXV includes several penny stocks (those with share prices under $1). Indeed, all 2,400-odd companies on the Venture exchange have a combined market capitalization of about $78 billion. That’s significantly less than the market cap of Royal Bank alone.

Buckle up for the ride. You can expect Venture-tracking ETFs to be much more volatile than a broad-market Canadian index fund. According to the prospectus for the forthcoming iShares ETF, companies on this exchange “are subject to substantially greater risks of loss and highly volatile price fluctuations because their earnings and revenues tend to be less predictable and their markets less liquid than companies with larger market capitalizations. These companies may also be highly speculative in nature and may not have established businesses.”

Tracking error could be significant. I would take a wait-and-see approach with any new ETF as small as TSXV. (The fund currently has less than $5 million in assets, and many of its holdings amount to less than $100,000.) The iShares ETF sounds more promising, given BlackRock’s long record of prudent management. But it remains to be seen whether a Venture ETF can ever have the economies of scale it will need to keep its costs low and its tracking error small.

Other ways to think small

If you want to tilt your portfolio to small-cap stocks, investing in the TSX Venture Exchange is not the way to do that: TSXV, at the end of the day, is a speculative investment in 30 extremely small mining and energy companies, and it’s not appropriate for most index investors. There are much broader options for those looking for small-cap exposure:

  • For Canadians, the iShares S&P/TSX Small Cap Index Fund (XCS) has more than 200 holdings and an MER of just 0.55%. Many of the companies are also part of the S&P/TSX Composite, though they carry more weight in this fund. Inevitably, XCS is skewed to mining and energy companies, too, but 40% of the fund is in other sectors.
  • The US small-cap market is incredibly rich, and the Vanguard Small-Cap ETF (VB) gives you more than 1,700 stocks for just 0.14%. Energy and materials are small parts of this fund, whose largest sectors are financials and technology (each about 20%), health care, industrials and consumer goods.
  • For global small-cap exposure, it’s hard to top the Vanguard FTSE All-World ex-US Small-Cap ETF (VSS). Canada actually represents the largest share of this fund, at more than 15%. The ETF includes more than 2,700 companies from around the world, with the greatest weight in the industrial, financial and consumer sectors. The MER is 0.33%.

{ 12 comments… read them below or add one }

Paul G March 30, 2011 at 2:21 pm

Of course, other ETFs like VTI and VXUS already include small-caps, and adding these other ETFs would just be a way to over-weight small caps (kind like in your uber-tube portfolio).

Canadian Couch Potato March 30, 2011 at 3:37 pm

@Paul: Yes, that’s true. Even though there are a lot of small-cap companies in these total-market indexes, their overall influence is dwarfed by that of the large caps. Look at the correlation between VTI and the S&P 500, for example. So to get meaningful exposure to small-caps you do need to hold a dedicated fund to overweight them.

Dong March 30, 2011 at 10:50 pm

for people already holding VTI and XIC, is adding a small-cap etf/fund providing any real benefits ?

My Own Advisor March 31, 2011 at 8:32 am

@Dong – I was thinking the same thing…

Canadian Couch Potato March 31, 2011 at 8:50 am

@Dong and Mark: Over the long term, small caps have delivered considerably higher returns than large caps, so there is a good argument to be made for overweighting them. However, this is certainly not necessary for small portfolios, or for people who want to keep things simple.

It’s important to understand that the role of small caps in funds like VTI and XIC is limited. The large companies in these cap-weighted index wield far more influence: the S&P 500 companies cover about 70% of the US market, which means the the other 2,800 stocks in VTI cover only about 30%. Same thing in Canada: the members of the TSX 60 dominate XIC and have far more influence than the 160 other companies.

gsp April 3, 2011 at 3:16 am

For EAFE small cap exposure I use SCZ to complement my large cap VEA holding. VSS did not exist when I first implemented my ETF portfolio but even now I’m not so sure it would make sense since all my equity holdings are outside sheltered accounts and holding 15% CAD small caps in a US vehicle should lead to losing the preferrential dividend tax treatment.

I use VB and VBR for US small caps to complement VTI. I doubt I will bother with VBR going forward as it adds complexity and seems to offer very little differentiation from VB.

Are there any interesting emerging market small cap ETFs?

Canadian Couch Potato April 3, 2011 at 8:05 am

@gsp: Thanks for the comment. It’s true that using VSS would forfeit the preferential tax treatment of Canadian dividends, but the savings would be quite small, as small-caps tend to pay low dividends anyway.

For emerging market small caps (if you want to slice your portfolio that thin), have a look at the ETFs offered by WisdomTree:
http://www.wisdomtree.com/etfs/fund-details.asp?etfid=53

gsp April 3, 2011 at 9:00 pm

Thanks CCP. Not sure if I want to slice that thin but seeing 21% of VSS in EM got me wondering. Found another from State Street. https://www.spdrs.com/product/fund.seam?ticker=ewx They have very different performance over the last few years, haven’t really looked into their differences yet other than the obvious(fundamental vs market cap)

I guess another reason I’m initially reluctant to embrace VSS is I’ve always maintained region allocation control up to now. Perhaps that’s more of a perceived negative than a real one if this ETF’s region allocation stays fairly consistent.

Have you seen a detailed analysis of XCS and its overlap to XIC? Went with XIC at the time over XIU for its added diversification and so far it’s all I’ve used for Canadian equities. Perhaps if implementing a strategy that includes XCS then XIU or HXT would be a better large cap alternative to avoid duplication and help mitigate the extra cost of XCS.

Canadian Couch Potato April 4, 2011 at 12:23 am

@gsp: You can get the complete holdings for XIC and XCS on the iShares website. There is some overlap, but again, it’s a question of weighting. The small-caps in XIC are there in number, but they don’t have a lot of influence.

Jon October 23, 2013 at 3:38 am

Hi CCP,

If my goal would be to create a portfolio similar to your uber tuber and I held both VXUS and VSS, would that reasonably replace XCS, EFV, SCZ, and VWO in just 2 ETF’s? Aside from missing out on rebalancing opportunities, would there be other obvious draw backs? Once again your advice is always appreciated!

Jon

Canadian Couch Potato October 23, 2013 at 8:08 am

@Jon: Combining VXUS and VSS would give you a huge small-cap tilt and no value tilt. The ETFs in the Uber-Tuber were carefully selected to get a particular small/value mix and making substitutions could change your exposure significantly. If you’re looking for something simpler (never a bad idea!) just consider the Complete Couch Potato.

Jon October 25, 2013 at 3:58 am

CCP, your point is well taken! I currently do have your complete couch potato…but in the near future I think my portfolio will be large enough to extract potential gains from small/value, my horizon is >30yrs, and I think I’ve got the discipline to stick with the game plan.

Then again, with all this temptation to tinker, I may end up shooting myself in the foot. On another note, in Ferri’s book (all about asset allocation), he talks about splitting the European and pacific rim regions for currency diversification. What are your thoughts on the subject?

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