http://www.moneychimp.com/articles/index_funds/small_value.htm

I use XIC for broad coverage, CRQ for a value tilt on the top 60 large caps, and XCS for a small cap tilt.

Many of my small caps have historically outperformed my large caps, mainly because a few of the ones I’ve liked have been “taken out” by one of the big guys. But with that being said, I can’t count on some consistency to my small cap returns. One year a name can get -95%, another year a different one can be 300%. All over the board. For me, I personally accept the investment risk and I like many of these small and micro-cap names. But I also know the volatility isn’t for everyone and so I don’t like to recommend to any new investors to follow me down this path – there are just too many landmines!

The tracking error could be positive or negative by dropping the smaller names. It is hard to say what a handful of small-cap companies in a narrow sector such as IT would do. It is very possible that excluding them hurts performance. It is also possible that excluding them improves returns. It is hard to say because many of the sector ETFs in the Canadian markets have a handful of names to begin with.

If you are talking about the real broad market such as the TSX, I agree that dropping the small cap names might affect performance as small caps have historically provided better returns than large caps.

So if you choose to narrowly focus on just a few stocks to avoid smaller companies, or you pick those with “better track records”, doesn’t that mean you are giving up the added return from small cap and value stocks which over a long term have been shown to outperform?

Also if you plan on making regular additional contributions then why not broadly diversify across more individual stocks, there isn’t any additional cost, what is the possible downside?

The broader TSX index and almost all Canadian Equity Mutual Funds are dominated by the Big 5 Banks, Big 3 Insurance names, a couple of Utilities and a couple of Oil & Gas companies. In my opinion, you don’t even need to buy all of these companies to mimic the funds because most of these stocks move in lock step with one another. For example, just picking two of the Big 5 Banks (let’s say the ones with the better track records), plus one Big Insurance (you really only have Sun Life, Manulife and Great West to choose from) company would probably be adequate to mimic the Financials index. Almost all funds have significant holdings in names like BCE, TransCanada Pipelines, Encana – so why not buy and hold with 0% MER? A side note is that a merged Petro-Canada / Suncor Energy will overtake EnCana as our largest energy company when that transaction is complete.

And another of my favourite areas is REITs. I haven’t checked lately but the biggest has always been RioCan, H&R and one other (whose name eludes me) round out the Top 3, which I believe makes up well over half of the market weighted index. So, buying 3 names will allow you to mimic the real estate index.

I also don’t buy any bond funds because I’d rather have a maturity date where I’m nearly guaranteed to get my principal back. So, 100% of my fixed income investments are also in individual names, albeit mostly with government, crown corporations, chartered banks and CDIC insured GICs.

Anyways, it’s a great subject and I have a natural bias against all mutual funds. It’s just my one man’s opinion, but I think that once someone’s portfolio size exceeds $100K, that is the “economy of scale” where your annual MER is damaging to your portfolio in absolute terms. With a portfolio size below $100K, it is difficult to remain diversified as the trading fees for smaller blocks of stocks would eat into your returns on both a relative and absolute basis. Small portfolios are the only place where mutual funds may make sense (in my humble opinion) but it’s a catch-22 as most brokers don’t like to deal with people with small portfolios.

Of course the point of tracking an index, economy or sector is broad diversification from company risk. Even with perfect tracking results you are exposed to greater risk when you concentrate on fewer stocks.