A Look At Canada’s Only Small Cap ETF (TSE:XCS)

Posted on February 26, 2020 by Dan Kent

For many investors, the allure of investing in a small-cap stock and striking it rich causes them to chase poor opportunities and inevitably lose money.

However, there is no doubt that small-cap stocks can be extremely profitable. We provide them to Stocktrades Premium members on a monthly basis.

But, they require extensive research, and mistakes can be amplified due to their overall volatility. As such, for beginners who are just learning how to buy stocks in Canada, it can lead to some large losses if you’re wrong.

So, how does a normal investor, who doesn’t have the time, knowledge, or skill level to pick small cap stocks gain exposure to some of these diamonds in the rough?

Well, they can buy a small cap ETF. And, if you’re looking for a Canadian ETF that holds small cap stocks, the iShares S&P/TSX Smallcap Index (TSE:XCS) is where to look.

The iShares small cap ETF is one of your only options in Canada

We’re fairly limited in Canada when it comes to small cap ETFs. In fact, we’ve really only got one.

But, this isn’t because there is a negligence towards creating small cap ETFs here in Canada, it’s just we don’t have enough small cap stocks to justify it.

As a result the iShares S&P/TSX Smallcap Index is going to be your only option.

So how has this small cap ETF performed?

Unfortunately, this small cap ETF has, to put it lightly, underperformed.

I’ve taken this chart directly from Vanguards website, but as you can see the ETF has been lackluster for the better part of 13 years.

TSE:XCT Small Cap ETF Performance Since Inception

Now, the ETF got off on the wrong foot, due to no fault of its own. It simply debuted right before the financial crisis and a $10,000 investment in the ETF quickly ended up being worth around $4000.

Since it’s recovery from the financial crisis, the small cap ETF has traded relatively sideways for the last decade and has provided little incentive for Canadians to invest.

However, as we see in 2020, this ETF has broke out and surpassed price levels it hasn’t seen since 2010. It seems like the iShares small cap ETF is getting some attention now. However, does it have the holdings to justify this?

iShares small cap ETF holdings

The iShares small cap ETF contains a little more than 200 holdings, and its top holding is currently the Great Canadian Gaming Corp (TSE:GC). As of writing, this is a company that is actually going through an acquisition situation. However, a lot of investors are upset with the price offered, so it will be interesting to see what happens there.

Although Great Canadian is the ETFs number one holding, it still only makes up 1.77% of the funds allocation. This is a diverse ETF, with its top 10 holdings making up only 14.33% of assets.

The top ten holdings in this small cap ETF are also diverse. They contain gold miners like Torex Gold Resources (TSE:TXG), independent niche grocers in The North West Company (TSE:NWC), cannabis company Aurora Cannabis (TSE:ACB), and financial lender Home Capital Inc (TSE:HCG).

Overall, the ETF has around 26.53% exposure to the material sector, which is more than 2X the next highest sector in industrials at 12.82%. The third largest exposure is oil and gas at 12.43%.

As we move through this small cap ETF, it’s becoming clearer why it has underperformed over the last decade.

With this large of exposure to gold, silver, and copper miners along with oil and gas producers, both of which have suffered through extreme bear markets over the last ten years, it’s no wonder the ETF has done poorly.

Exposure to material stocks could help this small cap ETF

There’s no questioning that gold stocks are going to benefit from the rising cost of gold due to currencies being produced at an unprecedented rate, and economic uncertainty on the horizon.

The ETF’s exposure to material stocks has hurt it, but moving forward it could be a reason for Canadians to have a look at this ETF.

Because the TSX is equally exposed to the material sector, I wouldn’t imagine it outperforms the index at a rapid pace. But, it could go from abysmal to reasonable returns for sure. It will be interesting to see how the next few years play out.

This iShares small cap ETF comes with an expensive price tag

When it comes to ETFs, fees are critical. And paying an extensive fee for a severely underperforming ETF is a tough pill to swallow.

XCS has a management fee of 0.60%, indicating you’re going to pay $6 for every $1000 invested in this fund.

Considering it’s been able to turn $1000 into a meager $1134 over the last 13 years in terms of capital appreciation, this is essentially a break even investment when it’s all said and done.

However, the ETF does pay a dividend, and more than you’d expect from a small cap ETF. At the time of writing, XCS pays a 2.35% yield.

This doesn’t make up for it’s lackluster performance, but it’s an added bonus for sure.

This Canadian small-cap ETF has just had exposure to the wrong companies

There are plenty of small cap options here in Canada. As I said, we bring them to Stocktrades Premium members all the time.

However, XCS has just had exposure to all of the wrong ones.

It’s top 10 holdings contain some lackluster Canadian companies like Whitecap Resources (TSE:WCP), Aurora Cannabis, Hudbay Minerals (TSE:HBM), and Home Capital Group. These, among many others, have been perennial underperformers for a long time.

Meanwhile, the ETF has low exposure to gems like Equitable Group (TSE:EQB), Goeasy Ltd (TSE:GSY), Park Lawn (TSE:PLC), and Savaria (TSE:SIS), among others, all of which have outperformed the index handily.

Overall, I’d be passing on it moving forward

As an investor who purchases individual Canadian small cap stocks on a fairly regular basis, I know there’s potential here in Canada for outsized returns.

However, this small cap ETF has performed relatively poorly since inception, and unless gold continues to maintain strength, it’s likely it will continue to underperform moving forward.

I don’t like the ETF’s excessive exposure to the material and oil sector. Small exposure to gold in terms of a hedge for uncertainty is one thing, but over 39% of this ETF is either exposed to material or oil stocks, both of which are prone to cyclical activity based on commodity prices.

Just keep in mind however, if you do decide to avoid this ETF and instead try your skills at investing in individual small cap stocks or even other ETFs that might be smaller, such as the Blockchain Technology ETFs, these do come with much more risk than say a blue-chip option.

Always understand how a particular investment fits in to your overall risk tolerance, and decide whether or not its right for you from there!

Disclaimer: The writer of this article or employees of Stocktrades Ltd may have positions in securities listed in this article. Stocktrades Ltd may also be compensated via affiliate links in the post below.

Dan Kent

About the author

An active dividend and growth investor, Dan has been involved with the website since its inception. He is primarily a researcher and writer here at Stocktrades.ca, and his pieces have numerous mentions on the Globe and Mail, Forbes, Winnipeg Free Press, and other high authority financial websites. He has become an authority figure in the Canadian finance niche, primarily due to his attention to detail and overall dedication to achieving the highest returns on his investments. Investing on his own since he was 19 years old, Dan has compiled the experience and knowledge needed to be successful in the world of self-directed investing, and is always happy to bring that knowledge to Stocktrades.ca readers and any other publications that give him the opportunity to write. He has completed the Canadian Securities Course, manages his TFSA, RRSPs and a LIRA at Qtrade, and has compiled a real estate portfolio of his primary residence and 2 rental properties, all before his 30th birthday.