The all-cap S&P/TSX Composite Index is up 22 per cent year-to-date to Oct. 31.Aaron Vincent Elkaim/The Canadian Press
Canadian equities have enjoyed robust returns in 2025 in spite of the turmoil created by tariffs, actual or threatened. The all-cap S&P/TSX Composite Index is up 22 per cent year-to-date to Oct. 31. This, however, is well below the 32-per-cent return from the TSX Completion Index, which measures the return of those stocks from the composite that are not part of the big cap TSX 60 index. The TSX Small Cap Index return of 37 per cent is even better and all are blown away by the TSX Venture Index return of 60 per cent over the same time period.
Does this recent surge in small cap returns mean that the sector is back in favour after a decade of poor relative performance, or is it just statistical noise? To answer that question, we need to recognize that the economic sector profile of each index is very different, so it is not always size which is driving the relative performance. Sometimes it is simply sector weights. For example, the dominant sector weights in the S&P/TSX Composite are financials at 32 per cent, energy at 16 per cent and materials at 16 per cent. For the Small Cap Index the top three are: materials at 36 per cent, energy at 23 per cent and industrials at 11 per cent. There aren’t many small cap banks, so the financials only weigh in at 5 per cent.
We can approximate the small cap versus sector impact fairly simply: take the year-to-date large cap sector returns and weigh them according to the small cap sector weights as of the beginning of the year. This normalizes the sector weightings for both indexes and provides an indication of the small cap impact. For 2025 to date, the sector-adjusted Composite Index return is 26 per cent, a four-percentage-point increment over the reported number. Based on this analysis, a little less than one-third of the 15-percentage-point advantage for small cap stocks is a result of the index composition. The balance appears to be a preference for smallness within each sector.
Meanwhile, a contrary message is unfolding in the U.S. equity market. The big cap S&P 500 Index is up 18 per cent year-to-date, driven by a one-third weighting in information technology stocks. The S&P 500 equal weight index, which, as the name implies, gives equal weighting to all 500 stocks, is up only 9 per cent while the S&P 600 Small Cap index is barely ahead with a 3-per-cent gain year-to-date.
Bigger and brighter doesn’t always win the investment performance race
Opinion: Not enough small-cap research? Let the issuer pay
For an individual investor with limited financial and time resources, the apparent endorsement of a Canadian small cap revival should not lead to a major portfolio rebalance as it provides no clues as to future relative performance and the conflicting message from the U.S. is a concern. But it is a reminder of another useful attribute of small cap stocks, which is often overlooked in portfolio construction: their ability to introduce diversification – a powerful rationale for maintaining a small cap exposure in your portfolio at all times. Not quite a separate asset class, but clearly a different category from the benchmark index.
For many small companies, success is primarily dependent on new product introductions, the competence of senior management and balance sheet flexibility. They may be affected by a few big-picture issues such as tariffs into/out of the U.S., but they are essentially impervious to central bank interest-rate moves or similar macro issues. It is not difficult to create a small cap portfolio made up of companies in very different industries, each of which marches to its own drummer and has low correlation with the fortunes of the big cap index holdings.
How many stocks are needed to achieve a reasonable degree of diversification? In the early days of efficient market portfolio research, the consensus was that 12 to 14 holdings captured most of the benefits of diversification.
We now know this conclusion came from academics who observed the distribution of average returns from portfolios of different size holdings through repeated iterations. Now we realize that most of us do not get to experience life through repeated iterations, so the new consensus is that 30 to 40 names are necessary.
For someone with a full-time job, the thought of monitoring a 30-stock portfolio may seem daunting, but smaller companies typically have a less complex business model to analyze and there is less competition from sell-side analysts who dominate the big cap sector. A good place to start might be to download the Small Cap Index Excel database provided regularly by Globe reporter Jennifer Dowty and research those companies with the lowest analyst coverage in each industry.
The reason to focus on low analyst coverage is supported by research performed by Prof. Avner Arbel of Cornell University. In essence, he claimed that investors were incorrectly attributing superior returns to small cap stocks, which really belonged to the more persistent “neglected firm effect.” In fact, he asserted that better returns were achieved from a neglected large cap stock than a well-followed small cap stock. Many neglected stocks are small cap, so the confusion is understandable, but it is neglect and not smallness which drives the superior return. His database mainly covered the decade of the seventies, so it may be time-period specific, but his argument certainly has a lot of intuitive appeal even today.
Clearly, an investor needs patience to succeed with a neglected stock strategy, but unlike the professional money manager who is pestered by clients every quarter, an individual investor has the luxury of time. My observation is that investors should always maintain exposure to the small cap sector because you never know when the superior returns will be delivered, but sensible diversification is a key element of the strategy.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.