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Thinking small brings big returns

Six months ago, Eric Sprott did a funny thing for a business owner: He turned away customers.

Scores of investors wanted into the Sprott Opportunities Hedge Fund; why wouldn't they, after two years of 40-per-cent gains? They phoned. They pleaded. But the firm refused. Too much money can hurt performance, it said. The fund has less than $300-million.

Around the same time, Mr. Sprott's fellow enthusiast for energy stocks, Tom Stanley, was breaking the bad news to his own clients. He'd decided to liquidate the Resolute Growth Fund, irritated at new regulations that force Canadian mutual funds to disclose what they own every three months. Mr. Stanley valued the ability to trade in secret and to stay flexible -- which is why, when the fund grew to $214-million in assets a couple of years ago, he told new investors that he didn't want their dough.

The Resolute's fund's amazing track record -- it turned $10,000 into $174,000 over a decade -- made Mr. Stanley famous on Bay Street. Here's a name that's not so well-known: David Vanderwood. As the main man on domestic stocks for Burgundy Asset Management, he can take a lot of the credit for the market-beating performance of the firm's two primary Canadian funds: a small-capitalization fund that's returned 22 per cent a year for the past five years, and an all-cap fund that's done 15.5 per cent (both figures are before fees).

Numbers like that are easy to sell to new clients. Yet the firm decided to shut the small-cap fund when it got to $250-million, and the larger Canadian fund was closed when it reached $1-billion. "If you want to own no more than 10 per cent of a company," explains Burgundy president Richard Rooney, "it shrinks your investment universe pretty dramatically by $1-billion [in assets]."

Notice a pattern? Three excellent money managers, three different styles, each prepared to say no to letting their funds get swamped with new money. They've got something else in common, too: They've been absent from this latest round of moaning about the incredible shrinking Canadian stock market. Inco, Falconbridge and ATI, all members of the large-cap S&P/TSX 60, are set to disappear in takeovers. They are following five others from that club -- CP Ships, Fairmont Hotels, Dofasco, Molson and Placer Dome -- to have been bought out in two years.

Cue the hand-wringing from the buy side. One money manager even complained to Bloomberg that researching smaller companies is "a lot more trouble. . . . It's easier to buy Inco." Those management fees, apparently, aren't for finding the best investments, but the easy ones. Comforting.

Still, the guy had a point. It is a lot easier just to buy Inco, if you're looking for a mining stock that's going to trade $100-million in shares on an average day. But maybe we're misjudging the nature of the problem here. Maybe it isn't that our market is too thin, but too many of our mutual funds are too fat.

Take AGF Management's Canadian Large-Cap Dividend Fund, which, at $3-billion, ranks as one of the 50 largest domestic stock funds. If there's much difference between this and an index fund, it's hard to identify what it is, other than the cost (1.85 per cent a year). The top holdings -- Manulife, EnCana, TD Bank, Petro-Canada -- are the top names in the index, and the returns are index-like. (9.1 per cent over five years versus 11 per cent for the S&P/TSX total return index.)

But that's very hard to avoid when you're bigger than all but 90 companies in the entire country. If the AGF fund's managers wanted to own, say, Home Capital Group -- a smaller-cap dividend-payer -- they'd have to buy 10 or 15 per cent of the company before it would make a real difference to their results.

"Size, I think, is an issue," says Dan Hallett, president of research firm Dan Hallett & Associates. "But I think it's really difficult to nail down a specific figure as to how big is too big." CI Financial's Kim Shannon or BMO's Michael Stanley have produced good numbers while running billions.

But that takes a special talent, one that the majority of Canadian managers lack. For them, size is a handicap. Foreign takeovers of Canadian companies are a reality -- get used to it. Big, liquid stocks are vanishing. Yet most big fund companies -- the banks, CI, IGM Financial -- rarely respond by cutting off sales to some funds to protect their customers. Why not?

vox@globeandmail.com

By the numbers

22

Annual percentage return over

five years for Burgundy Asset

Management's small-cap

Canadian fund.

250

Amount in millions of dollars

at which Burgundy closed its

small-cap fund to new investors.

60

Number of TSX-listed companies

and income trusts over $5-billion

in market cap.

© 2007 The Globe and Mail. All rights reserved.

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