The beginning of 2016 had most people thinking that we were in for a rough one. There were some negative months to start things off, and a few more throughout the year, but all things considered 2016 was a great year to be in the market. That is not the story that you may have heard from the media, who were warning us to sell everything back in January. Despite Brexit and Trump, US and International markets continued to climb through December, and the Canadian market hit its highest 1-year return since 2009. Even bonds pulled their weight with a modest but respectable return.

It was small cap and value stocks that stole the show in 2016, delivering on return premiums that were starting to be forgotten or dismissed. Only emerging markets saw small caps underperform, while Canada, the US, and international developed markets saw small cap outperformance. Value stocks outperformed across the board.

The following is a breakdown of how the major asset classes that make up our portfolios performed in 2016 (in Canadian dollars).

After a slow start, the US equity market (Russell 3000 Index) continued to roll ahead through December, posting a final return of 9.41%. US small caps (Russell 2000 Index) posted a return of 17.73%, and US value (Russell 3000 Value Index) finished the year with a return of 14.91%.

International developed equity (MSCI EAFE IMI Index – net div.) posted a slightly negative return of -1.83%, but had a bit of a boost from international developed small caps (MSCI EAFE Small Index – net div.) with a return of 2.18%, and international developed value (MSCI EAFE Value Index – net div.) with a return of 1.93%.

Portfolios with an emerging markets allocation did get a further bump in performance. Emerging markets (MSCI Emerging Markets Index – net div.) returned 7.91%, emerging markets small caps(MSCI Emerging Markets Small Cap Index – net div.) finished with a -0.74% return, which was more than made up for by emerging markets value (MSCI Emerging Markets Value Index – net div.) which returned 11.52% for the year.

The end of 2015 and beginning of 2016 looked dismal for the Canadian equity market, but by the end of 2016 anyone that had dismissed Canadian stocks was kicking themselves. The Canadian market(S&P/TSX Composite Index) closed out 2016 with a 21.08% return. Canadian small caps (MSCI/Barra Canadian Small Index) posted a 27.16% return, and Canadian value (MSCI/Barra Canadian Value Index) ended the year with a whopping 32.38% return.

Fixed income seems to get a lot of negative attention, but continues to have decent returns. Global bonds (Bloomberg Barclays Global Aggregate Bond Index – hedged to CAD) still managed to post a return of 3.73%. It was a drop from the 6.43% YTD return that global bonds saw in July, but still nothing to complain about. Canadian bonds (FTSE TMX Canada Universe Bond Index) did not fare so well, posting a return of 1.66%.

Piecing it all together

The portfolios that I recommend to clients use products from Dimensional Fund Advisors, which aim to passively capture market returns with an increased weight given to small cap and value stocks. The funds are built this way based on the academic evidence that supports doing so. Dimensional funds do have higher fees than broad market ETFs. Is it worth it? I think so, and this year is a good example of why. I have compared a model portfolio of Dimensional funds to a model portfolio of ETFs by security, and by overall portfolio performance.

DFA Canada Five-Year Global Fixed Income Fund 2.30%
DFA Canada Global Targeted Credit Fund 2.53%
DFA Canada Investment Grade Fixed Income Fund 3.73%
DFA Canada Canadian Core Equity Fund 27.48%
DFA Canada Canadian Vector Equity Fund 31.05%
DFA Canada US Core Equity Fund 11.93%
DFA Canada US Core Equity Fund (H) 14.33%
DFA Canada US Vector Equity Fund 15.79%
DFA Canada US Vector Equity Fund (H) 18.13%
DFA Canada International Core Equity Fund 1.80%
DFA Canada International Core Equity Fund (H) 7.22%
DFA Canada International Vector Equity Fund 2.48%
DFA Canada International Vector Equity Fund (H) 7.00%
DFA Canada Global Real Estate Securities Fund 2.59%

iShares Canadian Short Term Bond ETF 0.76%
Vanguard FTSE Canada All Cap ETF 21.45%
Vanguard US Total Market ETF 8.99%
iShares Core MSCI EAFE IMI ETF -2.34%
iShares Core MSCI Emerging Markets IMI ETF 5.98%

Equity/Fixed Income Dimensional ETFs Difference
100/0 15.25% 9.76% 5.49%
80/20 12.85% 7.96% 4.89%
70/30 11.41% 7.06% 4.34%
60/40 10.15% 6.16% 3.99%
50/50 8.82% 5.26% 3.56%
40/60 7.50% 4.36% 3.15%

Where did the extra returns come from?

The obvious answer is small cap and value. When they outperform the market, a portfolio that holds more small and value than the market will also outperform.  There are a few more edges that the Dimensional portfolio had over ETFs in 2016.

Dimensional’s fixed income is globally diversified, while the ETF portfolio holds only Canadian bonds; we saw above that global fixed income returns (hedged to CAD) more than doubled those of Canadian fixed income last year. The ETF model portfolio holds only short-term bonds with an average maturity of 2.92 years, while the Dimensional portfolio has an average maturity of 4.6 years – still short, but longer than the iShares Canadian Short Term Bond ETF. Longer bonds are riskier, but have higher expected returns. That risk paid off in 2016.

Currency hedging also played a role. Currency has no expected return, so over the long-term a currency hedge should not have a meaningful impact on performance. In the short-term, currency can add significant volatility to returns. The Dimensional portfolios partially hedge equities and fully hedge fixed income to CAD. The hedge resulted in a significant performance boost in 2016 as the CAD strengthened.

Not a free lunch

This post is not a victory lap. 2016 made Dimensional funds look good, but in past years that has not been the case. There is a risk to allocating more to small cap and value. Any given year may see underperformance, even over multiple years. We take the approach that it is optimal to follow the academic evidence that small cap and value stocks will outperform over the long-term, with the understanding that this does not mean higher returns every year.

Data sources: BlackRock Canada, Vanguard Canada, Dimensional Fund Advisors Canada, MSCI, S&P Dow Jones, Russell, FTSE TMX, Bloomberg Barclays, analyzed using Dimensional Returns Web