With everything investors have to worry about these days, liquidity risk probably doesn’t receive a whole lot of thought. But as markets trade lower and lower, this often neglected factor has become a clear and present danger for many mutual funds. Perhaps nowhere is this more of an issue than for small-cap Canadian equities.

Two funds that are in radically different positions with respect to liquidity are Dynamic Focus+ Small Business Fund, sponsored by Goodman & Co. Investment Counsel Ltd. of Toronto, and Toronto-based Franklin Templeton Investments Corp.’ s Bissett Small Cap Class A Fund.

As of Aug. 31, the Dynamic fund, managed by Goodman & Co. vice presidents Oscar Belaiche and Jason Gibbs, was sitting on cash levels of 40%, while the Bissett fund’s lead manager Ralph Lindenblatt had only 3% in cash as of Sept. 30. The comparison is not perfect because of the different time periods of the available information. However, from an investment strategy viewpoint, the Bissett fund is kept fully invested. The cash portion of the Dynamic fund, on the other hand, is managed tactically.

What this means is that the Dynamic fund has the flexibility to deal with redemptions without liquidating assets, while the Bissett fund may be forced to sell assets in an inhospitable market in order to meet redemptions.

Compounding the difference is the fact that the Bissett fund has a more concentrated portfolio, with 48% of assets under management in the top 10 names, whereas the Dynamic fund’s top 10 comprise just 26% of AUM. And the Dynamic fund, at $111.1 million in AUM across all fund versions as of Nov. 30, 2008, can be fairly nimble; across all versions the Bissett fund had AUM of $416 million, which means it has a lot more money tied up in each of its small-cap stocks.

As early as April 2007, Belaiche moved to build the Dynamic fund’s cash position, which has helped the fund achieve top-quartile performance this year. Its one-year loss of 19.7% to Nov. 30 may not sound like cause for celebration, but it handily beat the median Canadian small- and mid-cap equity fund loss of 42.3%. With a loss of 43.6%, the Bissett fund performed slightly below than the median.

Over longer time periods, the Dynamic fund’s five-year average annual compound return of 12.4% looks particularly strong, although that performance is mainly the result of its heavy bias toward high-flying income trusts. While the Bissett offering can report only an average annual loss of 2.1% in the five years, it has put together a solid long-term track record under various managers.

The Bissett fund lost lead manager Chris Fernyc, who had held that position since June 2000, in the fall of 2007. Lindenblatt, who has been with Franklin Templeton since 2001, was co-manager with Fernyc beginning in 2006. It will no doubt take some time for Lindenblatt to prove himself as the lone shot-caller. So, don’t expect the look and feel of the fund to change much in the immediate future.

More pertinent is how the funds are positioned today.

Through a combination of market impact and net withdrawals, the Bissett fund is half the size it was a year ago. And, with retail investors exhibiting increasing skittishness, it’s a fair bet there will be more redemptions. That will put the fund in the uncomfortable position of having to sell holdings that can’t easily accommodate large orders.

Based on the average daily trading volume of the stocks involved, roughly half the value of the Bissett portfolio is in positions that would take several weeks to liquidate. Earlier in the year, there were some larger names in the fund, including Alimentation Couche-Tard Inc. and Gildan Activewear Inc., which would have provided a cushion. But those are gone and only smaller names remain. Forced selling could result in the fund taking a significant haircut. And it is the small-cap funds flush with cash — such as the Dynamic fund — that will be in a position to take advantage of the ensuing fire sale.

With companies in the Bissett and Dynamic portfolios having average market caps of $600 million and $400 million, respectively, the funds operate very much within the same universe of stocks. Both funds invest entirely in Canadian companies and each have large weightings in the energy sector, with the Bissett fund focusing a little more on the information technology and consumer discretionary sectors.

@page_break@Belaiche has a long-held bias toward real estate securities, a manifestation of his career experience prior to joining Dynamic. The Dynamic fund has a large portion of its portfolio concentrated in income trusts and holds some preferred shares as well, which accounts for its higher yield relative to the Bissett fund.

The Bissett fund was closed to new investors in February 2005 and reopened on Oct. 27, 2008. If there are any potential investors waiting in the wings, that move may work to bolster the fund’s capital position. But with a new lead manager and a scary investment environment, it seems unlikely the reopening will translate into net sales.

Another area of significant difference between the two funds is their fees. The Bissett fund is certainly not cheap — its management expense ratio of 2.78% is higher than two-thirds of the funds in the Canadian small- and mid-cap equity category.

But the Dynamic fund is considerably more expensive; its stated MER of 4.42% can shift dramatically from period to period, owing to the presence of an incentive fee of 10%, which applies to performance in excess of the BMO Nesbitt Burns small-cap index but limited to 2.25% of net asset value in a given year. The fee also has a “high-water mark” provision, meaning this year’s losses will have to be recouped before any new performance fees are levied.

However, a major problem with incentive fees is that the manager participates in the upside without suffering the downside, which encourages excessive risk-taking and thereby fails to align the interests of management properly with those of unitholders. The Dynamic fund’s unitholders must be prepared for the fact that the fund’s high MER will eat considerably into their returns over time.

The Bissett fund has shown itself to be a solid performer over the long term, and being fully invested means the fund would probably outperform its Dynamic counterpart should equities markets turn around soon. But the question of liquidity risk, which has long remained hidden below the surface, has become highly pertinent in the current environment. Based on exposure to that particular source of potential peril, the Dynamic fund is in much better shape. IE

Al Kellett is a mutual fund analyst with Morningstar Canada in Toronto.