The hallmark of Ethical Special Equity has been its remarkable ability to keep pace with the index when markets are hot, while outperforming during tougher times.

It’s management’s conservative approach and discipline have mitigated losses, beaten the fund’s benchmark and peers, and provided a smoother ride along the way.

Our confidence in the management’s ability to protect on the downside makes this one of our favourite funds in the risky Canadian Small/Mid Cap Equity category.

That being said, it’s still capable of large losses in short order and is only suitable for investors who can stomach a wild ride.

However, throughout the latest turmoil, this offering has continued to beat its benchmark and a majority of its peers.

Lead managers Leigh Pullen and Joe Jugovic of QV Investors had been vocal about the mispricing of risk they were seeing in the marketplace, well before the first cracks appeared in the financial system. given their concerns, and the rich valuations the market was affording resource stocks, these managers began shifting money out of resources and into consumer staples, into names such as Empire Company Ltd. (EMP.A/TSX), which owns food retailers like Sobeys and IGA.

Furthermore, their remaining resource exposure was geared toward more conservative plays. For instance, instead of loading up on hot base metal companies, the managers invested in packaging specialist CCL Industries, a much less volatile play. While materials stocks lost an average of 42% over the past six months, CCL was down just 16%.

Nonetheless, the fund has suffered gut-wrenching losses. Although the duo had predicted a market correction, they weren’t expecting stocks to fall so far. As they sold off their most overvalued names, they redeployed money back into stocks that have only continued to get cheaper. the fund’s 33% drop in 2008 demonstrates the type of losses that a small cap manager – even a conservative one who predicted a difficult market environment – can suffer.

Another concern we continue to monitor is the size of QV Investors’ asset base in canadian small-cap stocks. the firm’s assets have fallen recently, but so have smallcap stock values. Furthermore, liquidity in this part of the market has dried considerably, which could result in large losses for any manager faced with a wave of net redemptions. For now the fund’s 6% cash position allows management some flexibility.

Despite these caveats, we think there’s a lot to like here. While horrific on an absolute basis, the fund’s performance still ranks in the first quartile of the Canadian Small/Mid Cap Equity category, and bests the 47% loss for the BMO small cap index. the fund’s performance is particularly impressive since many funds that had historically outperformed have failed to repeat their success this time around. We’re optimistic the management’s relatively cautious approach in this tumultuous space will continue to pay off.

David O ’leary is an analyst at Morningstar Canada.