Active Management – Demystifying the Canadian Stock Market

Written by Investment Team on .

Index funds, or funds that passively track indexes, have a role to play in investor portfolios. Jack Bogle created the Vanguard 500 Index Fund in 1976, the first index fund. He had the most noble of intentions – to provide investors with the cheapest possible way to get exposure to the market index. The fund was structured as a unit trust, similar to a mutual fund, where pricing is set once a day. Then in 1993 the first Exchange Traded Fund (ETF – a marketable security that tracks an index, a commodity, bond, or a basket of assets like an index fund) was created by State Street Advisors. The S&P 500 Depository Receipts currently sits with $250 Billion in Assets Under Management. The structure of this instrument allows investors to trade the entire index in real time, just like a common stock on a stock exchange. These funds opened the door to passive instruments and passive funds now hold more than 30% of all US assets. Canadians are now also discovering that they can get broad market exposure for a fraction of the price that they have been paying and have begun to invest in index funds as well. This growth in index funds has created both opportunities and dangers for investors.

Background

As of October 2017 the ETF market in Canada was $141 Billion versus $1.5 Trillion for the mutual fund industry. ETFs are growing much faster than traditional mutual funds – 30% vs 10% on a rolling 12 month basis, as of October 2017. The number of ETF providers has also grown, from 10 in April 2016 to 24 in June 2017. There are now over 500 ETFs available on the Toronto Stock Exchange.

What has driven this growth?

Canadians are tired of paying high fees to gain exposure to the Canadian Stock market where ETFs provide this exposure for a fraction of the cost. The unmasking of another practice, closet-indexing, where high cost funds have “hugged” the index while positioning themselves as specialist have also, understandably, moved many investors to ETFs. Low costs have certainly been a big driver of growth. However the idea that ETFs provide exposure to a broad base of stocks, often an index, thus minimizing sector risk is also attractive to many investors.

So low costs and diversified exposure are two big drivers of growth but they shouldn’t be the only considerations. Low costs are easy to qualify, but here we test whether the Canadian Stock market index represented by the iShares S&P/TSX 60 Index ETF gives investors the diversification they assume.

How diversified is the Canadian index?

Two things need to be highlighted. First, the Canadian index represents only about 3% of total stock market capitalization globally. Second, most Canadians have a large percentage of their net worth in Canadian assets (their largely domestic investment portfolio and their home). Is there a risk here?

Industry Composition

One of the appeals of index investing is the way investors can mitigate risk by spreading it across the many different industries within an index. In Canada, this doesn’t readily follow. The Canadian index is largely made up of three sectors:  Financial Services – 40%, Energy – 20%, Materials – 10%, accounting for 70% of the total market. Not very well diversified after all. In contrast the ishares MSCI World Index ETF has 29% exposure to these industries (Financial Services – 18%, Energy – 6%, Materials – 5%). Thinking you are buying a diversified index that is just focused on a few sectors increases the risk for an index investor.

Company Concentration

Digging into the Canadian index a little deeper reveals more cracks in the diversification assumption. 51% of the index as a whole is made of 10 companies. The Financial Services sector which comprises 40% of the index, is itself dominated by only a handful of companies, with Royal Bank, TD Bank, Bank of Nova Scotia and Bank of Montreal accounting for 26% of the total index. Royal Bank alone accounts for almost 9% of the Canadian index. There have been times in the past where individual companies have accounted for large amounts of the overall index. Nortel, Blackberry (formerly Research in Motion) and Valent all come to mind. Nortel for example accounted for 35% of the Canadian index at its peak in the summer of 2000. Index investors felt the pain as Nortel went to zero over the ensuing years. Buy the index, but be wary of its ability to diversify your portfolio.

How diversified is your portfolio?

Real Estate Exposure

According to a 2012 survey by the international Monetary Fund, Canadian investors hold about 59% of their equity in domestic stocks. Given the rise in the real estate market in Canada, most Canadians also own a home. Consider that Canadian banks, which dominate the index, are also exposed to residential mortgages, then you can see that many investors have double exposure to the real estate market – through their home ownership and through their equity ownership in Canadian banks. Of note, Canada escaped the major housing collapse in 2008, housing prices have risen almost continuously for 16 years and we believe at some point we will have an adjustment.

Conclusion

There’s no doubt that Canadian ETFs can provide you with a low cost way to gain exposure to the Canadian market, but that market is not as diversified as you may think.

To augment the diversification in your portfolio, investors need to research investment opportunities that are counter correlated to the Canadian Index. Where the index is exposed to Banks, Energy and Materials, find investments that have minimal weightings in these sectors.

Pender Value Fund

The Pender Value Fund has very little exposure to banks, energy companies or material companies. Instead the Fund is focused on information technology, consumer discretionary and industrial sectors. By pairing the Pender Value Fund with your Canadian Index Fund, we believe you increase your diversification and reduce your industry and company concentration and therefore your risk. (See the Sector Allocation for the Pender Value Fund here).