The Canadian stock market should carry a warning label.
Just ask Eric Kirzner, a professor of finance at the Rotman School of Management at the University of Toronto and one of this country's foremost experts on investing. He has long been a fan of indexing – the practice of purchasing index funds that track the broad market at low cost. But this veteran advocate of buying the market as a whole doesn't much like the Toronto benchmark's increasing tilt toward a handful of sectors.
Financial services, energy and gold-mining companies now account for more than 60 per cent of the total value of the S&P/TSX composite. In decades past, one of the big appeals of index investing was the way it reduced risk by spreading an investor's bets among many different industries. But with the Canadian market, the opposite is now the case – by focusing an index investor on just a few sectors, it increases risk compared to a more widely diversified portfolio.
"I no longer consider the Canadian market a good, diversified market for investors," says Prof. Kirzner. "It's fine if you're looking for exposure to the specific sectors it focuses on, but by itself, it's no longer enough."
Canadian investors have to look beyond this country's borders if they want to hold a wide-ranging portfolio of stocks, he says. That increased need for international diversification is just one way that investing in general – and index investing in particular – has changed since Prof. Kirzner devised what he called the Easy Chair portfolio back in 1997.
Intended as a simple strategy for do-it-yourself investors, the Easy Chair approach recommended placing 20 per cent of your money in a money market fund, 30 per cent in safe Government of Canada bonds, 35 per cent in an index fund tracking the Canadian stock market and 15 per cent in an index fund that mirrored the S&P 500 index in the United States.
For years, the Easy Chair portfolio cranked out strong returns, but it's now showing its age. These days, with interest rates so low, money market funds have become an outstanding way to erode your purchasing power, while Canada bonds aren't offering a much better deal. On top of those problems, the unbalanced Canadian market focuses the Easy Chair's stock holdings on too narrow a range of industries.
Prof. Kirzner says if he were to be recommend an updated version of the Easy Chair, he would forget about money market funds and put 10 per cent of the portfolio in a high-interest savings account. Another 30 per cent would go into an exchange-traded fund, such as the iShares Canadian Universe Bond ETF, that tracks a broader range of bonds than just Government of Canada offerings.
He would devote the remaining 60 per cent of the portfolio to an internationally diversified selection of stocks – but he would avoid investing in them through traditional benchmarks such as the S&P/TSX composite or the S&P 500. He now prefers RAFI, short for Research Affiliates Fundamental Indexes.
Rob Arnott, the chief of Research Affiliates LLC, a California-based financial strategy firm, devised RAFI a decade ago to avoid some of the problems raised by traditional benchmarks. Those time-honoured market gauges, like the S&P 500, typically hold their constituent securities in proportion to each stock's market capitalization – a measure of the total amount of money invested in the stock.
The design of many older indexes means they are susceptible to fads, like the dot-com boom, in which money pours into dubious sectors, raising market capitalizations beyond reason. Even in tamer times, traditional indexes tend to persistently overweight frothy stocks that are being held up by investor enthusiasm. They also underweight cheap, boring stocks that lack an investor fan base.
RAFI aims to fix the problem by holding stocks in proportion to their score on four fundamental factors – book value, average cash flow, sales and dividends. Prof. Kirzner likes the design of the new benchmarks, but cautions that anyone who intends to invest in any of the numerous ETFs based on RAFI or similar approaches should do their homework first. "It's vital that you understand what you're buying," he says.
The same point holds true more generally, as well. Many investors, he says, suffer from what academics term "myopic loss aversion," a tendency to obsess over the short term and suffer high levels of distress from temporary losses.
"Investors focus too much on what's happening to their portfolios right now and not enough time thinking about the structure of their portfolios," he says. Don't know where to start? The redesigned Easy Chair portfolio offers one thoughtful approach.