News

Index investing in the Canadian market today sort of resembles the 1854 British cavalry attack that was immortalized by Alfred, Lord Tennyson, in his poem The Charge of the Light Brigade.

Tennyson wrote: "Into the valley of Death/Rode the index investors." Sorry, make that: "Rode the six hundred."

Rhetorical exaggeration? Possibly, given that the British faced "cannon to the right of them/cannon to the left of them," while index investors merely have to contend with a stock market juiced on volatile commodity stocks.

Just remember that with indexing, you're buying the market. Where the S&P/TSX composite index is concerned, you have an approximate 45-per-cent weighting in energy and materials, which includes metals and gold stocks. With the S&P/TSX 60 index of big blue chips, you have 41-per-cent exposure to commodities. For investors willing to sacrifice a bit of upside to limit downside, this is too much.

A way to cut this risk, suggested by George Vasic at UBS Securities, is to reinvent your indexing in the Canadian market. Instead of holding a broad-market index fund or exchange-traded fund, use a blend of specialty and sector ETFs to approximate the holdings in the S&P/TSX composite or 60 indexes. "You can add them up yourself and maybe have a more comfortable balance," Mr. Vasic said.

Let's see how this might work for someone who owns the popular iShares CDN LargeCap 60 Index Fund (formerly known as the i60), which at March 31 had a weighting of 26.6 per cent in energy and 14.3 per cent in materials.

One approach is to build part of your index holdings using sector ETFs and then use an individual stock or two to cover off areas like health care or consumer discretionary not covered by a Canadian-market ETF. Another is to use the iShares CDN Dividend Index Fund as a foundation for Canadian index holdings and add exposure to sectors as needed.

Why use the dividend ETF? For one thing, it contains a mix of stocks with high yields in the 4- to 6-per-cent range, as well as lower-yielding stocks like the banks that offer good potential for capital gains. Over all, the dividend yield is about 2.8 per cent.

More importantly for the work at hand, this ETF has just a token 5.9-per-cent weighting in energy stocks through TransCanada Corp. and Enbridge Inc. (they're actually pipelines as opposed to oil and gas stocks) and its sole materials stock is forest products company Norbord Inc. Energy and materials are the second- and third-largest sectors in the 60 index and we'll certainly want them to have a significant presence in our reconfigured index portfolio. But let's not address this issue until we get the other components squared away.

It may come as a surprise, but the largest single sector in the S&P/TSX 60 index is financials, at about 36.1 per cent. You can buy this sector through an ETF called the iShares CDN Financial Sector Index Fund, or you can rely on the iShares dividend fund and its 51.4-per-cent weighting in banks, insurers and fund companies (note: this weighting will be diluted in your eventual portfolio by adding other ETFs).

The next sector of the 60 index you'll want to add is industrials. There's no ETF for this group, so you'll have to look at buying individual stocks like Canadian National Railway or Canadian Pacific Railway. Or, you can rely on the 3-per-cent chunk of the iShares dividend ETF that is accounted for by Russel Metals Inc. Consumer discretionary stocks are the next largest sector in the 60 index. There's no ETF for this sector, either, which means you'll have to buy shares in constituent companies like Thomson Corp., Magna International, Rogers Communications or Canadian Tire Corp. Or, you can rely on the 7-per-cent weighting the iShares dividend ETF has in consumer discretionary stocks through a holding in Magna, Torstar and Reitmans (Canada) Ltd. Another significant presence in the 60 index is information technology, which you can nail down by investing in the iShares CDN Tech Sector Index Fund. The big holdings in this ETF are Research In Motion and Nortel, a stock that bolsters the argument for caution in an index heavily dependent on one stock or sector. After peaking at 34.6 per cent of the S&P/TSX composite back in August, 2000, Nortel collapsed and took the entire index on a plunge from which it took five years to recover.

Buying the iShares dividend fund covers you off on three more sectors not represented by ETFs -- telecom services, consumer staples and health care and utilities. If you don't want to use the dividend ETF, you'll have to pick one or two dominant stocks in each sector.

One last sector to work into our rejigged index portfolio is health care, which accounts for a tick under 1 per cent of the S&P/TSX 60 index. There's no Canadian health care ETF, largely because there aren't enough major firms. Your options are to buy stocks like Biovail or MDS Inc., or you could buy a U.S. exchange-traded fund called the Select Sector SPDR Health Care Fund. You'll have some vulnerability here if the Canadian dollar keeps rising, but this fund gives better exposure to health care than anything in the domestic market.

At this point, we've achieved exposure in all the components of the 60 index except energy and materials. The supply-and-demand dynamics for oil are such that you wouldn't want to shut yourself out of the sector entirely. So let's go top up the energy holdings in the dividend ETF using the iShares CDN Energy Sector Index Fund. Materials are also too hot to ignore, so let's also top up the dividend ETF's holdings in this areas using the iShares CDN Materials Index Fund. We'll shoot for energy exposure of close to 15 per cent and materials at 8 per cent, but you can adjust this.

As you'll see in the chart, the sector weightings for the iShares CDN LargeCap 60 Index Fund and the alternative index portfolio are similar, except for energy and materials (by design), as well as utilities and telecom services. The latter sectors have been abysmal this year and will probably be a drag on performance as long as interest rates are rising and investors are chasing hot stuff like oil and gold.

The main point of indexing is to get low-cost access to market returns. The iShares LargeCap 60 does this with its ultra-low management expense ratio of 0.17 per cent, compared to about 2.45 per cent for widely held Canadian equity funds. The reconfigured index portfolio is also a bargain compared to mutual funds, but it's a fair bit more costly then the LargeCap 60 ETF at 0.51 per cent (that's a weighted blend of all the ETFs in the portfolio).

Setup costs are another area where the reconfigured index portfolio is more expensive. A $50,000 investment in the LargeCap 60 would cost just $20 to $30 at an on-line broker, whereas you'll pay multiples of that depending on how many ETFs replace this fund. Call these costs the price of security against the commoditization of Canada's major stock indexes.

"What it comes down to is, do you want 45 per cent or so of your portfolio in resources at this point?" said Mr. Vasic of UBS Securities. "It's a question everyone should ask themselves."

Charging out of danger

Let's say you like the low-cost indexing approach to investing, but you're worried about the heavy degree of exposure to volatile commodities in the major Canadian stock indexes. Here's a blueprint for reconfiguring your index investments to tone down the risk that a reversal in energy and metal prices will hammer your portfolio:

Your current index investment of $50,000

z $50,000 in the iShares CDN LargeCap 60 Index Fund (XIU-TSX)

Sector breakdown for your holdings*

Financials: 36.1%

Energy: 26.7

Materials: 14.3

Industrials: 5.2

Consumer discretionary: 5.0

Telecommunications: 4.6

Information technology: 4.4

Consumer staples: 2.2

Health care: 1.0

Utilities: 0.5

Management expense ratio: 0.17%

*as of March 31

Cost to buy: $20 to $30 at an on-line broker

Your alternative index investments of $50,000

z $40,000 in the iShares CDN Dividend Index Fund (XDV)

z $5,000 in the iShares CDN Energy Sector Index Fund (XEG)

z $2,500 in the iShares CDN Materials Sector Index Fund (XMA)

z $2,000 in the iShares CDN Tech Sector Index Fund (XIT)

z $500 in the Select Sector SPDR Health Care Fund (XLV-Amex)

Sector breakdown for your holdings

Financials: 41.1%

Energy: 14.7

Materials: 8.0

Consumer discretionary: 5.7

Information technology: 4.0

Industrials: 2.4

Telecommunications services: 12.4

Consumer staples: 2.2

Health care: 1.0

Utilities: 8.4

Blended management expense ratio: 0.51%

Cost to buy: $105 to $155 at an on-line broker

DATA: ROB CARRICK