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).
