As weaker oil prices weigh on Canadian energy stocks again, devout index investors are no doubt wondering if their approach to buying Canadian stocks is flawed. But they may be disappointed by the alternatives.
Index investors eschew stock selection in favour of baskets of stocks – often low-cost exchange-traded funds. These funds give investors instant diversification and returns that consistently match the indexes they track, less a small fee.
For U.S. stocks, an ETF that tracks the S&P 500 index is a good, obvious choice. But in Canada, index-tracking ETFs have a quirk: The Canadian market is dominated by financials and commodity producers. That's a problem when one of these areas is struggling.
Within the S&P/TSX composite index, financials have a 33-per-cent weighting, energy stocks have a 21-per-cent weighting and materials have a 12-per-cent weighting. Making matters worse is the fact that sectors such as health care and technology are relatively tiny.
The heavy concentration in financials doesn't seem so bad, given that the big banks are consistently profitable and they distribute large dividends.
But commodity producers are notoriously volatile. Energy stocks slumped more than 50 per cent between 2014 and 2016, when the price of crude oil collapsed. These stocks are still down more than 30 per cent from their 2014 levels.
Can investors do better with an ETF that weights stocks differently? ETF providers have been devising different approaches to the Canadian index, with mixed results.
One of the most intriguing examples: The Horizons AlphaPro S&P/TSX 60 Equal Weight ETF weights all 60 stocks equally, and rebalances each quarter. That means Agnico Eagle Mines Ltd. starts each quarter with the same influence as Royal Bank of Canada, even though RBC is nine times the size of the gold producer, in terms of market value.
This approach shrinks the importance of financial stocks relative to the S&P/TSX 60, inflates materials stocks and leaves energy stocks about the same – which is to say, it might not satisfy a desire for playing down commodity producers. What's more, the dividend yield for the ETF is about 1.6 per cent, versus 2.9 per cent for the index.
As for performance (including dividends), though, it has beaten the popular index-tracking iShares S&P/TSX 60 ETF this year, by 0.4 percentage points. It has also outperformed the ETF over the past three years, by a slim 0.1 percentage points, but it lags by seven percentage points over five years.
Another option is the PowerShares FTSE RAFI Canadian Fundamental Index ETF, which weights stocks based on factors such as dividends, cash flow, sales and book value. Financials get a bigger weighting in the ETF, of about 44 per cent, which boosts the dividend yield to 2.9 per cent. But energy stocks also get a bigger weighting.
The ETF has outperformed the iShares fund over one- and two-year periods, but lags over three and five years.
Lastly, the RBC Quant Canadian Equity Leaders ETF selects stocks that have attractive valuations and better growth characteristics. Energy stocks account for a still-hefty 17 per cent of the index though, and materials have a 12-per-cent weighting. It is a relatively new ETF, but it has lagged the iShares fund over one and two years.
The verdict? Even alternative Canadian equity ETFs have a tough time dodging exposure to commodity producers, largely because they have little choice but to reflect the undiversified nature of our capital markets. And, perhaps more important, their relative performances haven't been standing out in any significant way.
One solution is to supplement a Canadian index-tracking ETF with individual stocks that can boost your non-commodity exposure. For what it's worth, I've done this with Hydro One Ltd., Power Financial Corp., Brookfield Infrastructure Partners LP and Brookfield Asset Management Inc.
Another approach: Keep your enthusiasm for Canadian stocks in check. The Canadian market accounts for about 4 per cent of global equities. It might make sense to favour the home team, but not at the expense of everything else.