It's our new national investing anthem. After a great start to the year, Canadian stocks have been among the world's worst performers in the past month or so. The energy stocks that once drove our market higher are choking it right now.
Canada's stock market has been a global doormat before and rebounded stunningly. But smart investing isn't about riding boom-bust cycles. It's based on sensible diversification that carries you through all kinds of market conditions. In this edition of the Portfolio Strategy column, we look at how to globally diversify your exposure to stocks.
As a starting point for diversifying globally, let's consider the Canadian weighting in some indexes that act as a benchmark for the world's stock market. The MSCI world index gives Canada a weighting of about 4 per cent, while the FTSE global all cap index slots Canada in at 3.6 per cent. Back in the late 1990s, there were gung-ho global investors who used weightings like this to rationalize holding just a tiny amount of Canada in a portfolio (more on that later). That was too extreme a position to take back then, and it remains so today for people who will live, work and retire in Canada.
Another way to divide up your global stock market exposure is to look at what pension plans are doing.
The people at the pension and benefits consulting firm Eckler Ltd. provided some data from market data specialists Greenwich Associates showing that smaller-size corporate and public defined benefit pension plans average 22.7 per cent exposure to Canadian stocks in their portfolios and 30.5 per cent to non-Canadian stocks (for total equity exposure of 53.2 per cent). Small pension plans are most relevant to individual investors because they don't make as much use as big plans of alternative investments like private equity and infrastructure.
Still another way to look at foreign content is to examine what some quality balanced funds – ready-made portfolios in a single product – are doing. Here are a few examples of how money is allocated in these funds to Canadian, U.S. and international stocks. Note: These weightings focus just on stocks and don't show percentages held in bonds and cash.
- Beutel Goodman Balanced D: Canadian stocks 32 per cent, U.S. stocks 17 per cent, international stocks 18 per cent.
- CI Signature High Income: Canadian stocks 14 per cent, U.S. stocks 13.4 per cent, international stocks 8.2 per cent.
- Mawer Balanced: Canadian stocks 19 per cent, U.S. stocks 21 per cent, international stocks 17 per cent, global small-capitalization stocks 7 per cent.
For more perspective, check out the accompanying chart showing how several investment advisers and portfolio managers divide up stocks between Canada and the rest of the world. You'll quickly notice there's zero consensus on this aspect of portfolio building. This means you'll have to find a mix that feels comfortable for you.
Now for a few caveats about global diversification. First, there's the additional layer of risk when investing outside Canada caused by currency fluctuations. When our dollar is weak, as it is today, your returns will be enhanced beyond what your underlying funds or stocks are returning. When our dollar rises, it undercuts your global returns. Note: You can reduce the impact of fluctuations in the Canadian dollar by investing in U.S. and international fund products using currency hedging.
Second, there can be tax issues when investing outside of Canada. Dividends are a great example in that only payouts from Canadian corporations qualify for the dividend tax credit. Also, depending on what type of account you invest in, you may lose a portion of your U.S. or global dividends to withholding taxes set by foreign governments.
One final point is that markets outside Canada tend to have less exposure to energy and metals than the S&P/TSX composite index, and more exposure to important sectors such as technology and health care. This works in your favour now, but a rally by commodity stocks could once again put Canada in a leadership position.
If history is any guide, Canadian investors often set their exposure to Canadian, U.S. and international stocks by reacting to market conditions as opposed to portfolio planning. Note: In investing circles "international" means everywhere but North America, while the term "global" means worldwide.
Back in 1998, bad times for Canada prompted a surge of popularity for global investing. The S&P/TSX composite index, known back then as the TSE 300 index, fell 3.2 per cent that year, while the S&P 500 rose 27 per cent and European markets climbed about 20 per cent on average. So great was the attraction of global investing that global equity funds were the fund industry's biggest stars. The trend didn't last.
After the tech bubble popped early in the previous decade, a couple of factors made the Canadian market the place to be. One was a rise in the Canadian dollar that crushed gains in stocks from other countries for several years, while another was a boom in the commodity stocks that are the foundation of Canada's stock market.
Today's market conditions in Canada look a fair bit like 1998. Commodities were out of favour then, and the economy's health was in question. These days, oil prices are plunging and the economy is fragile enough to deter the Bank of Canada from raising interest rates off the current historic lows.
Will investors respond to Canada's current problems by jumping onto the global investing bandwagon? It might already be happening. The exchange-traded fund with the largest inflows for the year through the end of November was the BMO S&P 500 ETF (ZSP) at $822-million, and the fund with the largest outflows was the iShares S&P/TSX 60 Index Fund (XIU) at $2.3-billion.
Don't chase trends in diversifying your portfolio. Find a sensible mix of Canadian, U.S. and international stocks and use that as a guide.
Divide and conquer
Here's how some portfolio managers and investment advisers allocate money to the Canadian, U.S. and international stock markets. The percentages shown here apply to the stocks in a portfolio only. So if you had 60 per cent of a $100,000 portfolio in stocks, you'd use these percentages as guidelines for dividing up $60,000.
Target Investor: 10+ years to retirement and a moderately aggressive risk tolerance
Nancy Graham, portfolio manager at PWL Capital:
- Canada: 33.30%
- U.S.: 33.30%
- Int’l: 33.30%
Note*: Applies to a portfolio 60 per cent in stocks and 40 per cent in bonds; one-third of the U.S. and international exposure would be currency hedged.
Neville Joanes, portfolio manager at WealthBar, an online advisory service:
- Canada: 50%
- U.S.: 34%
- Int’l: 16%
Note: Equity exposure has been optimized to provide Canadians with global diversification while focusing on cash flow. This asset allocation was derived using historical trends, valuations, macro expectations, cash flow, accessibility, tax regimes and cost.
Lise Andreana, certified financial planner (CFP) with Continuum II Inc.:
- Canada: 55%
- U.S.: 23%
- Int’l: 17%
Note: The weightings apply for a balanced portfolio with at least 30 to 50 per cent in bonds. These numbers add up to 95 per cent – the remaining 5 per cent could go to real estate, which could be Canadian or global.
Eric Kirzner, head of the investment committee at the online advisory firm Wealthsimple and professor of finance at the University of Toronto's Rotman School of Management:
- Canada: 20%
- U.S.: 40%
- Int’l: 40%
Note: Many Canadian investors have a high concentration to Canadian stocks and end up with a relatively large exposure to financials, materials, and energy. There's nothing wrong with keeping a small home country bias, but investors are encouraged to own more of a global portfolio. That will properly diversify their assets, assuming they can accept the foreign exchange exposure.
Paul Gardner, partner and portfolio manager at Avenue Investment Management:
- Canada: 75%
- U.S.: 20%
- Int’l: 5%
Note: Most Canadians have present and future liabilities in Canadian dollars. Sensitivity to foreign exchange can dramatically affect your wealth -- remember when the Canadian dollar went from 65 cents (U.S.) to $1 (2002-07). Most important, owning a Canadian-based portfolio in today's context gives you global exposure due to underlying companies' reach (e.g., TD Bank has more than 50 per cent of revenue coming from the United States).
Larry Berman, chief investment officer and founder at ETF Capital Management:
- Canada: Variable
- U.S.: Variable
- Int’l: Variable
Note: Start with Canada at 4 to 30 per cent, depending on your need for tax efficiency (e.g., the dividend tax credit) and views on energy, which is a key component of the Canadian stock market. Other regions are adjusted according to the opportunities available.
Nest Wealth, an online advisory service:
- Canada: 47%
- U.S.: 35%
- Int’l: 18%
Note: Since the financial crisis, international markets have demonstrated higher volatility than U.S. or Canadian markets, while also showing strong correlation with North American markets. This minimizes the diversification benefits they offer. Because of this greater volatility and the time horizon (10 years until retirement is not a lot of time to recover from inopportune market declines), it's suggested that this investor pare back on his or her international exposure.
Compiled by Rob Carrick.
* Notes based on advisers' and managers' comments.