The bargain hunter's quandary: How to invest in the Canadian stock market without being swamped by energy and financials.
In a volatile patch for stocks globally in the past month or so, our market stands out for having been pounded especially hard. An easy way to buy the dip would be to put some money in an exchange-traded fund tracking the Canadian market. But with a weighting of around 60 per cent in financials and energy, Canada's benchmark stock indexes should provoke some diversification consternation.
You have alternatives. John Gabriel, Chicago-based ETF strategist with the analysis firm Morningstar, has crunched the numbers for equity ETFs and come up with seven ways to buy Canada without making a big bet on energy and financials. "One of the criticisms of the Canadian market is this concentrated exposure," Mr. Gabriel said. "These ETFs are one way to remedy that."
Name a broad index of Canada and you'll almost certainly find a financials-energy chokehold. The S&P/TSX composite index had 36.6 per cent in financials late this week and 20.3 per cent in energy; the S&P/TSX 60 index had 39 per cent in financials and 20.1 per cent in energy; the FTSE Canada Index had 42.6 per cent in financials and 20.2 per cent in energy; the FTSE RAFI Canada Index had 45.8 per cent in financials and almost 22 per cent in energy. All of these indexes are investable through ETFs, and all have delivered solid returns in the past. But if you want to minimize the short-term risk of large weightings in financials and energy, consider your options.
It's important to note that alternative Canadian equity ETFs in no way short-change financials and energy. They just hold less than the conventional indexes used for Canada, thereby reducing the risk to your portfolio from the two sectors.
Energy, you know about: With crude oil prices falling, the sector has been the downfall of the Toronto market in the past month or so. Financials offer a more theoretical risk. If the economy slows or if the housing market slumps, companies in this sector could fall hard in price and prove an even bigger drag on the index than energy stocks.
Several of the alternative Canadian equity ETFs highlighted by Mr. Gabriel have done extremely well in an otherwise lukewarm year for the domestic market. The star in the group is the BMO Low Volatility Canadian Equity ETF (ZLB), which as of midweek was up 0.7 per cent for the previous one-month period. Major Canadian indexes were down about 3.5 per cent over the same period.
Here, we have a good case study of an ETF tracking the Canadian market with reduced energy and financial exposure. Energy came in at a 13.1-per-cent weighting as of midweek, while financials were at 18.4 per cent. Note: When a fund underweights a sector, it is simultaneously overweighting another. ZLB's top sector is consumer staples at 21.3 per cent; in the S&P/TSX composite, the comparable weighting is just 3.7 per cent.
Consumer staples are defensive stocks that thrive in uncertain market conditions like today's. But in a fast-rising market generated by strong economic growth, consumer staples would be trampled. This brings us to an important warning for people considering alternative ways to buy the Canadian stock market: You need to understand that what works today may cause you to underperform the S&P/TSX composite and other measures of broad Canadian market exposure later on.
"If energy rebounds, funds that underweight energy will certainly lag the broader market," Mr. Gabriel said. "But over the long term, performance should be very similar to what you would get out the composite index."
Most of the funds on Mr. Gabriel's list take you far away from the classic index investing approach used by the biggest Canadian equity ETFs. These big ETFs take the market as it comes, weighting stocks and sectors by the size of the companies within them. ZLB is a rules-based fund, which is to say it uses a set screening process to build a portfolio. BMO starts with the 100 largest and most liquid stocks in Canada and reduces the list to 40 by isolating those that have been least sensitive to stock market volatility in the past five years.
Another alternative Canadian equity ETF that has generated better returns lately than the big stock market benchmarks is the First Asset Morningstar Canada Momentum Index ETF (WXM), where no one sector had a weighting of more than 17.1 per cent as of Nov. 30. WXM is based on the Morningstar Canada Target Momentum Index, which uses a screening process to emphasize stocks meeting criteria such as above-average returns on assets and equity. XWM has fallen about 0.7 per cent for one-month period ending midweek, but its year-to-date 12.9-per-cent return was close to double that of ETFs tracking the main Canadian stock indexes.
The dog in the alternative ETF group is the iShares S&P/TSX Small Cap Index ETF (XCS), which has suffered from an investor preference for large blue-chip companies. This ETF was down about 6.9 per cent for the year to midweek.
Something to consider when researching alternative Canadian equity ETFs is that they may hold stocks of midsized companies and not big blue chips. Mr. Gabriel said ZLB and the iShares Canadian Growth Index ETF (XCG) are the most exposed in the group to large companies. Investing in the shares of smaller companies may offer better long-term growth, but also more volatility.
Higher fees are another consideration in using alternative Canadian equity ETFs. Mr. Gabriel said the biggest ETFs tracking Canadian stocks have management-expense ratios as low as 0.05 per cent, while the alternatives on his list are closer to 0.5 per cent.
The most obvious and cheapest way to buy the Canadian market is to drop some money into large and popular ETFs such as the BMO S&P/TSX Capped Composite Index ETF (ZCN), the iShares S&P/TSX 60 Index ETF (XIU) or the Vanguard FTSE Canada Index ETF (VCE). But if the big energy and financial weightings in these funds is a turnoff, check out the alternatives.
Lightening up on energy and financials
Here are some exchange-traded funds with portfolios that are less weighted to energy and financial stocks than the S&P/TSX composite index