Overexposure to Canadian stocks will put a chill on gains

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Canadian market pullbacks are perhaps least welcome by those who use proximity as a stock-picking principle.

In spite of the merits of international diversification, Canadian investors very much prefer the perceived safety of investing domestically.

A portfolio heavily concentrated in local stocks can deliver great returns when Canadian resources are in demand, for instance. The risks of home bias become much more visible when commodities weaken, such as with the recent oil price shock.

"You've already experienced some pain as a result of your unnecessary overexposure to Canada," said John DeGoey, vice-president and portfolio manager at BBSL. "When are you going to realize that by investing as much as you are in Canada, you're exposing yourself to commodity swings that you don't have to be exposed to?"

While long-term investors shouldn't generally react to market shifts, economic and market deterioration afoot in Canada should compel those with concentrated domestic holdings to reduce their Canadian exposure, Mr. DeGoey said.

There is more than enough room to trim back. According to a June Vanguard report, the average Canadian investor has a 60-per-cent domestic equity weighting, which compared to the size of the Canadian market, amounts to "ridiculous overexposure," Mr. DeGoey said. "What you're doing is placing sector bets by overweighting Canada."

The Canadian market is, of course, dominated by resources and financials, which together account for 68 per cent of the total $2.1-trillion market capitalization of the S&P/TSX composite index.

Maintaining a disproportionate weighting represents a bet on Canada perpetually beating the global market, largely on the strength of oil and gas, mining and the banks.

Of late, that bet has been a losing one. The crash in crude benchmarks has shaken the Canadian market in general, and crushed the energy sector in particular.

Despite the oil selloff, the rash of capital budget cuts, and declining economic growth expectations, the Canadian index actually gained 0.3 per cent in January. "However, Canadian assets in fact underperformed the U.S. dramatically as the Canadian dollar declined 8.7 per cent," Brian Belski, chief investment strategist at BMO Nesbitt Burns, said in a note.

On a U.S. dollar basis, in fact, S&P Dow Jones Indices ranked Canada as the worst performer among developed markets in January. The financial sector was the big loser, with the Canadian banks sliding by 10 per cent, Mr. Belski noted, adding that financials now offer compelling relative value.

And yet, there are many Canadian investors who should use the occasion to trim back their bank exposure, which is the likely culprit behind a great deal of Canadian home bias, said Kurt Rosentreter, a financial adviser at Manulife Securities.

Canadians put great faith in the big bank stocks, and for the most part, those investments have paid off. The Big Six banks have produced an average total return of 160 per cent over the past 10 years.

There's an assumed safety in Canadian bank investment, Mr. Rosentreter said. "God forbid we ever have some kind of banking stock correction, because it would have a far bigger impact than Canadian energy stocks," he said. "Diversify your exposure and don't get greedy."

Western European and Japanese markets, for example, don't have the resource concentration seen in Canada. Meanwhile, the U.S. stock market has far greater depth in consumer sectors, health care and technology, which have been some of the best performing sectors over the past few years and which are thinly represented in Canada.

Long-term investors in bank stocks may be reluctant to trim their holdings and trigger capital gains. But the oil selloff may offer the opportunity to offset those gains by selling energy losers, thus reducing exposure to each sector, Mr. DeGoey said.

Many investors tired of piddling GIC rates were lured into high-yield small-cap energy stocks, Mr. Rosentreter said. Several of those names are down by as much as 70 per cent since the middle of last year.

"This sudden drop in energy that's clobbered the small-cap energy stocks in particular is a powerful wake-up call to the average investor," Mr. Rosentreter said.