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Academic research has shown categorically that index-based, passive investing strategies are the best options for investors. This realization does not, however, answer every portfolio allocation question for Canadians. The biggest problem – deciding which equity indexes to buy and how much of each – represents an even bigger investor dilemma now as the TSX continues to benefit from the global recovery from lockdown conditions.

Most investors will pay their expenses in Canadian dollars, so it makes perfect sense to own an exchange-traded fund tracking the domestic equity benchmark. Unfortunately, this practice has led to underperformance relative to more internationally focused portfolios over the long term.

The S&P 500 has dramatically outperformed the S&P/TSX Composite Index over the past three decades, thanks in large part to the U.S. benchmark’s greater diversification. The S&P 500 has much higher weightings in technology and health care stocks, to name only two examples, and this has helped U.S. stocks to an average annual total return of 11 per cent in Canadian dollar terms over the past 30 years.

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The S&P/TSX Composite’s average annual appreciation of 8.1 per cent over the same period leaves total cumulative returns lagging badly: The S&P 500′s total 30-year loonie return of 1,991 per cent leaves the TSX’s 937 per cent in the dust.

If diversification is a good thing, then a global equity index including hundreds of national stock exchanges would outperform U.S. stocks, right? Not so much. The MSCI All Country World Index has had an average annual total return of 8.3 per cent in Canadian dollar terms since 1991, which beats Canadian stocks marginally but doesn’t approach the 11 per cent mark for the S&P 500.

The past decade has been particularly terrible for TSX-only equity portfolios. The domestic benchmark’s 5.8-per-cent average annual total return is almost two-thirds lower than the 16.8-per-cent Canadian dollar performance for the S&P 500 on the same basis. The All Country index was more competitive with U.S. stocks, at 12.6-per-cent annually.

The domestic market’s lack of diversification has helped returns more recently. Thanks to large weightings in energy and materials that benefit from recovering global business activity, the S&P/TSX Composite’s 12 per cent total return over the past six months has more than doubled the 5.2-per- cent appreciation for the S&P 500.

An index investor looking to the future will be tempted to allocate more assets to the Canadian index to profit from economically sensitive market sectors during the recovery. Investors looking more in the rearview mirror might be inclined toward a currency-hedged version of an S&P 500 index-tracking ETF.

But either way, the decision will be based on a forecast for the future – exactly the kind of determination that passive investing was supposed to save us from. Even passive investing is hard.

-- Scott Barlow, Globe and Mail market strategist

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This is the Globe Investor newsletter, published three times each week. If someone has forwarded this e-mail newsletter to you or you’re reading this on the web, you can sign up for the newsletter and others on our newsletter signup page.

Stocks to ponder

Neo Performance Materials Inc. (NEO-T) Shares of this rare earths metals producer are trading near all-time highs after it struck a unique production agreement with a uranium player. Brenda Bouw reports.

The Rundown

Why the No. 1 bond fund manager of 2020 thinks the recent spike in Treasury yields is just another head fake

The rapid rise in long-term interest rates in 2021 has many people worried that richly valued equities and bubbly housing markets could be at risk. But, according to Lacy Hunt, economist and senior executive at Hoisington Investment Management Co. who has quite an impressive track record forecasting Treasuries, it’s just another head fake from the bond market. Larry MacDonald spoke with Mr. Hunt to find out why.

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Also see: Fed may need more than words in next battle with markets and U.S. bond derivatives signal calm, but economic fundamentals could spur more sell-offs

Three mistakes investors are going to be tempted to make in the months ahead

People don’t talk much about the stress of investing in a raging bull market, but it’s there. The fear of missing out, or FOMO, gets people agitated, and there’s an intolerance for anything that lags the great returns of the major stock indexes and particular market-leading stocks. In this kind of environment, it’s easy to fall victim to investing mistakes with long-term repercussions. Rob Carrick looks at three of them.

Why the smaller Canadian bank stocks were able to outperform this earnings season

All of Canada’s big banks sailed past analysts’ profit estimates when they reported their quarterly financial results last week. But the smaller of the Big Six, with cheaper valuations, scored some of the best share price gains. This may be something for investors to keep in mind as the market anticipates the end of the pandemic, along with improving economic activity and lower loan losses: A return to normal, or something close to it, could be particularly good for banks that appeared to have the most to lose when the economy was sinking last year. David Berman reports.

Expected returns for all stocks on the S&P/TSX composite index

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Jennifer Dowty provides a complete list of all 219 companies in the S&P/TSX composite index grouped by sector and ranked based on analysts’ expected price returns.

As a post-pandemic boom builds, foreign investors are showing renewed interest in Canadian stocks

International investors have rediscovered an appetite for Canadian stocks, fuelling the sharpest spike in net foreign inflows into Canada in more than five years. Suddenly, Canada’s heavy weighting in banking and commodities has turned from a weakness to a strength. Tim Shufelt reports.

Also see: Investor frenzy accelerates Canada stock market activity in February, says TMX

One thing is for sure: this is no time for value investors to throw in the towel

The current issue of the Financial Analysts Journal has a lengthy article on why value stocks have lagged since the financial crisis in 2007. It doesn’t directly address the issue of when value investing will return to favour, but the article’s title, “Reports of Value’s Death May Be Greatly Exaggerated,” provides a hint as to their conclusions. Robert Tattersall reviews the new research.

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Emerging markets feel the heat of the ‘bondfire’

Just when developing economies were ready to bask in the post-COVID-19 rebound in global growth, in sweeps a bond market blaze to scorch them again. Most major investment banks were predicting a stellar 2021 for emerging market assets as long as one crucial snag – global borrowing costs rising too fast – was avoided. Well guess what, they are on a tear. Marc Jones and Tom Arnold of Reuters look at what may come next.

Others (for subscribers)

Wednesday’s analyst upgrades and downgrades

Wednesday’s Insider Report: Executives make million-dollar purchases in these two stocks

Tuesday’s analyst upgrades and downgrades

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Tuesday’s Insider Report: CEOs bought these two high-yielding utility stocks around oversold levels

Number Cruncher: Fifteen low-beta TSX stocks

John Heinzl’s model dividend growth portfolio as of Feb. 28, 2021

Globe Advisor

Why the nascent psychedelics industry is getting investors’ attention

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Ask Globe Investor

Question: I am trying to determine the dividend payout ratio for Algonquin Power & Utilities Corp. (AQN-T) but different sources give different numbers. Can you help?

Answer: Based on analysts’ notes I have read, Algonquin’s estimated payout ratio for 2020 is about 94 per cent. This is calculated as the dividend per share divided by estimated earnings per share adjusted for one-time items.

While that may seem high, it’s not a cause for concern in Algonquin’s case. The company’s utility and renewable power businesses deliver secure cash flows, and Algonquin’s US$9.4-billion investment program over the next five years is expected to drive annual growth of 8 to 10 per cent in adjusted earnings.

Algonquin’s growing earnings should allow it to continue raising its dividend (which is paid in U.S. dollars). At its investor day in December, Algonquin signalled that it plans to increase the dividend by 10 per cent this year. After that, analysts expect that dividend growth will moderate, supporting Algonquin’s goal to have a long-term payout ratio of 80 to 90 per cent.

Nelson Ng, an analyst with RBC Dominion Securities, estimated in a recent note that, if Algonquin achieves growth of 9 per cent in earnings per share, it could raise its dividend by about 6 per cent annually starting in 2022 while bringing the payout ratio down to the midpoint of its target range.

Bottom line: Don’t be put off by Algonquin’s high payout ratio. The dividend will almost certainly continue to grow for many years to come, which makes its current yield of 4 per cent even more attractive.

--John Heinzl

What’s up in the days ahead

Dr. George Athanassakos, the Professor of Finance at Ivey Business School and value investing instructor, reveals his students’ latest stock pick.

Click here to see the Globe Investor earnings and economic news calendar.

More Globe Investor coverage

For more Globe Investor stories, follow us on Twitter @globeinvestor

You may also be interested in our Market Update or Carrick on Money newsletters. Explore them on our newsletter signup page.

Compiled by Globe Investor Staff

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