So much has changed in the pandemic, but not the averageness of Canada’s stock market.
More than ever, we are rich in sectors that excite investors little or not at all and deficient in the sectors that everyone’s talking about. How long are Canadians supposed to put up with the middling performance produced by this mix?
There’s lots to think about as we pivot from summer to a fall where a second wave of COVID-19 looms, including the level of commitment a Canadian investor should have to Canadian stocks. For some answers to this question, let’s look at what the investment industry is doing.
A mid-month survey of mutual fund, exchange-traded fund and robo-adviser portfolios for balanced investors (roughly a 60-40 mix of stocks and bonds) found an average portfolio weighting of 14.5 per cent for Canadian stocks, 19.5 per cent for U.S. stocks and 23.8 per cent for developed international stocks, or those from outside North America, plus emerging markets in some cases.
A few observations about portfolio-building from this survey:
- In no case did Canada get the biggest share of stock market exposure;
- Just over half of portfolio managers give the U.S. market a top weighting, with the rest favouring international stocks plus emerging markets in some cases;
- Exposure to U.S. and international markets is much less of a factor in bonds than it is in stocks.
Canadian investors were once notorious for their home bias, which means a tendency to put too much Canadian content in their portfolios and ignoring opportunities elsewhere. Years of outperformance by U.S. markets has definitely opened some minds to diversification, but a 2017 survey by the investment firm Vanguard found that Canadians still held nearly 60 per cent of their stock market investments in domestic stocks and equity funds.
If you have 60 per cent of a portfolio in stocks and 60 per cent of that allotment in Canadian stocks, you have a total portfolio weighting of 36 per cent in the domestic market. That’s well above what we see in the survey of how balanced ETFs and robo-portfolios are diversified globally.
The benchmark for global stock market investing is the MSCI World Index, which has the United States, Japan and the United Kingdom as its top three holdings at 66.7 per cent, 7.6 per cent and 4.1 per cent, respectively. Canada’s weighting was 3.1 per cent.
In the survey of fund and robo-adviser portfolios, the one with the Canada weighting closest to the MSCI World Index was offered by Wealthsimple. This robo’s balanced portfolio had 6 per cent of its assets in the Canadian stock market, 15 per cent in the U.S. market and 29 per cent in international developed markets plus emerging markets.
Wealthsimple diversifies its portfolios with a goal of generating consistent returns and minimizing losses in down markets, said Ben Reeves, chief investment officer at Wealthsimple Inc.
Mr. Reeves said the low Canada ranking does not reflect a particular view of the attractiveness of Canada for investors. Rather, it’s seen as a way to diversify clients away from risks in the domestic economy that could affect both their income and their investments.
“Diversifying sources of return is really helpful because you don’t want your financial portfolio declining at the same time as you might lose your job,” he said.
The argument for investors raising their Canada exposure beyond the World Index is that they live in Canada, are paid in Canadian dollars and will, at least to some extent, spend their retirement savings in this country. Investing in Canada means you’re not subject to currency fluctuations that can both augment and erode your actual returns when they’re converted back to Canadian dollars.
Chris McHaney, a portfolio manager at BMO ETFs, cited this rationale when explaining the 15.3-per-cent weighting in Canadian stocks in the BMO Balanced ETF (ZBAL-TSX). The U.S. weighting, among the biggest of any of the seven funds and portfolios surveyed at 27.6 per cent, reflects the diversification opportunities in the U.S. market.
“It has a lot of companies in different sectors that Canada doesn’t necessarily have exposure to – IT and health care are a couple of examples,” Mr. McHaney said.
ZBAL’s U.S. exposure comes from the S&P 500, which has about 27 per cent of its assets in technology and 14 per cent in health care. By comparison, the S&P/TSX Composite Index has a weighting of 9.1 per cent for tech and 1 per cent in health care.
International exposure for ZBAL comes from the Morgan Stanley Europe Australasia Far East (EAFE) Index, which covers developed markets outside North America. If you compare EAFE returns measured in Canadian dollars with the S&P/TSX Composite over the past decade, you won’t see much diversification benefit.
“EAFE returns have been somewhat uninspiring in the last few years,” Mr. McHaney said. “But we think there’s opportunity in there. One of the areas where EAFE is strong is in global exposure to companies like Roche, Novartis, Sanofi and GlaxoSmithKline – global pharmaceuticals that are based in Europe, the U.K.”
The biggest question for Canadian investors in dividing up their stock market exposure may actually be how much to weight the U.S. market, which dominates the MSCI World Index and has dramatically outperformed both the Canadian and international benchmark indexes over the past decade.
Mr. McHaney argues that Canada’s underperformance actually makes a case for a strong weighting in a portfolio. “Historically, if you buy companies with a price-earnings ratio where the U.S. market is now, the following 10 years' returns will be substantially lower than if you bought at a PE where Canada is.”
A key decision when adding exposure to U.S. and international stocks via exchange-traded funds and some mutual funds is whether to buy a version that uses hedging to limit the distortions on returns caused by currency fluctuations.
A rising Canadian dollar reduces returns from foreign currencies, while a falling dollar enhances returns. With a hedged fund, you get the returns of your underlying index and can ignore what the Canadian dollar is doing against its U.S. counterpart and other currencies.
The survey of balanced portfolios and ETFs found little use of hedged equity exposure and a small amount of hedged U.S. bond holdings. With bond returns as minimal as they are right now, even a slight turn in the value of the Canadian dollar could be detrimental.
You’ll appreciate a non-hedged portfolio in market declines like the one earlier this year. Money tends to flow into U.S. assets at times like these, which means the Canadian dollar declines against the U.S. buck. That’s extra fuel for the U.S. stocks that should be a major part of a Canadian investor’s well-diversified portfolio in 2020 and beyond.
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