Canadians, Watch Your Weight

05/21/2012 11:30 am EST

Focus: GLOBAL

Rob Carrick

Columnist, The Globe and Mail

US indexes give a bigger slice of the pie to tech, health care, and consumer products than the commodity-heavy TSX, a crucial point to consider when the latter is underperforming, writes Rob Carrick, reporter and columnist for The Globe and Mail.

Here's an answer for your struggling Canadian stocks and equity funds: Buy American.

We have a monster weighting in commodities; the US market does not. Our tech, health care, and consumer products sectors are stunted, while the US market is well-stocked.

A quick summary of stock market action this year: Commodities down; health care, tech, and consumer products up.

The best part of a Buy American strategy is that you don't need to spend a lot of time agonizing over the right investment. If you prefer exchange traded funds, any product that tracks broad markets (as opposed to sectors) should work. If you prefer US equity mutual funds, there are almost none that mirror the big energy and materials weighting of Canadian equity funds.

It wasn't long ago that many investors would scoff at the idea of having a significant weighting in US stocks. With its commodity bias, the Canadian market outperformed US stocks for years on end. Massive debts, a struggling economy, and government gridlock cinched the decision to avoid the United States.

Last year, the US stock market reasserted itself by rising a bit while the Canadian market fell sharply. Same thing this year. The S&P/TSX composite index was off 5.2% as of May 17, while the S&P 500 was up 3.8%.

There are signs of economic recovery in the United States, and corporate earnings have improved. But what's really attractive about the US market to Canadians is that it's rich in what we don't have, and poor in what we have in abundance.

Information technology is a great example. The sector accounts for 1.2% of the S&P/TSX composite index; the two dominant companies are CGI Group (GIB) and Research In Motion (RIMM). Together, they make up about half of the S&P/TSX capped information technology index.

CGI, a technology outsourcing company, is a quiet success story in the tech field. The company's shares are up a cumulative 104% in the past three years, and in this year's tough markets they've risen 9.2%. RIMM you know. Its shares are down 86% over the past three years and 22% this year alone. That's a big reason why the info tech index is down about 6% this year.

The S&P information technology index in the US market has climbed 11% this year, thanks to stocks like Apple (AAPL), up 31%; eBay (EBAY), up 29%; and Microsoft (MSFT), up 14%. In fact, tech is now the largest sector in the S&P 500, at 20%.

Frankly, that seems like a heavy weighting for a sector as flighty as technology. But given the Canadian market's near-zero exposure to tech, it's not like this sector is going to overrun your portfolio if you pair up funds that cover both the Canadian and US markets.

It's worth highlighting that after tech, the dominant sectors in the S&P 500 are financials, at just over 14%, and health care at almost 12%. Our Canadian market is far more concentrated in its top three sectors. Financials, energy, and materials add up to 75% of the index.

The S&P 500 is often used as a proxy for the US stock market, but it's actually an index of large companies, and thus does not provide an accurate reading on the broader universe of large, medium, and small companies. For that, a total market gauge like the MSCI US Broad Market index is more useful.

A sector breakdown for this broad market index shows tech at just under 20%. It is followed by financials and consumer discretionary stocks. Energy and materials account for less than 15%.

A definitive index for small US stocks is the Russell 2000, where the combined energy and materials exposure gets squeezed down to about 13%. The weightiest sector is financials at 25%, which compares to 32% for the S&P/TSX composite. A reasonable conclusion here is that pairing up US small stocks with a broad index of Canadian market investments will result in financial sector overload.

An advantage of using an index of US large stocks is that you get exposure to multinational companies that do not depend strictly on how the American economy does. You can get the same diversification benefits from global investing, of course.

The MSCI World index, a benchmark for global equity funds, has a combined energy-materials weighting of about 17%. The MSCI Europe Australasia Far East (EAFE) index, a benchmark for funds that invest everywhere but North America, has a commodity weighting of about 18%. Watch the financials, though. The sector dominates both indexes with weightings of about 20%.

It's the US market that looks most inviting right now, though. It's a much stronger performer of late than either Canada or the EAFE index. Over the past ten years, though, it's the laggard. In Canadian dollars, the S&P 500 had an annual average loss of 0.02% over the decade to April 30, while the EAFE index made 1.1% and the S&P/TSX composite made 7.4%.

Exchange traded funds that track major stock indexes are an ideal instrument for diversification of a portfolio into the US market. Between the TSX and the New York Stock Exchange, there are ETFs covering all the indexes mentioned here.

US, global, and international equity mutual funds are other options. (International funds invest outside North America, global funds can go anywhere.) But recognize that many funds can't keep up with their benchmark indexes. Suggestion: Seek out mutual funds that have managed competitive, if not necessarily index-beating, returns with lower risk than their peers.

I ran a screen on our Globeinvestor Gold Web site for funds like this and came up with one standout name, Mackenzie Ivy Foreign Equity. It has close to half the volatility of the MSCI World index, and fell not even 7% in 2008, while global funds fell 34% on average.

The fees are high at 2.47%, but returns have beat the world index over many periods. Commodity content is negligible, while consumer stocks dominate. Now, that's a hedge for a portfolio with a lot of Canadian content.

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