Profit Big from the "Canada Loophole"

03/23/2011 11:59 am EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Investors tracking the most popular global index are missing out on Canada’s powerful bull market, write Paul Justice and Samuel Lee of Morningstar ETFInvestor.

The MSCI EAFE (EFA) is the de facto international index for many investors. And it does, in fact, represent virtually all the rich-world stock markets—except Canada.

Due to this quirk of history, many investors have no exposure to one of the biggest, most important markets in the world. Canada accounts for about 4% of the world’s stock-market capitalization, or about 7% of the non-US market.

Aside from diversification benefits, investors may want to hold the iShares MSCI Canada Index ETF (EWC) as a way to benefit from rising commodity prices and a depreciating dollar. Unlike emerging markets, Canada is one of the most stable, transparent, and diversified commodity exporters, with a record of fiscal probity that’s the envy of the rich world.

The Canadian stock market straddles an unusual place, influenced both by its neighbor, the US, and the emerging markets, whose insatiable thirst for commodities has helped fueled Canada’s economy over the past decade.

On one hand, America is by far Canada’s biggest trade partner, and so its fortunes are tied to the US economy. On the other, Canada is blessed with copious natural resources. Its confirmed oil reserves, including oil sands, are second only to Saudi Arabia, and it’s a major producer of minerals, natural gas, and agricultural commodities.

Bound Up With Commodities
During the past 40 years, the Canadian market’s monthly correlation to the US stock market was around 0.74. (With 0 representing no correlation and 1 perfect correlation.) However, commodities have begun playing a bigger role, and its trailing three-year correlation to the GSCI, a major commodities index, spiked up to 0.80 as of the end of January 2011.

Because Canadian materials and energy companies have benefited heavily from emerging markets’ demand for their products, EWC can be seen as partly an emerging-markets play. However, its economy is more diversified than many emerging-market economies, and its strong democratic institutions mute country-specific political risk.

Besides the 50% devoted to energy and materials stocks, EWC contains a 30% helping of bank holdings. Canada’s five big banks benefit from a thicket of regulations that keeps competitors at bay and allows them to earn above-market returns on their capital.

Canadian banks, owing to government restrictions, didn’t participate in the toxic sub-prime market—and emerged from the financial crisis as some of the strongest in the world.

Canada’s government compares favorably with other rich-world governments. Its debt-to-gross-domestic-product ratio is 56% as of November 2010, well below 91% for the US. While its fiscal condition deteriorated with the global economy during the recession, Canada runs a structural surplus.

Business leaders and experts also consider its government exceptionally clean. According to the 2010 Corruption Perceptions Index, Canada ranked 6th out of 178 countries.

Next: Look Out for the Loonie

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Look Out for the Loonie
Canadian stocks have outperformed both US stocks and the GSCI by about 9% annualized during the past decade. Investors should pay attention to the source of the returns, lest they be lulled into thinking Canadian companies are simply excellent capital allocators.

About 3.7 percentage points of Canadian stocks’ outperformance comes from an appreciating Canadian dollar. Exchange rates tend to fall back to their historical averages over time. Since 1970, the average exchange rate has hovered around 1.2 Canadian dollars per US dollar; with the exchange rate around parity, the historical record suggests the currency will act as a long-run headwind.

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EWC holds about 100 stocks that primarily trade on the Toronto Stock Exchange. It charges a 0.53% expense ratio, steep for a portfolio of highly liquid, easy-to-access stocks. However, it’s the only game in town for investors seeking a basket of Canadian large caps.

The IQ Canada Small Cap ETF (CNDA) is the only other Canada ETF. [Richard Lehmann recommended it in December—Editor.] This small-cap ETF has a heavy exposure to materials (which accounts for about 50% of the fund) and energy (17%) sectors. The expense ratio of this fund is 0.69%.

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