How to invest in Canadian equities

One reason we invest in stocks is to participate in a country’s economic growth.

A broad, capitalization-weighted approach best represents this objective. But investing, like politics, is a mix of facts and beliefs. The U.S. executive branch currently emphasizes beliefs over facts.

On the other hand, the persistent flows into indexed mutual funds and ETFs over the last decade, and away from active mutual funds, suggests the investment industry has been moving toward facts (see Does passive investing undermine capitalism?).

Conventional active management is any strategy that does not replicate a benchmark index. The performance of all active strategies in aggregate equals index performance minus fees, according to Nobel Prize winner William F. Sharpe, professor emeritus at Stanford University. Those are the facts. The ideas that any single active strategy can consistently outperform a related index, and that the strategy can be conveniently identified just as it outperforms the index, are alternative facts.

Those in search of more facts may want to learn about the underlying indexes themselves. Understanding how indexes are constructed will help advisors build solutions that get clients to their financial goals, the only performance that really matters. Outperforming a composite of benchmark indexes is a secondary objective in the evolving world of goals-based, passive investing.

Which index?

Index providers like S&P Dow Jones, MSCI and the FTSE Russell typically charge ETF sponsors a percentage of ETF assets under management, included in the expense ratio, for the right to use their branded index. So which index should you choose? Institutions have benchmarks against which their performance is measured, so they may prefer to use the component’s branded index to minimize tracking error. The S&P/TSX Composite is the standard index for Canadian equities, as is the S&P 500 for U.S. stocks and the MSCI Europe Australia and Far East index for international stocks. Tactically, institutions may seek the most liquid indexes to move large sums while minimizing market impact.

Retail investors have plenty of flexibility for choosing an ETF and what they’d like to track. The index selected should reflect the nature of the advisor’s mandate. If large-capitalization, liquid names are more suitable, the S&P/TSX 60 is a better choice than the TSX Composite. Table 1 compares the two indexes’ median and smallest capitalizations. The 60 has a median capitalization of $17 billion, compared with $2.8 billion for the TSX Composite. The TSX 60’s smallest name has a market cap of $3.3 billion versus $636 million for the Composite. The liquidity of the underlying securities determines the liquidity of the ETF, and because the TSX 60 is more liquid, it may be preferred by institutions for tactical trading.

Diversification is another matter. Concentration of holdings can be good and bad. The percentage of the portfolio represented by the ten largest holdings is a quick way to check. The FTSE Canada and S&P/TSX 60, for instance, each score about a 50% concentration for their top 10 holdings. Compare that to a more diversified 37.7% for the TSX Composite and 39.2% for the FTSE Canada All Cap. Portfolios are subject to both risk from the market (systematic) and risk from individual companies (stock-specific and unsystematic). Effective diversification reduces the latter. Measured by the lowest residual stock-specific risk for each ETF, we ranked the diversification of Canadian equity market ETFs. The TSX Composite ranked first, ahead of the All Cap and the FTSE All Canada. The TSX 60 ranked fourth, according to TMXmoney.

The number of holdings is critical for this analysis. Valuations measured by price-to-book ratio are comparable for all ETFs, although the TSX 60 is clearly higher than the others.

Performance will vary in the short term for any groups of securities that differ from each other. For these Canadian equity indexes, performance is similar in the long run. The broader TSX Composite and All Cap had similar five-year returns of 8.25% and 8.10%, respectively, while the more focused FTSE Canada and TSX 60 had somewhat higher returns of 8.56% and 8.99%, respectively.

When selecting ETFs, be aware that each will have tracking error. Also note that the Horizon S&P/TSX 60 ETF is derivatives-based, so its price reflects the total return, and no dividend distributions are made. This structure is most efficient for taxable accounts but bears counterparty risk based on the forward contracts used. The Horizon ETF’s lower fee of 0.03% reflects this counterparty risk. (Disclosure: my firm provides model portfolios to Horizons.)

A last word on benchmarks

For some investors, illustrating that their passive portfolio is beating a portfolio of mutual funds is good evidence that a strategic move to ETFs was sound. Using Morningstar mutual fund indices as a comparative benchmark, calculated net of fees, can be useful. You can be reasonably certain that any ETF should outperform its Morningstar equivalent simply because of the fee difference. Exploit your advantage over those pursuing alternative facts.

Table 1: Comparison of major Canadian indexes

*derivatives based. Source: PUR Investing

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.