Unwind an over-concentrated portfolio

Canadians like to buy local with their investments, tending toward names they’re familiar with.

The downside is that the TSX is comprised largely of resource and financial firms, leading some investors to end up with heavily concentrated portfolios.

Read: Careful: Canadian stocks near record highs

For others, the concentration is through no fault of their own—it’s part of their compensation, and they’re looking for ways to get out without taking a tax hit.

We took a look at three archetypal investors caught in this situation, and asked three advisors for solutions.

Samantha is a 44-year-old information technology professional with a penchant for DIY investing. She’s married to Reeve, a graphic designer, and they live in Montreal. The couple started trading stocks through an online brokerage account 15 years ago. However, their only investments are now banking and resource companies. How can this pair deal with their portfolio?

Tina Tehranchian

branch manager and senior financial planner at Assante Capital Management

A lot of DIY investors are only familiar with the Canadian market, so their portfolios usually lack diversification. That’s the situation in this case.

If Samantha and her husband both want to stay DIY, they should look into ETFs that would give them exposure to global markets without them having to look into the individual stocks.

It’s difficult for self-directed investors to follow stocks in different countries under different economic and political conditions, so a broad-based ETF will allow them to diversify out of the resource and banking sectors, and reduce volatility. It could be as broad as the MSCI World Index, or they could choose regional indices. They need exposure to the U.S., Europe, Japan and emerging markets.

Read: 2 risks of frontier markets

If they don’t want to sell existing holdings (for tax reasons, or the fact that the stocks are doing well), they should at least choose global-oriented ETFs for future purchases. Sectors that are anti-cyclical to financial and resource industries include pharmaceutical and technology, which are under-represented in the Canadian market.

They need to be careful, tax-wise. Holding banking stocks for 15 years means they’ve likely accumulated a lot of capital gains. While they can’t avoid that hit, they should be as tax-efficient as possible for new investments. If they have RRSP room, making contributions will reduce their taxable income. They can also look at global corporate-class mutual funds, where they can switch from one fund to another without being hit by capital gains taxes.

“Using the loan proceeds, James can build a portfolio that has zero exposure to mining.”

James, 56, is a top mining executive in Vancouver. His generous compensation package includes company stock, which trades on the TSX. However, the firm’s hit hard times thanks to the commodity slump, and performance of that stock is dragging down the value of his overall portfolio. What can James do to shore up his holdings?

Neil McIver

portfolio manager at Richardson GMP

It’s probably not politically palatable for him to sell his stock, [so] I would suggest he explore equity monetization. This lets him hand his company shares to a financial institution and that institution will lend him up to 90% of that agreed value, depending on the stock’s quality and liquidity. James should first confirm his company allows this (some view it as a disposition in substance).

Read: Manage portfolios to fixed risk levels

The institution puts a collar option around the stock (created by purchasing an out-of-the-money put option while simultaneously writing an out-of-the-money call option), and the stock would remain in the client’s hands. The institution absorbs the cost of the collar, and the structure can be unwound at will. If the stock drops below the strike price, the loan won’t be called; the institution protects itself by shorting the stock. But, if the stock rises above the forward price, James will owe the institution the difference. When the contract expires, James can sell the shares to cover the loan, or he can roll over the arrangement. (Note, such transactions are treated as a disposition for tax purposes, so James has to weigh the tax hit against the benefits of becoming less concentrated.)

Using the loan proceeds, James can build a portfolio that has zero or minimal exposure to mining (see “A good mix for James,” below). The whole idea is to get his money outside of the concentration.

Read: Why outcomes are the new alpha

A good mix for James

Source: Neil McIver

He’ll likely receive more stock, so he may want to continue doing equity monetization and piggyback off the original structure, depending on the company’s performance. Assuming James’s asset-allocated portfolio will be invested in dividend-paying stocks, the tax implications are fairly minimal. And, the dividends can also pay for the interest on the loan. Since he’s investing the proceeds, the interest is also tax-deductible.

Minoo, 39, is a single schoolteacher whose retirement investment hinges on her contributions to the Teachers’ Pension Plan. She’s uninterested in the stock market. Recently, she inherited a basket of Canadian blue chip stocks from her father that is mostly full of mining and energy stocks. Should she unwind them, or invest further to diversify? Where should Minoo start, and what are the tax implications of her inheritance?

Daniel Merriam

investment counsellor and director of private wealth, Toron AMI International Asset Management

All capital gains accrued until Minoo’s father died were paid by his estate, so she’s only responsible for subsequent capital gains taxes. If she incurs losses after inheriting the stocks, she has a three-year window to create a tax loss against any gains.

Next, let’s look at the stocks. Which are paying dividends? What’s each stock’s track record of returning cash to shareholders? As for returns, I suggest a hurdle rate of around 10% annually. Anything lower is probably not worth keeping, although exceptions can be made if she thinks a stock may reach 10%, plus dividends, going forward.

After identifying what she’ll keep, she can sell the rest and look at diversifying away from mining and financial stocks to lower the overall portfolio volatility. Minoo has considerable time to generate more income, so I would allocate 20% into bonds and 80% into equities. She can look at technology companies in the U.S. with good valuations; consumer discretionary is also relatively thematic now; and she could look at utility companies in Europe.

Geographically, she can put a third of her portfolio in the U.S., and break the rest into Asia, Europe and a little bit of South America.

Teachers’ pension plans are locked into specific formulas to calculate member contributions, so she should create unregistered accounts to supplement that. She may want to examine the plan’s mix and avoid duplicating company investments, but I wouldn’t be scared of investing in the same industries as the plan.

I would also suggest she top up her RRSP with some fixed income, and then open a TFSA for slightly higher-risk equities (growth stocks or small caps). I have clients with pension plans who look to RRSP and TFSA accounts to have more sources of disposable income when they retire.

10% hurdle rate for equities 33% of assets can be American

Canada versus the U.S.

The American market dusted Canada’s last year. The S&P 500 posted a 32% gain last year, while the TSX advanced by about 13%, says Stephen Carlin, senior portfolio manager of Canadian equities at CIBC Asset Management.

What’s more, that 32% gain is represented in U.S. dollars, he adds. When factoring in the weak Canadian dollar, the rise of U.S. markets was more like 41%.

The performance gap between the exchanges is significant, concedes Carlin, but he suggests that clients shouldn’t give up on Canada.

To stop those flocking south, advisors can show people how much index construction impacts overall market returns. They can also recommend that investors look beyond general TSX data when seeking market opportunities.

When comparing U.S. and Canadian markets, investors should consider what drives index performance in each country, says Carlin.

The top three sectors represented of the TSX are energy, financials and materials, he adds, and together, they make up about 75% of our domestic index.

In contrast, the top three sectors of the S&P 500 are financials, information technology and healthcare, which make up 45% of that index.

Evelyn Juan is a Toronto-based financial writer.