Passive index funds are a simple and fast way for investors to access a diversified portfolio. These funds provide the investor with index returns for a low cost. However, not all indices are the same with some being better suited for passive exposure than others.
As an example, the Canadian market defined by the S&P/TSX Composite consists of 230 companies and has historically been heavily weighted to the Energy and Financials sector. On the other hand, the US market defined by the S&P 500 consists of 505 companies that represent a much more broad based economy and therefore balanced index. Often investors fail to realize these flaws before buying the Canadian market passively thinking they are buying a diversified portfolio.
The two charts illustrate the historical sector exposure of the US vs. Canada – as you can see in the bottom graph, representing the Canadian market, there is a notable concentration in Energy and Financials in Canada.
Given the smaller size of the Canadian market, companies have a tougher time growing into global leaders. Comparatively, the U.S. is home to most of the largest companies in their respective industries. This is not to say that global leaders do not come out of Canada – for example, we have Shopify in e-commerce and CAE in aviation training. However, when a company outgrows the Canadian market and sees success globally the ability for one company to dominate the index is considerably higher than in the U.S.. The best example of this was the Canadian telecom giant Nortel which at it’s height in 2000 accounted for 35% of the index.
In order to avoid these potential pitfalls of the Canadian market, the best solution is to invest in a strategy that does not look like the broad index. Typical active share numbers (a measure of how different your portfolio looks from the index with 100 being completely different and 0 being exactly the same) for Canadian equity funds usually fall into the 50’s[i] – essentially mimicking the index. This is a result of two factors: the first is that given the size of the market large funds gravitate towards the larger market cap names to ensure liquidity and the second is that portfolio managers protect their jobs by providing index-like returns rather than deviating too far from the index.
The Bristol Gate Canadian Equity strategy – with an active share of over 70 – pairs and complements both passive indexes or more typical Canadian equity managers. As you can see below, the sector allocations below show the meaningful difference between the Canadian strategy and the S&P/TSX Composite.
With large weightings in Financials, Energy and Materials, the TSX will perform well in an environment when these sectors are strong. Conversely, our Canadian Equity strategy will trail in this environment. However, the benefit of diversification is that in adding the Strategy to a more index-looking product, when the dominant sectors lag, the Strategy will perform better.
While the breadth of the Canadian market will never be able to match the U.S. market, there are still a number of quality companies across different sectors – some that are widely owned and some that are smaller and under the radar. In a market dominated by certain sectors and few large companies, we believe the importance of decerning investment managers is even more important.
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