With Valentines Day behind us, is it time to dump market-cap weightings on the TSX?

Our great country, with a vast expanse of land and abundant resources is often viewed as just that, a resource rich country reliant on the natural resources that are stuck in the ground. While a large amount of our economy does depend on these resources, investors and citizens alike often forget that there is much more to this country than oil, gold and big banks. Looking at many investors’ portfolios and even the weighting in the TSX, however, would make one think that this is actually the case. So why does the Canadian market need to be a feast or famine type of market whose performance is dependent on oil and financials? Why do investors need to shadow the overrepresentation toward these industries and expose themselves to concentration risks? Maybe it is time to recognize that the resource abundance does offer a particular uniqueness to Canada but that there is more to this country than resources. Maybe it is time to cast away a somewhat arbitrary focus on market-weighted indices in Canada and give some other industries some time to shine.

If you are matching TSX weights or own pretty much any Canadian equity mutual fund, many of which tend to shadow TSX weights, you already have roughly a 33% weighting toward commodities (Energy and Materials) and another 34% weight to Financials which can move in sympathy with materials, since much of the bank loan demand can come from resource industries. So it is understandable that an investor sells once they see that 67% of what they view as a diversified portfolio is in the red. So how does an investor fix this? We think there is a rather simple solution, that while may take a little more work than just buying the TSX index, could be well worth the extra effort:

Equal Weighting Industries:

The below table outlines the one, three, five and ten year returns for the 10 TSX sectors as well as the dividend yield within those sectors. Next, it calculates an equal weighted performance of the TSX (10% weight to each industry) and shows the degree of outperformance of the equal weight TSX portfolio relative to the market capitalization weighted portfolio. The results surprised even us.  Shorter-term, there is some significant outperformance but even over a ten-year period, the outperformance of essentially 1.5% is nothing to scoff at, considering a very limited increase in risk. One could even argue the investor assumes less risk, as they have now devoted fewer resources toward one or two specific industries. In addition, there is very little that is being given up in yield between the two portfolios. 

Admittedly, there is a bit of a convenience of timing in the above analysis as the recent and substantial decline in oil helps to weight the TSX down relative to an equal weight portfolio but this is also the point of the analysis. An equal weight TSX portfolio shelters investors from riskier commodity based sectors than a market-cap weighted option. Some years, the risk (and higher oil) will benefit the market-cap weighted index but other years it will not.

Aside from higher volatility (which in our view is questionable as a primary risk consideration for a passive, diversified investor), what are some other downsides to implementing an equal weight portfolio opposed to following the market capitalization index?

  • Might miss the next ‘big gain’ - This is a bit of a double edged sword as while you may miss out on the next boom in oil, you would also avoid the next crash while having exposure to all of the other industries that could experience their own bull market. Not to mention, the investor would still benefit from a rising oil market, just not as much as your peers might in this particular case.
  • Time Investment – This strategy takes a bit more time but we would not think it is that much more effort for a passive investor. It should be fairly easy to calculate the amounts of each fund that needs to be held. While you technically have more funds to watch over, a passive investor is unlikely to be checking in on the investments on a day-to-day basis because daily movements shouldn’t really matter.
  • Transaction Costs – Holding more funds does mean more trades in order to rebalance back to an equal weight. Fortunately, the individual investor can control the rebalancing frequency so that they are not incurring exorbitant amounts in additional fees.
  • Low industry depth – This can admittedly be an issue in Canada and specifically in the healthcare industry. There just aren’t that many options for investments so owning a 10% position in a healthcare ETF is likely to expose an investor to some concentration risks. An investor could always add in some US or global healthcare exposure to help mitigate these potential issues but this starts to muddy the waters in a passive investment strategy.

And the benefits of an equal weight portfolio:

  • Potentially superior returns – We have to have ‘potentially’ here as a caveat because even though the equal weight portfolio outperformed on a 1, 3, 5 and 10-year period, it does not mean it will continue to do so.  Regardless, it is hard to ignore the outperformance over the last ten years.
  • Reduced industry concentration risks - Equal weighting actually helps to reduce the main issue we have seen in numerous Canadian portfolios, which is an overweighting toward specific sectors. Often times, portfolios become a bet on the financial and energy sectors because they have a larger representation in Canadian market-cap indices.
  • Tax loss selling – We see this as an interesting benefit. When you hold a market-cap weighted ETF fund, you have to sell the whole fund to take advantage of tax losses (if any). The ‘bundling’ of the industries within a fund mitigates the dollar loss that you can claim. However, if you unbundle all of these industries into an equal weight portfolio and hold them as individual industry ETFs, it is much easier to optimize any tax-loss selling as you can sell only the industries that underperformed or are sitting at a loss, and then buy them back at the appropriate time.
  • This is the true passive(?) – We are getting a little philosophical here when we pose this question: What is passive investing? If a passive investor in Canada owns the TSX composite, are they not actually making a bet on the financial and energy sectors? Is an equal weight portfolio not more passive than market capitalization? In an equal weight portfolio, you are not expressing any opinion on where you think certain markets will go. You are simply exposing your portfolio to all of the areas that make up an economy equally, with no bias one way or another.

We are not trying to say market-capitalization indexing is a bad thing, it is better than many of the alternatives out there. The problem we often see, however, is that investors do not realize how big of an allocation Canadian markets have toward a few industries. Market-cap indices are essentially the de-facto standard and it is better than nothing but maybe it is time for investors to reawaken that natural instinct to question everything and maybe it is time that we dump market-cap weighted indices.

I hope to expand on this topic a bit further in an upcoming issue of Canadian MoneySaver magazine.

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