Breaking Down The TSX Composite Index
The vast majority of people understand the concept of not putting all your eggs in one basket, and this wise advice carries over nicely to investing. I can’t tell you how many times I have heard the advice of investing in a well-diversified, low-cost Canadian Exchange-Traded Fund (ETF). You get the benefits of automatic rebalancing and access to a wide variety of Canadian companies for far cheaper than what it would cost if you were to buy them individually. And you’ll always, more or less, match the market.
Most of this is true. The one thing I take issue with is the “well-diversified” part of the sales pitch. Because the S&P/TSX Composite Index is anything but well-diversified. And if this is the reason why you have chosen to invest in an ETF linked to this index, you may be in for a rude awakening.
Let’s begin with how the Index is constructed. The S&P/TSX Composite Index is a market capitalization-weighted index. What this means is that its calculations are based on the weighted average market value of each company in the index. Larger companies such as the big banks affect the index more than smaller companies, so it is unsurprising to see that Financial Services and Energy make up approximately 35% and 18% respectively. That’s over half invested in just two sectors. The remaining 47% is divided up between the other nine sectors. Is this representative of the Canadian economy? Well, to some extent, yes, but that is no reason to invest this way.
Modern Portfolio Theory educates us on the benefits of diversification when it comes to reducing risk. Without going into too much detail, consider an investment in Stock A with an expected risk and return of 10% and 5%. Stock B has an expected risk and return of 20% and 10%. What is the expected risk and return of this two-stock portfolio? Well, the return will always just be the weighted average return of the two, therefore the average of 5% and 10% is 7.5%. The risk, however, is trickier to calculate. And it in large part depends on the correlation between the two stocks.
First, let’s assume that Stocks A and B are perfectly correlated - that is, their correlation coefficient is 1. This means that both stocks move up and down together perfectly. If that is the case, then the risk is actually the weighted average as well, or 15%. But we live in the real world where no two stocks move exactly the same in each direction, and investors can exploit this concept in order to reduce their risk. If the correlation is instead 0.5, then the risk of the two-stock portfolio is going to be something less than 15%. If it’s 0, then it will be even less. In fact, this pattern continues until the correlation is -1, or perfect negative correlation. Only then will we have achieved the maximum benefits of diversification.
So shouldn’t we just seek out assets with perfectly negative correlations? Well, yes, but similar to stocks with perfectly positive correlations, they are virtually impossible to find. So what can the average do-it-yourself investor do instead?
At the very least, we can attempt to avoid choosing groups of stocks that are very highly correlated with each other. While correlation is not widely available on investment websites, beta is. Beta is a measure of both direction and volatility of a stock compared to the market.
Let’s go back to the S&P/TSX Composite Index now. Of the Top 10 Constituents, four of them are Big Banks. Below are the beta values, as calculated by MS Money, for each company.
Royal Bank of Canada (Financial Services): 0.98
Toronto-Dominion Bank (Financial Services): 0.93
Enbridge (Energy): 0.86
Canadian National Railway (Industrials): 0.90
Bank of Nova Scotia (Financial Services): 1.20
Suncor Energy (Energy): 1.40
Bank of Montreal (Financial Services): 1.05
TC Energy (Energy): 1.03
Brookfield Asset Management (Financial Services): 1.00
BCE (Communication Services): 0.37
At first glance, it’s not hard to see what the problem is. Looking at Financial Services companies alone, they are all very closely correlated with the market. This begs two questions. First, why would somebody invest in all the big banks which virtually have the same correlations with each other? Second, why would somebody dedicate such a large portion of their portfolio to these same stocks? I think it’s safe to say that the more prudent advice would be to choose one or two and stick with them.
Especially given the alternatives out there. The largest company in the Consumer Defensive sector by market cap is Alimentation Couche-Tard, with a beta of -0.30. The next largest is Loblaw Companies with a beta of 0.28. Utility companies regularly have betas much less than 1. Fortis has a beta of 0.06. Companies in the Basic Materials sector typically aren’t highly correlated with the market either. Barrick Gold, Agnico Eagle Mines, and Franco-Nevada - the sector’s largest companies by market capitalization - have betas of 0.45, 0.40, and 0.32 respectively.
Essentially, when investing in these ETF’s, you don’t get much exposure to these low-beta stocks because their market capitalization isn’t high enough to make much of a difference. There is an equal-weight option as well, where all 239 stocks in the index are given an equal weight, but upon review of the Index’s Sector Profile, this is nothing more than a switch of about 15% between Financial Services and Basic Materials, without any meaningful changes in the other sectors.
To conclude, we don’t want you to leave with the impression that ETF’s have no place in an investor’s portfolio. They absolutely play an important part for many investors, especially those willing to hold long-term and just want to match the market. What we wanted to do though was challenge the idea that these ETF’s are diversified products, and how you may be shortchanging yourself by not seeking out better alternatives.
As always, please ensure you reach out to a trusted professional before making these important investment decisions and if you have any comments, feel free to leave them below.