Mitigating Canada’s Bank and Energy “Trap”
This is second of a two-part blog series on constructing Canadian equity portfolios with an eye toward minimizing sector concentrations.
One of our common themes has been the peculiar nature of Canada’s hyper-concentrated stock market. Two sectors make up nearly two-thirds of this country’s equities, while the other nine sectors are largely neglected. Nothing like this phenomenon exists in the U.S., nothing like it exists in Germany, nothing like it exists in France. The list goes on.
We call this the “Canada trap” because it works out when it works out, but when it doesn’t, the trapdoors open. The contrast with the sector mix of global equities in the MSCI World Index is stark, as shown in figure 1.
Figure 1: Sector Weights, MSCI Canada vs. MSCI World
And as we showed in the first part of this series, Canada’s severe over-weighting in financials and energy stocks can lead to situations in which Canadian equities perform handsomely versus global equities on a sector-by-sector basis, but it is all for naught if financials and/or energy in general are out of favour.
In that post, we combined the MSCI Canada Index with the WisdomTree Canada Quality Dividend Growth Index (“WisdomTree Index”) to create equity baskets that have sector compositions that look much more like those of a global portfolio, because the WisdomTree Index is distinctly under-weight in financials and energy.
That makes the WisdomTree Canada Quality Dividend Growth Index ETF (DGRC) an interesting possibility for a sizeable allocation inside the portfolio’s core.
Taking that exercise further, we solved for a 100% Canadian equity mix that has sector-level allocations that are even closer to those of the MSCI World Index than was the case in the first exercise, subject to constraints:
- The MSCI Canada Index must be at least 33.3%.
- The WisdomTree Index must be at least 33.3%.
- All sectors target a weight that must be +/- 3% from the MSCI World Index.
- Because broad Canada is widely understood to have just one health care stock (Valeant), introduce U.S. health care stocks in Canadian dollar terms to avoid “optimizing” into a large Valeant position.
The optimizer generated the mix in figure 2. In addition to the one-third weight in the MSCI Canada Index and in the WisdomTree Index, the investor would need to add 0.59% in Canadian industrial stocks, 1.16% in Canadian consumer discretionary stocks and so on, to create a Canadian equity portfolio that has a “worldly” sector mix.
Figure 2: A Canadian Mix That Approaches MSCI World Sector Weights
Figure 3 shows how cutting the allocation down from 100% MSCI Canada to a 33.3%/33.3%/33.3% mix of MSCI Canada, the WisdomTree Index and individual stocks can create a Canadian equity mix1 that eliminates the “Canada trap.”
Figure 3: Making Canada’s Sector Mix Worldly
In the table above, the New Mix cuts down the financials sector from its 25.4% over-weight status to to just 1.1% overweight relative to MSCI World. Financials are still a significant 19.3% of the allocation, but no longer does the sector dominate quite like it does in common market capitalization-weighted Canadian indexes. Similarly, energy is cut in half, bringing it into closer alignment with global business dynamics, where the sector is only one-sixteenth of the total makeup. Additionally, the other side of the coin is topped up too. In technology, for example, Canada does have five companies in that sector, but they aren’t mega-caps, so they are neglected by many portfolios. They can be accumulated by putting a percentage point or two in each, evening out the sector score. In all sectors that we topped up, the companies were added in proportion to their market capitalization-weighted influence on MSCI Canada.
With its twofold wager on the banks and oil companies, the MSCI Canada Index embodies the Canada trap. In contrast, the New Mix is much broader, with the top 10 companies rounded out by tech, consumer staples, rails and, yes, still some banks.
Critically, the New Mix moves away from MSCI Canada’s 47.9% allocation to 10 companies, with a reallocated top 10 making up 28.8% of the allocation. Also, rather than having nine companies that are each 3% or more of the pie, with some in the high single digits and also engaged in the exact same lines of business as other concentrated positions, the New Mix does away with such unnecessary concentrations (figure 4).
This is broad Canada, whereas indexes such as MSCI Canada or the S&P/TSX Composite are certainly “narrow” Canada, trapped Canada, roller-coaster Canada.
Figure 4: Top 10 Company Holdings, MSCI Canada vs. Optimized Mix
In addition to these sector-level risk concentration benefits, we find that the presence of the WisdomTree Index in the lot aids the fundamental valuation profile too. For example, the MSCI Canada Index offers a 2.71% dividend yield, which looks high because it is so heavy in the big dividend-paying banks. But if the Index was reconfigured to have the same sector weights as the MSCI World Index, it would only yield 1.79%, because sector-level payouts in Canada are actually middling. The New Mix bumps that yield to 2.14%.2
DGRC is the ticker that tracks the WisdomTree Canada Quality Dividend Growth Index. We believe it can be used to help solve the Canada trap, and we encourage readers to investigate our unique approach to the core.
1We are assuming that any extra health care exposure is achieved via U.S. stocks in that sector, instead of adding in 11%+ to one company (Valeant).
2Source: Bloomberg, as of 1/19/18.