Concentration
best for small market
I look at
many portfolios over the course of a year. Usually, I’m looking at them because
they require major reconstructive surgery – so they tend to have their share of
problems. There are common problems that span across the investing public – one
of which is the excessive number of Canadian equity funds held in most
portfolios. There are good reasons to keep portfolios simple – but compelling
reasons to do so in Canada.
As of a
month ago, the Toronto Stock Exchange (TSX) had more than 1,600 securities
listed for trading issued by 1,300 companies with a total market capitalization
(i.e. total market value) of more than $1 trillion. Sounds impressive until you
realize that the entire TSX is slightly smaller than General Electric,
Microsoft, and Pfizer combined.
These three
U.S. heavyweights have a combined market value that slightly exceeds the value
of the entire TSX while making up just 9 percent of the market value of the
companies that comprise the S&P 500 stock index.
To put the
TSX’s depth in perspective, the sixty largest TSX companies (i.e. the
S&P/TSX 60 Index) makes up about half of the exchange’s total market value.
The Composite index (which contains just over 200 firms) covers about 70
percent of the total market value.
That means
more than ¾ of the 1,654 securities listed on the TSX aren’t very big. As a
result, they don’t garner much interest from large institutional investors
(i.e. pension funds) given their inability to buy significant stakes in such
illiquid securities.
I find that
most mutual fund portfolios hold too many Canadian equity funds. And quite
often, I see three funds all with a mandate to buy mid-to-large cap Canadian
stocks in one portfolio. But there are only 60 large cap stocks in Canada, if
that, and maybe another 60 or so mid-cap stocks. Beyond that, most large cap
Canadian stock funds simply can’t buy smaller companies due to size and
liquidity.
The
problems start when investors hold two or more funds targeting the same segment
of the market but with few stocks in common. I’ve talked about overlap before
in the context of holding two funds that play the same role in a portfolio. In
the context of Canadian stocks, the worst thing an investor can have is two or
more funds shopping in the same market but with very different lists.
Trimark
Canadian Endeavour and Mackenzie Ivy Canadian are two of Canada’s largest
Canadian stock funds – and both focus on mid-to-large Canadian companies using
a price-sensitive growth approach. As of December 31, 2002 Trimark held 27
Canadian stocks while Ivy held 21. Only four stocks are common to both funds –
which means they held 43 unique Canadian stocks between them.
Roughly
half of Trimark’s and 70 percent of Ivy’s stocks are also included in the
S&P/TSX 60 large cap index. Large caps account for 67 and 76 percent of
Trimark and Ivy’s Canadian equity investments, respectively. In total, holding
both funds together provides exposure to 23 unique large cap stocks, which make
up nearly 60 percent of the S&P/TSX 60 Index, albeit in different
proportions.
The point
of all this is to illustrate that:
a.
Holding
both funds provides broader exposure within a small market; and
b.
The smallness
of our market is confirmed by the disproportionate amount of assets held by
relatively few larger companies.
The two
funds illustrated hold relatively few Canadian stocks compared to most. Recall
that holding just these two relatively concentrated Canadian stock funds
results in holding almost 60 percent of the index. Holding such a big chunk of
the index while paying fees well north of 2 percent annually will make the
index a rather high hurdle to leap over time.
I strongly
recommend holding just one fund for exposure to larger companies in Canada.
Funds from AIM/Trimark, CI, Dynamic, Mackenzie, Mawer, and Saxon all have good
core Canadian stock funds. Alternately, Barclays Global Investors Canada and TD
Asset Management each offer much cheaper ways to gain passive exposure to
Canadian stock indexes.
No matter
what route you choose, pick just one fund. Then, if you’d like, pick one good
fund for exposure to smaller companies. But that’s it.
Our market
is too small for any investor to go on a Canadian stock fund buying spree.
Treat Canadian large cap stock funds like potato chips. While the temptation is
high, you’ll be (financially) healthier if you stop at just one.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling
Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.