Canada is a wonderful country for a whole host of reasons. It’s amazingly inclusive compared to most places in the world, the land itself is beautiful and, let’s face it, we’re tops at hockey. Things are far from perfect, but as countries go, Canada is a pretty good one to live in.
With all this said, it’s important for investors not to become too enamoured with the Great White North. Just as it’s a good thing to do some travelling to see other countries and become acquainted with different cultures, some geographical diversification is prudent.
Canada the Concentrated
Imagine that, for the equity portion of a portfolio, an investor simply bought an index fund tracking all 300 stocks on the TSX. They’d be pretty diversified, right?
Well, not exactly. On the surface, owning shares in 300 companies should provide excellent diversification.
Problem is, the TSX itself is wildly un-diversified. In fact, two broad sectors, financial services and resources (the latter is split into the metals and energy sub-sectors), comprise over 65% of the value of the whole index. Financial services, led by the major banks, form the largest share, at nearly 35%. Energy companies are responsible for about 19.7% of the total market capitalization of the exchange, and metals and mining shares contribute a further 11.4%.
Why is the TSX so concentrated? For one thing, the banks have been incredibly profitable over the years, and have what many acknowledge to be a de facto oligopoly. They also did very well in comparison to global competitors when the financial crisis hit, which increased their allure among investors. As bank shares have risen, so too has the percentage of the market they represent.
It’s easy to understand why natural resources are such a big part of the market. Canada is fortunate to have large reserves of everything from oil to gold and potash (to name but a few commodities). As a result, we have numerous companies that explore for and produce key commodities that the world needs.
Interestingly, the Canadian equity market is far more concentrated than the U.S. one. Take the benchmark S&P 500 Index, for example. Information technology is the biggest sector, at 24.5% of the index. Financials come next, at nearly 15%. These are big weightings, to be sure, but think of it this way: the top two sectors in the U.S. are just under 40% of the market, whereas in Canada the comparable figure is over 65%.
Source: S&P Dow Jones Indices
The Bottom Line
In prior posts, we’ve talked about the value of diversification. In short, a well-diversified portfolio reduces the overall volatility of your investments and leads to better long-term returns. For this reason, we think geographic diversification is a good idea for clients. Canada is a very concentrated market, and given the world of opportunities globally, there’s no reason to keep all the eggs in a couple of baskets.