BY MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS
May 22, 2018
Investing in Canadian stocks can be frustrating because the breadth of the Canadian market is so narrow. Canada’s three major sectors – Financials, Energy and Materials – account for more than 65% of the market capitalization of the S&P/TSX Composite Index.
If you use a broad Canadian index strategy for your Canadian stock exposure, you have effectively chosen to heavily overweight these three sectors.
The recent relatively poor performance resulting from this sector concentration can lead investors to conclude that the Canadian equity market is a poor investment opportunity versus other geographic regions, most notably the U.S.
On a one-year basis, the contrast between U.S. stock performance – heavily driven by equity performance – and the Canadian market has been stark. U.S. equities, as represented by the S&P 500 Index, are up approximately 13.3% for the 12-month period ending May 1, 2018. On the other hand, Canadian equities, as represented by the S&P/TSX Composite Index, are up only about 3.1% over the same period.
However, the pendulum may be swinging to support a heavier allocation to Canadian vs. U.S. equities. There are some fundamental reasons why:
1) Strong economic growth: Canada continues to be supported with some of the strongest economic growth in the G7 (even though many forecasts, including that of RBC Economics for example, expect growth to stall by the end of 2018). So far, Canada has shown surprising economic resilience. Currently at a year-over-year GDP growth of 3%, Canadian growth continues to keep pace with the developed world.
2) Oil Prices: This is an interesting facet of the Canadian economy, since higher-than-average oil prices can provide leverage for overall Canadian economic growth – via additional revenue for select energy producing provinces, as well as regional economic stimulus. The uptake in oil production by U.S. shale producers in the Bakken and Permian Basins has reduced the overall demand for the heavier crude oil produced in Canada. The key crude oil metric for Canadian energy producers is the Western Canadian Select (WCS) price, which currently trades at a steep discount to the more widely followed West Texas Intermediate (WTI) price. If this latter metric rises, it could start to help the revenues of Canadian oil producers.
3) Integration with the U.S.: The single-most important factor in the growth of the Canadian economy is the health of the U.S. economy. Canada and the United States are the world’s largest trading partners. According to Statistics Canada, 77% of Canada’s goods and services are exported to the United States. As the U.S. economy fires on all cylinders, Canada should benefit.
According to the Office of the United States Trade Representative, Canada was the United States’ largest goods export market in 2017. U.S. goods exports to Canada in 2017 were USD $282.5 billion, up 5.9% (USD $15.7 billion) from 2016 and up 13.5% from 2007. U.S. exports to Canada are up 181% from 1993 (pre-NAFTA). U.S. exports to Canada account for 18.3% of overall U.S. exports in 2017. It’s very difficult to envision the U.S. wanting to hamstring its most important export market through NAFTA negotiations, as it could result in significant economic risks for the U.S. economy.
The earnings of Canadian-based companies that export heavily to the U.S. can only trade at a discount for so long, assuming the U.S. continues its upward economic trajectory.
Not All Sectors Have Suffered
The heavy weighting to the Canadian Energy and Financial sectors used by the market-capitalization index strategies such as the S&P/TSX Composite Index or the S&P/TSX 60 Index tend to undersell the strength of the Canadian market.
If we look at a sector breakdown of the S&P/TSX Composite Index, we see that some sectors of the market have done quite well over the last year and year-to-date for the period ending May 1, 2018 – most notably the Canadian Information Technology sector and the Canadian Industrial sector. The big moves in the Canadian Health Care Index are largely due to the categorization of the isted marijuana producers in that sub-sector.
Sector Breakdown of the S&P/TSX Composite Index
Source: Bloomberg, as at May 1, 2018.
The point is, if an investor took a more diversified approach to Canada, there’s a greater statistical likelihood of generating better returns than with the broader Canadian market as a whole. However, it’s important to highlight that with broader diversification, you also mitigate the impact of big moves in concentrated sectors.
Index Strategies that Weight Canada Differently
Both the Horizons Cdn Insider Index ETF (HII) and the Horizons Inovestor Canadian Equity Index ETF (INOC) are index strategies that use different weighting criteria to hold Canadian stocks.
Horizons Cdn Insider Index ETF (HII)
HII seeks to replicate, to the extent possible, the performance of the INK Canadian Insider Index, net of expenses. The INK Canadian Insider Index is designed to provide exposure to the performance of 50 TSX-listed growth and value stocks with significant insider buying and ownership by the officers and directors of those companies.
Many investors use value and momentum metrics to assess the viability of a stock. The problem is, how do you avoid falling knives/value traps, or how do you avoid a stock that has run out of gas? This is where the unique insider commitment metric comes into play. By looking at the buying history and purchase intentions of senior directors and officers of a company, the ETF index is seeking to confirm whether these insiders believe the company is a good buying opportunity. Of course, like all other investors, insiders can be wrong, but the assumption is they do have a lot more knowledge about the long-term prospects of their company versus other investors.
Horizons Inovestor Canadian Equity Index ETF (INOC)
INOC seeks to replicate, to the extent possible, the performance of the Nasdaq Inovestor Canada Index, net of expenses. The Nasdaq Inovestor Canada Index is a large-capitalization equity index of diversified constituents, selected largely from the Canadian equity universe.
INOC’s key point of differentiation versus other index strategies is its focus on economic profit. IINOC assigns a greater weighting to stocks that generate a higher level of profit relative to their cost of capital. This screen provides a bit more of a value-tilt than a traditional index, but also emphasizes companies generating strong revenues. In both cases, by focusing on these different factors, both HII and INOC end up less concentrated in Financials and Energy.
|GIC Sector||TSX Composite||INOC||HII|
Source: Bloomberg as at May 1, 2018.
In the case of HII, a smaller concentration in Energy and Financials has helped the ETF generate much better returns than S&P/ TSX Composite Index. Since its inception in January of 2015, HII has outperformed the S&P/TSX Composite by approximately four percentage points per year since its inception. Over the last year, HII has delivered a 9.8% return while the S&P/TSX Composite has delivered a total return of only 3.11%.
|Horizons Cdn Insider
|S&P/TSX Composite TR||1.82%||-1.41%||-1.15%||-2.78%||3.11%||3.87%||7.77%||5.79%||03/01/1977|
* Source: Morningstar Direct, as at May 1, 2018.
Note: The Horizons Inovestor Canadian Equity Index ETF (INOC) is not included in the performance chart above because investment fund regulations restrict the presentation of performance figures until a fund reaches its one-year anniversary.
The indicated rates of return are the historical annual compounded total returns including changes in per unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The rates of return shown in the table are not intended to reflect future values of the ETF or returns on investment in the ETF. Only the returns for periods of one year or greater are annualized returns. The index is not directly investable.
There are two key things to keep in mind: At this juncture, Canada could provide some meaningful relative upside, particularly versus U.S. stocks. Secondly, and perhaps more importantly, is that investors are not limited in how they get that exposure – there’s more to Canada than energy and bank equities. By using strategies such as HII or INOC, there are other ways to obtain diversified exposure to the full breadth of the Canadian equity market.