Cooling it on energy, commodities

If a single sector is going to account for half your national stock market, you could do a lot worse than commodities.

While they're prone to sharp ups and downs, energy and mining stocks have made the Canadian market one of the world's top performers in recent years. Looking ahead, commodities keep us wired into many of today's strongest investing themes - the scarcity of oil and other resources, the rebounding global economy and the massive growth potential of India and China.

But let's get real. Energy and mining stocks have come a l-o-o-o-ng way in the past couple of years, and lately they've been shaky. That's why conservative investors should be thinking about cooling it on commodities.

One approach to minimizing commodity risk is to look at exchange-traded funds and mutual funds that have less than the combined 48-per-cent weighting in energy and materials of the S&P/TSX composite index. You're still investing in Canada with these funds, but you're taking a more judicious stance with commodities by reducing (not eliminating) your exposure.

The logic of reduced exposure to commodities could be seen in a recent decline in the S&P/TSX composite index that was linked to falling oil prices and concerns about economic growth in China. The index was off 0.4 per cent for the year through May 12, while many U.S. and international indexes were up as much as 7 to 10 per cent.

These numbers remind us of how commodities can work against you rather than for you. So do the returns earned by mutual funds and exchange-traded funds that focus on the Canadian market but put less emphasis on commodities than the composite index. In many cases, these funds have made money this year, even while the composite index is slightly in the red.

Let's look at some ideas for investing in Canada while limiting your commodity exposure:

1.) Exchange-traded funds that track lesser-known Canadian indexes

The composite index is the benchmark for our stock market, but it's far from the only index that covers Canada. For example, there's the FTSE RAFI Canada Index, which you can buy into through the Claymore Canadian Fundamental Index ETF (CRQ) . This index weights stocks not by size, as most indexes do, but rather by cash flow, sales, book value and dividends paid out.

The net result is a version of the Canadian market where energy and materials account for 30 per cent of the whole. Returns for CRQ have lagged the composite index modestly in the past year, but they're better over the past five years.

Another ETF that takes a different slant on Canada is the Dow Jones Canada Select Value Index, which you can buy into through the iShares Dow Jones Canada Select Value Index Fund (XCV) . The term "value" here refers to an emphasis on stocks that are undervalued by various criteria. Commodities are in the mix, but only to a weighting of 27 per cent.

One more ETF possibility will appeal to investors who want to stay close to market weight in commodities but reduce your exposure to the stocks that have risen the most. The Horizons AlphaPro S&P/TSX 60 Equal Weight Index ETF (HEW) limits any one stock to approximately 1.7 per cent. So while Suncor Energy, Canadian Natural Resources, Barrick Gold and Potash Corp. of Saskatchewan combine to account for about 12 per cent of the S&P/TSX 60 index of large blue chip stocks, they amount to 6.8 per cent of the S&P/TSX 60 Equal Weight Index, which HEW follows.

Overall sector weightings in HEW are only slightly lower than the S&P/TSX 60 index, which is made up of the biggest blue chips in the composite index. But by limiting exposure to any single stock, this ETF protects you to some extent from declines in the big commodity names.

2.) Dividend Funds

Many commodity companies pay a dividend, but few are among Canada's elite dividend stocks. That's because energy and mining companies tend to pay comparatively small dividends, which generate low dividend yields. Also, the reliability of dividends is suspect because of the volatility of commodity prices. A crash in oil prices suggests lower dividends from energy producers.

Now you understand why energy and mining companies are junior players in dividend mutual funds and exchange-traded funds. Consider RBC Canadian Dividend, the country's largest dividend and income equity fund with a massive $14.1-billion in assets. As of its most recent portfolio update, about 30 per cent of its assets were invested in the energy and materials sectors.

The indexes of dividend stocks tracked by the iShares Dow Jones Canada Select Dividend Index Fund (XDV) and the Claymore S&P/TSX Canadian Dividend ETF (CDZ) are even lighter on commodities. The iShares dividend ETF has just 15 per cent of its assets in commodities, while the Claymore fund's weighting is 22.6 per cent.

One thing to be aware of with dividend funds, and other funds that go easy on commodities, is that they tend to have a big weighting in the financial sector. RBC Canadian Dividend has a 43-per-cent weighting in this sector, while the iShares ETF was at just over 52 per cent. Claymore's dividend ETF offers the most sector diversification with a 13.5-per-cent weighting in financials.

3.) Conservative Canadian equity funds

Equity fund managers at most fund firms have to deliver solid returns to further their careers and one way to do this is to go with what's working on the stock markets. For that reason, energy and, to a lesser extent, materials are both prominent sectors in many Canadian equity funds.

In fact, some screening of funds in the Canadian equity category done with the GlobeinvestorGold website found only eight Canadian equity funds with an energy weighting of less than 20 per cent and 12 funds with less than 10 per cent exposure to the materials sector.

There are some mainstream Canadian equity funds that deviate from the indexes, but you'll find the best examples of independent thinking among small independent fund companies. A common characteristic of these firms: They manage money for pension funds, foundations and other entities that put an emphasis on a conservative approach.

To find some examples of funds that combine a below-market weighting in commodities combined with decent returns, I ran a screen (details in the chart) and came up with three names: Beutel Goodman Canadian Equity D, Leith Wheeler Canadian Equity B, and Mawer Canadian Equity.

Canada's economy is commodity-driven in large part, and the long-term outlook for energy and metals remains bright as long as the global economy is growing. All of the ETFs and funds mentioned here acknowledge this with exposure to commodities that is both ample and less risky than the broader market.

Three Ways to Cool It On Commodities in the Canadian Market

The benchmark index for Canada's stock market, the S&P/TSX composite index, is almost 50 per cent weighted to the energy and materials sectors. Here are some options for investors who want to invest in Canada but limit their commodity exposure.

1.) Exchange-traded funds that track lesser-known indexes

2.) Dividend ETFs and Mutual Funds

3.) Conservative Canadian equity funds