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Why it’s almost impossible to be a passive investor in Canada

Ryan Modesto, CFA, is CEO at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.

What if I told you that as of June 28, 2017, essentially halfway through the calendar year, only one sector out of 10 (including REITs with Financials) was negative? What if I told you that out of those 10 sectors, six of them had returned over 5 per cent in the year-to-date period and three of those had returned in excess of 10 per cent over the year-to-date period? With the TSX flat to slightly negative over the same period, you would likely call shenanigans, but it's true. Only one sector is negative for the TSX in 2017 and due to its heavy weighting, it has been the main contributor to the lack of any returns on the TSX so far this year.

Year to Date Performance of TSX Industries

Industry% Return
Energy-13.6%
Materials0.3%
Financials0.5%
Healthcare1.9%
Consumer Staples5.3%
Telecom7.0%
Utilities9.0%
Information Technology11.0%
Consumer Discretionary11.9%
Industrials12.6%

Source: Thomson Reuters Eikon

To be fair, the fact that the next two largest industries in Canada were flat for the first half of 2017 did not help either, but herein lay the problem. The TSX is a bad benchmark to use because it is too heavily weighted to a few sectors and makes it difficult for passive investors in Canada. What's more, being a 'passive' investor in the TSX could actually be an oxymoron, as an individual is really making an active tilt toward the financial and energy sectors. As can be seen in the table below, if an investor takes a passive approach to the TSX, they are putting 55 per cent of their allocation in two sectors and 66 per cent in three sectors.

Weights of Each TSX Sector

Industry% Weight
Energy19.6%
Materials11.2%
Financials35.2%
Healthcare0.7%
Consumer Staples5.5%
Telecom6.0%
Utilities4.0%
Information Technology3.0%
Consumer Discretionary4.4%
Industrials10.5%

Source: Thomson Reuters Eikon

What is perhaps more interesting is that if an investor had taken an equal weight approach, a strategy one could argue is even more passive than owning a benchmark that weights against company size, the equal weight portfolio would actually return 4.6 per cent over the year-to-date period. This is a return that is competitive on an annual basis any given year. We don't mean to criticize passive investing, in fact, we think passive investing along with exchange-traded funds are some of the best movements and innovations to develop in the finance industry in quite some time. We do, however, believe that there is a difference in being passive with one's investment style and passive with one's risk management.

An investor can be passive with their style in that they set an allocation that achieves long-term goals, does not trade often, seeks low cost solutions, and simply lets the markets do what they do. That does not, however, mean that an individual should be passive with managing risks. This includes putting 55 per cent  of one's Canadian allocation (which is more than likely the largest part of ones portfolio for better or worse*) into two sectors just because an arbitrary benchmark does so. You could probably ask just about any financial professional about holding 55 per cent of one's portfolio in two sectors and the uniform response would be that it is a high-risk strategy akin to speculating or trying to time the market, in other words, 'active' strategies. And yet here we are. Canadians continue to benchmark returns against a market that is largely driven by a volatile commodity* and in turn a good amount of funds are forced/incentivized to manage their portfolios against the same benchmark.

If you are a Canadian investor and believe you are passive, there are three areas where you may run into facts to the contrary. The first is that your Canadian equity allocation is likely far larger than a truly passive 'Global' fund would hold. The second is likely that you are over concentrated in one or two industries. The third is that even if you have addressed issues one and two, you are now likely forced to own what is essentially one or two stocks in the thinner sectors such as Healthcare and Consumer sectors. So hopefully the underperformance of one sector weighing down a whole market in the first half of 2017 will be a good case study as to why it's great to be a passive investor but almost impossible to be a passive investor in Canada.

*To gain further detail and insight to this analysis, The Globe and Mail has secured a one month free trial to 5i Research for readers. Gain further insight into the above analysis as well as access to 70 research reports and three model portfolios. Learn more here.

Readers can follow @5iresearchdotca on Twitter to get timely updates on dividend initiations, increases and cuts in Canadian markets.

Please perform your own due diligence before making investment decisions.

In order to remain truly conflict-free, the writer and employees of 5i Research cannot take a position in individual Canadian equities.

Read other reports here.

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