June 24, 2008

Portfolio dilution excessive in Canada
Dilution a problem but worst for Canadian stocks

Canadian mutual fund investors have experienced disappointing long-term performance. About eighteen months ago (the last time I looked), stock mutual fund investors had experienced an annualized return of less than 5% annually over a thirteen-year period. Fees and the poor timing of buys and sells were certainly culprits. But the main cause, I suspect, was portfolio dilution caused by holding too many funds.

Drilling down more deeply reveals that the worst dilution occurs in our own tiny stock market. Look at virtually any wrap program and find out where most of the funds or managers are focused. I'll bet it's on Canadian stocks. Here are a couple of examples.

Canada - where most get it wrong

Elements is AGF's fund-of-funds wrap program, which features portfolios of AGF mutual funds. Looking across all five Elements portfolios, I found that the following funds are used to cover the Canadian stock market: AGF Canadian Stock (mid-large cap), AGF Canadian Large Cap Dividend (mid-large cap), AGF Canadian Growth Equity (small-mid cap), and AGF Canadian Value (mid-large cap).

Collectively, these funds hold in excess of 450 Canadian stocks (estimated using data from fund reports and Morningstar's Paltrak software). Some of these are overlapping (i.e. the three mid-large cap funds would have many stocks in common) so the number of unique names might be 'only' in the 300 range. This is just silly since it is more spread out than the S&P/TSX Composite Index, which recently had about 250 stocks.

Exposure to U.S. stocks more concentrated

Crazier still, Elements is using more funds and stocks to cover Canada than it does to cover the world's largest stock market. AGF U.S. Value Class, AGF U.S. Risk Managed Class, and AGF Special U.S. Class collectively hold only about 240 U.S. stocks - again not accounting for any names common to all three funds.

This is completely nonsensical. I can't think of one valid reason why any investor should have broader coverage of our very small stock market compared to relatively narrow coverage of the much larger U.S. stock market. It's downright loonie. Of course there are reasons, but they have nothing to do with investment merit.

One explanation, I suspect, is that AGF and its peers have a longer list of Canadian stock funds on offer compared to the list of U.S. funds they sell. Another possible reason involves the internal politics of picking one in-house manager over another. Finally, where there is a heavier allocation to Canadian stocks, some may find safety in broader diversification.

I have picked on AGF here but the same criticism can be lobbed in the direction of some of its competitors, like Franklin Templeton (Quotential), RBC (Select Portfolios), SEI, and TD (Managed Asset Portfolios).

Institutional investors no better

Institutional investors don't seem to be much better in this regard. One example is the University of Toronto Asset Management (UTAM). By all accounts, it's a well regarded institution with a board of directors that reads like a who's who of the investment industry. Yet, its list of active managers very much mirrors the above example.

UTAM uses more active managers for Canada than it does for the U.S. As of March 31, 2008 its list of Canadian stocks was north of 200 names. While its list of U.S. stocks was much longer (at more than 900), it was more concentrated than the Canadian portfolio.

UTAM's 80 biggest Canadian stock holdings accounted for 90% of its Canadian stock portfolio. By contrast, its 68 biggest U.S. holdings accounted for 90% of its U.S. stock portfolio. So, its stock investments are more spread out in the much smaller Canadian market - where dilution is a greater risk.

Food for thought

I have no beef with the concept behind wrap programs. Such programs do, in fact, provide some very tangible benefits to investors and advisors. However, as with many things, much of this theoretical strength is lost in the execution.

Whether you're looking to structure your own portfolio or considering wrap programs, pay attention to Canadian concentration. If it looks illogical, go back to the drawing board.