July 6, 2003

In Canada, keep it simple
Concentration best for small market

I look at many portfolios over the course of a year. Usually, I'm looking at them because they require major reconstructive surgery - so they tend to have their share of problems. There are common problems that span across the investing public - one of which is the excessive number of Canadian equity funds held in most portfolios. There are good reasons to keep portfolios simple - but compelling reasons to do so in Canada.

Market size and depth

As of a month ago, the Toronto Stock Exchange (TSX) had more than 1,600 securities listed for trading issued by 1,300 companies with a total market capitalization (i.e. total market value) of more than $1 trillion. Sounds impressive until you realize that the entire TSX is slightly smaller than General Electric, Microsoft, and Pfizer combined.

These three U.S. heavyweights have a combined market value that slightly exceeds the value of the entire TSX while making up just 9 percent of the market value of the companies that comprise the S&P 500 stock index.

To put the TSX's depth in perspective, the sixty largest TSX companies (i.e. the S&P/TSX 60 Index) makes up about half of the exchange's total market value. The Composite index (which contains just over 200 firms) covers about 70 percent of the total market value.

That means more than 3/4 of the 1,654 securities listed on the TSX aren't very big. As a result, they don't garner much interest from large institutional investors (i.e. pension funds) given their inability to buy significant stakes in such illiquid securities.

Portfolio implications

I find that most mutual fund portfolios hold too many Canadian equity funds. And quite often, I see three funds all with a mandate to buy mid-to-large cap Canadian stocks in one portfolio. But there are only 60 large cap stocks in Canada, if that, and maybe another 60 or so mid-cap stocks. Beyond that, most large cap Canadian stock funds simply can't buy smaller companies due to size and liquidity.

The problems start when investors hold two or more funds targeting the same segment of the market but with few stocks in common. I've talked about overlap before in the context of holding two funds that play the same role in a portfolio. In the context of Canadian stocks, the worst thing an investor can have is two or more funds shopping in the same market but with very different lists.

Case study

Trimark Canadian Endeavour and Mackenzie Ivy Canadian are two of Canada's largest Canadian stock funds - and both focus on mid-to-large Canadian companies using a price-sensitive growth approach. As of December 31, 2002 Trimark held 27 Canadian stocks while Ivy held 21. Only four stocks are common to both funds - which means they held 43 unique Canadian stocks between them.

Roughly half of Trimark's and 70 percent of Ivy's stocks are also included in the S&P/TSX 60 large cap index. Large caps account for 67 and 76 percent of Trimark and Ivy's Canadian equity investments, respectively. In total, holding both funds together provides exposure to 23 unique large cap stocks, which make up nearly 60 percent of the S&P/TSX 60 Index, albeit in different proportions.

The point of all this is to illustrate that:

a. Holding both funds provides broader exposure within a small market; and

b. The smallness of our market is confirmed by the disproportionate amount of assets held by relatively few larger companies.

The two funds illustrated hold relatively few Canadian stocks compared to most. Recall that holding just these two relatively concentrated Canadian stock funds results in holding almost 60 percent of the index. Holding such a big chunk of the index while paying fees well north of 2 percent annually will make the index a rather high hurdle to leap over time.

Recommendation

I strongly recommend holding just one fund for exposure to larger companies in Canada. Funds from AIM/Trimark, CI, Dynamic, Mackenzie, Mawer, and Saxon all have good core Canadian stock funds. Alternately, Barclays Global Investors Canada and TD Asset Management each offer much cheaper ways to gain passive exposure to Canadian stock indexes.

No matter what route you choose, pick just one fund. Then, if you'd like, pick one good fund for exposure to smaller companies. But that's it.

Our market is too small for any investor to go on a Canadian stock fund buying spree. Treat Canadian large cap stock funds like potato chips. While the temptation is high, you'll be (financially) healthier if you stop at just one.