Diversification may be the key to weathering market cycles, but doing so successfully is quite another matter. The reduce-your-risk strategy can be even more challenging when investing in the Canadian stock market, which is prone to commodity-driven swings.
The balancing act lies in prudently spreading your investments across the sectors, along with diversifying by investment style and market capitalization. While this is true for equity investing generally, there are specific considerations that apply in the resources-heavy Canadian market.
Whether you invest directly in Canadian stocks, or prefer to do so through investment funds, it's important to understand the market's risk-return characteristics. Sadiq Adatia, chief investment officer of Russell Investments Canada Ltd., whose firm offers style-diversified investment pools and portfolio solutions, shared with Morningstar some of his key observations on sector risk and security-specific risk for those investing here at home.
"When building a Canadian equity portfolio," says Adatia, "you have to realize, first and foremost, that there are a lot of concentration issues in the Canadian market as a whole." For example, there is an over-emphasis in energy, financial and materials stocks, where those three sectors make up about 75% of an index.
"It's not as simple as picking a name in each sector," says Adatia, "because if you look at the health-care sector in Canada, it is less than 1% of the index, so to force yourself to put a name in there is wrong."
On the other hand, when it comes to the bigger sectors, such as financial services, it may be prudent to put a minimum of 15% of your overall portfolio in those sectors and perhaps five to 10% in another broadly based sector, according to Adatia.
"It doesn't have to be five or six different stocks, it could be 5% in the sector, so it could be one name," adds Adatia. Reiterating the importance of risk management, he says you want to make sure you have appropriate exposure to the three dominating sectors in the index. "I probably would never want to go more than 40% in any one sector."
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When it comes to individual stock holdings, Adatia suggests that a single holding shouldn't exceed 8% of the portfolio. If you're right about the stock and it moves up to a 10% weight as a result of capital appreciation, he adds, you might want to take some money off the table and reinvest it elsewhere.
(Currently, the most heavily weighted stock in the S&P/TSX Composite Index is Royal Bank of Canada RBC, at 6.3%. After the seven most heavily weighted names, all of the other index components have weightings of 2.5% or less.)
In the aftermath of the severe 2008-2009 bear market, Adatia thinks the trend is now more toward a "normalized" environment, where you don't generally see one or two sectors driving the market's returns. "We're not going to see the returns we saw last year, where we had massive 30% returns in the equity markets," Adatia believes. "Rather, we're likely going to see high single-digit, with perhaps low, double-digit returns."
In that sort of environment, you want to make sure your portfolio has exposure to dividend-paying stocks. "High-quality, dividend-paying companies paying 3% or 4%," says Adatia, "where almost 40% of your returns come from the dividends, gives you excellent downturn protection."
When it comes to managing volatility and protecting your portfolio, stock investors should "pay attention" concludes Adatia. "Things can change overnight." You can buy names that you'll hold for four or five years, but you have to keep up with what's going on with those names. A company's strategy or key management could have changed, the sector may be in a slump, there may have been a merger -- or you might want to take some money off the table.
Looking at the broader portfolio picture, the structuring of your Canadian equity component should be considered a second level of diversification. The first level, says Janesse McPhillips, managing director, private banking, at SEI Investments Canada Co., focuses more on the "traditional methodology" of an appropriate asset mix among stocks and bonds. The answer will depend on an investor's financial goals, risk tolerance and time horizon.
As for Canadian equities, SEI's cycle-proofing strategy is based on diversifying among multiple investment styles.SEI Canadian Equity, for example, employs eight different management teams representing a wide range of disciplines.
To illustrate the importance of style diversification, SEI shows clients a historical chart that indicates how various management approaches have performed over the years. What is amazing says McPhillips, is that the historical tool looks like a "checkerboard of colours" in terms of which styles have performed the best at various times.
"I think the chart is an excellent illustration," says McPhillips, "to help investors get their head around why style diversification matters. Yet we don't believe by style diversifying you're going to be a top-quartile performer." Rather, the approach tries to minimize the highs and lows of the market, providing a more stable rate of return.
