This month’s newsletter will be an interesting one, as I am going to structure it around getting exposure to equities in Canada.
Due to the TSX’s significant outperformance of the S&P 500 over the last year, I’ve had a lot of requests to cover Canadian funds.
However, the current outperformance of the TSX versus the S&P 500 right now is not as cut and dry as you’d think, and I’m going to shed some light on this, and go over 3-4 different types of funds that I love for Canadian exposure.
Let’s get right into it.
Why indexing in Canada is a confusing topic
When we think of indexing in the US, it’s easy. Just buy the S&P 500. You get instant exposure to the largest 500 companies in the United States.
In Canada, we could do the same with the TSX 60. However, there is a core problem with the “just buy the index” mentality in Canada: our market isn’t a mini-version of the global economy like the S&P 500.
It’s a bet on Canada’s concentrated, cyclical blue-chips. If you buy a broad Canadian equity ETF, you’re overweight in financials and commodities and underweight in faster-growing areas like tech. That concentration makes your investment far more tied to rate cycles, housing, oil prices, and global industrial demand than most investors realize. Indexing still works here in Canada, but it just needs to be planned out a little better.
Fund managers know this, so they have built out a lot of products that still give investors considerable exposure to the Canadian economy, but can isolate out industries they might not want exposure to.
But Dan, the cyclical exposure is what is causing the TSX to soar!
This is a good point.
The last 12 months have been a perfect example of why Canada’s “index” isn’t neutral and why that can work in your favour if you did just buy the broader index.
However, the one thing we do need to understand is that it’s still a cycle, not a new law of the markets. Don’t expect it to work in your favour all the time.
The same sector mix (gold, precious metals, etc.) that helped so much this year can become a headwind when the dollar strengthens, real yields back up, or metal prices cool.
If you look to a 3-year chart of the TSX and the price of gold, you’ll notice they’ve moved in tandem.
This is not all that surprising. Basic materials, which include gold, silver, and other precious metal miners, are the third-largest allocation on the index. See the chart below.
Now let’s look at the S&P 500. There is virtually zero precious metal exposure:
If your plan is to “own the market,” with the TSX, be clear you’re owning this market: financials + resources with meaningful exposure to precious metals.
The TSX’s strong year has been earned by the cyclical nature that usually frustrates Canadian indexers.
Here are some funds to look at it Canada, all with a unique approach
I know the main strategies among members here are going to be one of the following:
- I want to take advantage of rising precious metals and a potential rebound in oil, so a broad TSX index fund is perfect for me
- I want to index in Canada, but I think metals might have peaked, so I want to mitigate exposure to those
- I’m not a fan of indexing in Canada at all, so I want an ETF that is wisely picking Canadian stocks that have the potential to outperform
If you fit somewhere else or somewhere in the middle of these, feel free to reply to this newsletter or head to your ETF Insights account and utilize the Q&A. I’m happy to do some digging for you.
In this newsletter, I’m going to cover 3 funds in depth that cater to the above strategies.
For Broad Exposure – Global X Corporate Class TSX ETF (TSE:HXCN) or the BMO TSX Capped Index ETF (TSE:ZCN)
The reason I mention both of these funds in this newsletter is that, depending on your tax situation, one could be better than the other.
In a tax-sheltered account, a broad-based index fund with no bells and whistles like ZCN is likely the best route. However, if you are holding your Canadian index funds in a taxable account, Global X’s Corporate Class ETF HXCN could save you in taxes.
The fund pays no distributions. Instead, what it does is make a swap contract with a bank. Global X will go to the bank and say, “Give me the returns, including dividends, of the TSX Index, and I will pay you a fee.” This means that the entirety of the TSX’s returns are represented in the unit price of the fund, while something like ZCN will have the pricing return of the fund, and then the dividends. Let’s look at a simple chart to illustrate this.
If we look to the chart since 2020, it looks like an absolute no-brainer that HXCN is the better choice. However, this is simply the unit price of the ETF. It does not include dividends paid. Considering HXCN’s “dividends” are just represented in an increase in unit value, it can be expected to grow in price much more than ZCN. However, factor in the dividends, and the returns are nearly identical.
So who would choose HXCN over ZCN?
If we quickly look at fees, ZCN is the winner. However, it gets a bit more complex than that. Because HXCN is paying a fee for the swap contract, the true representation of which fund is more beneficial will be the after-tax returns of each fund.
Dividends are taxed in the year you receive them. This means someone holding ZCN for a decade will pay tax (if in a taxable account) every year on the distributions paid. Someone holding HXCN will pay $0 in tax.
Instead, they will simply pay capital gains tax whenever they decide to sell, and contrary to what many believe, capital gains is often the more friendly tax for many Canadians.
Obviously, the decision to buy either one of these funds heavily depends on which one is better from an investment account perspective and a taxable account perspective.
However, both are outstanding funds if you’re looking to get exposure to the entirety of the TSX Composite. These two funds are a near-perfect reflection of the index itself, which includes the heavy reliance on energy, basic materials, and financials.
As I mentioned at the start of this newsletter, it is not necessarily bad to buy the index. You just need to be comfortable knowing what exactly you’re buying.
For Those Who Don’t Want A Lot of Precious Metal/Energy Exposure – iShares TSX Canadian Dividend Aristocrat ETF (TSE:CDZ)
I had to get a bit tricky here with this one, but this type of situation has been the one I have been asked about the most.
Investors either own their own precious metal exposure, say for example, ZGLD for a gold ETF, or they own their own oil stocks. They want to buy some broad exposure to Canada, but they don’t want to double up on these industries.
I don’t blame them either. After all, if you own a bunch of ZGLD, you already have plenty of exposure to gold. There is no need to amplify it with an ETF that has 14%+ exposure to precious metals.
The good thing about CDZ is that it is a Dividend Aristocrat ETF, meaning the companies inside of it have raised dividends for at least 5 years straight.
The vast majority of precious metal and energy players cannot do this. They’re either poorly operated or they halt dividends during cyclical lows.
For this reason, CDZ does offer a pretty diverse basket of Canadian stocks without extensive exposure to basic materials and energy holdings.
The TSX Composite has around 13.5% exposure to basic materials and 17% to energy. That is more than 30% of the index.
CDZ, on the other hand, has only around 4% exposure to basic materials and 15% to energy.
This lack of exposure to mining companies has ultimately hurt it over the last year, but again, if the cycle slows down and metal prices peak, mitigating exposure to precious metals will likely help investors.
I am not the biggest fan of this ETF overall. It is not one I’d look to buy and hold long-term, primarily because I do not believe 5 years of dividend growth represents quality in any way. In fact, it is quite easy for even poor-quality companies to maintain this streak if their revenue streams are not cyclical.
However, if you are definitely looking for Canadian exposure without a boat-load of metals or energy exposure, there really is not a fund that does it in Canada outside of CDZ. In the event we see a pullback in terms of metal prices, I would not be surprised to see this one outperform the index over the short term, it’s just not one I’m a gigantic fan of long term.
Active Management With Outstanding Results – BMO Low Volatility Canadian Equity Fund (TSE:ZLB)
If you’re not looking to buy a broad-based index but still don’t want to pick individual Canadian stocks, ZLB is probably one of my favorite actively managed funds in the country.
Now, someone looking at surface-level numbers and returns may say to me, “Why would I pay the added management fees of ZLB when it just performs the exact same as the index?”
The answer to that question falls into the category of risk-adjusted returns. Essentially, risk-adjusted returns factor in the level of risk/volatility you are taking to achieve the returns.
Yes, for the most part, ZLB has returned the same amount as the overall index over the last 5 years. However, it achieves those returns with much lower volatility.
This is represented in the fund’s Sharpe Ratio, which is a ratio utilized to measure risk-adjusted returns, of 1.13.
Generally, a Sharpe Ratio over 1 indicates that a fund is doing a good job of providing solid risk-adjusted returns.
Because ZLB is a low-volatility fund, it has zero energy exposure, and its basic material exposure is left to industry leaders like Franco Nevada and Agnico Eagle.
The lack of energy exposure caused it to underperform during the pandemic due to the large-scale ramp-up in energy stocks and oil demand. But someone simply holding this and then an additional energy fund to get exposure to that sector did outstanding.
When we think of low volatility, we generally think of lower returns. However, the Canadian market is in a unique position. The vast majority of our low-volatility equities are often our best-performing.
Let’s look to some of the top holdings in ZLB and their returns over the last 5 years:
- Loblaw: 258%
- TMX Group: 115%
- Thomson Reuters: 150%
- Hydro One: 116%
I wouldn’t confuse ZLB’s “low volatility” with low returns. Factoring in risk-adjusted returns, it has been a strong outperformer of the index. Although nothing is guaranteed, in the event we see basic materials slow down, I would not be surprised at all to see ZLB return to market-beating numbers even on a non-risk-adjusted basis.
It is important to remember that this was a relatively consistent outperformer of the TSX Index up until the torrent gold surge we’ve witnessed over the last year and a half.
Overall, these 3 funds can be great core or satellite holdings to a diverse portfolio
All of these funds have a potential place in a portfolio depending on what you want to target, but it is important to understand that they are just part of an overall portfolio.
The Canadian equity market is a small slice of global investable equities, only a few percent by market cap, and it’s concentrated in financials, energy, and materials, with relatively little exposure to structurally growing areas like technology.
Time and time again, I see way too many Canadian investors with a large portion of their portfolio in Canadian-based equities.
That concentration can be a tailwind in some cycles (like the recent run in precious metal prices), but if history has shown us anything, it is that it will lead to long-term underperformance relative to global equities.
Think of Canada as a small chunk of a portfolio, not the whole portfolio. If you want the income, familiarity, and tax advantages of Canadian equities and ETFs, great. Keep them as a core or satellite position.
But anchor the overall plan to broad global exposure so you’re not over-reliant on one country.
In my own portfolio, around 40%~ of my money is invested in Canadian equities. However, among those Canadian equities, most all of them have the majority of their operations south of the border. I have few Canadian equities that are reliant or focused on the Canadian economy.
