Investing Insights: Diversification and the Canadian Market

Having a “well-diversified” portfolio means holding exposure to a variety of assets across a number of measures in order to lower overall portfolio risk.

Investors most commonly think of diversification in terms of economic market segments or sectors, asset classes, and geographies. The objective of course is to smooth out risk by having positive performance from some investments offset the negative performance of other investments. In order for this to be effective, however, the assets must not be highly correlated.

In other words, they must not be expected to typically move in the same manner or direction at the same time.

Broaden your horizons with asset allocation

A basic static asset allocation strategy establishes a strategic mix of holdings at the beginning of each regular review period, perhaps annually or quarterly, across various asset classes, such as equity and fixed income, or across economic sectors or geographic regions. This is done in a manner best suited to your financial objectives, balancing risks and rewards based on your goals and risk tolerance.

A dynamic asset allocation strategy by contrast, such as that employed by our Maestro Portfolios, is guided by a strategic asset allocation mix, but may adjust target allocations as market conditions change. This continuous optimization is an excellent way to reduce the impact of shorter-term fluctuations, a growing concern as recent events centered on oil and commodity prices, interest rates and currencies have not only resulted in financial markets becoming increasingly correlated both across and within asset classes, but driven up the level of short-term market volatility.

The challenge for Canadian equity investors

Many investors believe they are achieving adequate diversification by buying “the market” through an instrument such as an index fund.

Fully two-thirds of the index weight is in just three sectors: financials, energy and materials.

A look at the breakdown of the S&P/TSX by sector quickly reveals the problem with this approach. Fully two-thirds of the index weight is in just three sectors: financials, energy and materials. As the slowdown in global economic activity hit the energy and commodities groups, it has also weighed heavily on the financial firms who derive a great deal of their business from the struggling resource companies.

With these highly correlated sectors so dominating the index, it is difficult to imagine offsetting losses through relatively small exposures to less-correlated sectors such as heathcare.

Asset allocation possibilities are greater than ever before

From North America to Europe and Asia, investors traditionally diversified by investing in various areas of the world. Globalization, though, cast a new light on geographic diversification. Our more interconnected world has some investors sector investing by industry instead of location.

Dynamic asset allocation takes traditional asset allocation one step further. With advice built right into each portfolio solution, each asset can be adjusted to respond to market conditions.

What can you do?

The difficulty of achieving true sector diversification within the Canadian equity market highlights the utility of diversifying across one or more of the other categories as described earlier, by geography for example.

One of the simplest means of achieving greater sector diversification is by adding exposure to the S&P 500. While the U.S. and Canadian markets are typically highly correlated in a broader sense, the sector makeup of the two indices is quite different. Financials, materials and energy comprise only 27% of the S&P 500 versus 66% of the S&P/TSX Composite, while the growth-oriented sectors of technology, healthcare, and consumer discretionary comprise 48% of the U.S. market compared to just 12% in Canada.

Volatility? No problem!

From year to year and day to day, markets do go up and down. That roller-coaster idea of market volatility can make some investors want to shy away from participating in the markets. But, there is room for even the most risk-averse investors to participate and benefit in the markets. And they are doing so in droves in the low-volatility equity product market.

Low-volatility equity funds are appealing if you are looking for comparable returns to stock markets with potentially greater stability through market ups and downs, particularly if you are looking to reduce the impact negative markets have on the value of your portfolio. Avoiding large negative returns can help to protect your assets and preserve your retirement income stream now or in the future.