Chase the TSX at your peril

On the Contrary

One of best kept secrets mutual fund and ETF providers will never tell you is that near-term performance sells. So whenever a particular sector or market is posting some early momentum via strong returns over the past six to 12 months, investors are flooded with new products covering those sectors or markets. For example, we’ve seen new share buyback ETFs, junk bond ETFs, and preferred share ETFs, all sectors that have posted strong numbers this year.

Stockbrokers are also keenly aware of this and conveniently select those mutual funds or ETFs that have top 12-month performance. Therefore, add all of this buying together and it is no wonder momentum builds in overpriced segments of the market for a lot longer than many expect.

This is because it is human nature to have a fear of missing out and not doing as well as everyone else. As a result we end up throwing out the golden rule of investing, which is that past performance is not an indicator of future performance.

Taking a look at the current environment, it isn’t surprising to see investor appetite for Canadian stocks is once again on the rise, especially given the S&P/TSX is up a whopping 19.1 per cent to the end of November. It also helps that the top three sectors that account for more than 70 per cent of the index were top performers — a 23.5-per-cent gain in financial services, a 39.5-per-cent gain in energy and a 40.5-percent gain in materials.

Judging by the reaction of brokers we’ve seen at various events over the past few weeks, it’s almost as if the TSX’s 8.7-per-cent loss or the 27-per-cent loss in the energy sector last year never happened. Perhaps this is something to remember when opening your year-end statements, so be sure to look at those two-year returns and not just 2016 in isolation.

That said, while it was an easy sell for those last year recommending a global diversified approach to investing for Canadians, it is not so this year given the performance gap.

For example, the MSCI World Index is up only 2.9 per cent while the U.S. Aggregate Bond Index is up only 1.9 per cent and the Global ex-U.S. Aggregate Bond Index ETF is up 3.7 per cent this year compared to the S&P TSX’s 19.1 per cent gain and the FTSE TMX Canada Universe Bond Index that is up 0.89 per cent.

So assuming a 60/40 split, a global balanced portfolio that would be up only 2.9 per cent compared to a Canadian Balanced portfolio would be up 11.8 per cent this year.

Specifically, it isn’t uncommon to see well over half an equity portfolio being allocated locally, which is a large dislocation when considering the Canadian market represents a paltry three per cent of the global free-float equity market capitalization.

The problem is that the S&P/TSX is still weighted too heavily to the resource sectors representing nearly one-third of the index, which means you are making a very concentrated bet on the inflation trade — which fortunately has been the correct one since Donald Trump won the U.S. presidential election.

Therefore, getting Canadians to diversify their portfolios globally will be a real challenge heading into 2017 when in reality now may be the opportune time.

For example, we recently have been reducing some of our weighting to financials that are setting new highs and have been looking toward the REITs or utilities sectors that have sold off on the inflation trade.

Energy has some momentum that could last over winter, or at least until the U.S. shale producers respond to the higher oil price. That said, we think this certainly doesn’t mean having it make up 21 per cent of your portfolio, as it does in the S&P/ TSX.

We also think that there are more attractive value opportunities presenting themselves globally, such as Europe and Japan, although there are some risks such as the ongoing challenges facing the European Union.

Finally, we’ve also been trimming back our overall equity weights on the yearend strength and looking toward the recent sell-off in the bond sector, which has resulted in some more attractive yields. They also have more room for capital appreciation should the inflation expectations not materialize to the extent market participants are factoring in.