Canadians Need to Get Passionate About ETF Diversification
While exchange-traded funds have become a hot topic in the world of investing over the last few years, an often-ignored issue is the importance of ensuring that your ETF portfolio is globally diverse. Many investors tend to emphasize domestic investments rather than balancing their portfolio with a solid, and more importantly, risk-reducing mix of both international and domestic securities.
The issue with narrow, domestic approaches
According to Jeff Weniger, a lack of international diversification is an area of particular concern for Canadian investors. “Investors in many countries are biased toward their own nation’s ETFs — it’s what we call a home country bias and it’ s a big issue,” he says. “It’s not unique to Canada, but the situation is more critical in Canada than in the US because of the size disparity between the two economies.”
The lack of variety in domestic stocks mostly stems from the concentration of certain sectors in Canada’s economy. In contrast, US stocks add up to almost half of the global total, while its economy is more diversified. “When Americans hold a portfolio heavily weighted in US stocks, being overexposed to the home country is not as big of a deal because they’re actually not deviating too much from the recommended mix. However, Canadian stocks provide only three percent of the global mix, so investors have to be more careful when thinking about how large their domestic stock allocations should be,” Weniger says.
With 97 percent of the value of global stocks listed outside of Canada, “global diversification is so vital for Canadians — if they don’t diversify, they’re missing out on a massive percentage of investment options,” he says. “We find that many Canadians are holding 60 to 70 percent Canadian stock, which is way off from what a global mix should look like.”
Widen your scope
Making matters worse is the fact that Canadian investors tend to favour three investment sectors, which puts their portfolio at even more risk. “There’s a specific bias in the stock market that is heavily influenced by basic materials, energy, and financials at the expense of all the other sectors. These three sectors account for about three-quarters of the whole market,” says Weniger.
The home country bias is dangerous because it leaves Canadian investors at risk of a hit to their portfolios if the national economy goes into a downswing. “Canada has an economy that’s very exposed to things that may be out of its control — like the oil price — much more so than others,” he says. “Because of the peculiarities of the Canadian economy, global diversification can be a much more difficult concept for Canadians to fully appreciate because the Toronto Stock Exchange is a smaller, more concentrated stock market than many others.”
In fact, the Canadian dollar is also a much more volatile currency than many may think as it may experience a boon during economic good times, but then steeply decline during the bad times. “The small Canadian stock market and volatile currency double the threat to a portfolio because your stocks are going down and your purchasing power is declining. These kinds of dangers are why globalization is critical,” he says.
Consider a new approach to ETF investing
Although building a diversified portfolio may seem distinctly unpatriotic, we shouldn’t be too hard on ourselves. “It’s an interesting quirk with Canadians, because the lack of diversity is not due to nationalism,” says Weniger. “People like to see the names of familiar companies in their portfolio — Canadians know companies like Canadian Tire and TD and don’t necessarily know the Japanese equivalents of those corporations.”
This lack of familiarity with international foreign companies, as well as Canada’s relatively small national investment landscape, highlights the very reason why it’s important to reach out to the experts to ensure you’re properly diversified. Consult your financial advisor to learn more about Wisdom Tree’s suite of products. The company is the world’s 13th largest ETF provider and was among the first to pioneer a smart beta rules-based approach to ETF investing.