ETFS best way to diversify beyond S&P/TSX.

Three funds offer least correlation with S&P/TSX

Diversifying your portfolio with securities from a round t he world is often held up as a way to boost return or lower risk. In the past five years, however, we’ve witnessed multiple episodes of market correlations going to one — investments moving perfectly in tandem — causing many to question the validity of the concept.

Recall that a correlation of zero would indicate markets are moving independently from one another and that a lower number is better as far as generating some diversification benefits.

Over this time frame, correlations periodically decreased, or so it seemed. In the mid-2009/2010, and mid2010/2011 periods, for instance, an American investor opting to invest in Europe with the iShares S&P Eur

ope 350 (IEV/NYSEArca) would have looked favorably upon its relatively low correlation (0.55 and 0.51) with the SPDRS&P 500 ETF (SPY/NYSEArca). The potential diversification benefits are overstated, however, because removing the comings and goings of the U.S. dollar versus the euro from that relationship takes correlation back up significantly (0.97 and 0.89).

Going forward, we believe macro diversification will increasingly retreat in favour of more micro diversification. In other words, major indices may remain at elevated correlation levels, so investors will have to dig further into individual sectors and methodologies to get some diversification benefits.

For Canadians looking at diversifying in the U.S., the U.S./Canadian dollar relationship also sometimes magnifies the perceived benefit of diversification. For instance, in the second half of 2007, the correlation was 0.56 with currency, 0.87 without.

More recently, the benefit of diversification in the U.S. has reasserted itself. For many, the challenges the U.S. faces combined with the memories of the pain caused by our surging loonie versus its U.S. counterpart, particularly from 2002 to 2007, is seen as justification to never invest there again.

This is a mistake. Our economy and markets are intricately tied to the global economy, and driven by emerging markets’ appetite for our commodities. The U.S., on the other hand, offers exposure to sectors we generally lack access to in terms of high-quality companies. The obvious areas are the technology, consumer staples, consumer discretionary and health-care sectors.

Many TSX-listed ETFs provide foreign exposure, and remove the currency risk by hedging the Canadian dol-

U.S. technology and health care, global dividend funds look promising

lar. The accompanying table shows some of the main ones, with their recent correlation to a traditional Canadian large-capitalization basket.

Exposure to that basket can be readily secured, either through the 800-pound ETF gorilla — the iShares S&P/ TSX Large Cap Index Fund (XIU/TSX) — or some of its direct competitors such as BMO Dow Jones Canada Titans 60 Index (ZCN/TSX), Vanguard MSCI Canada Index (VCE/TSX) or Horizons S&P/ TSX60Index (HXT/TSX).

A few observations about reading the chart:

The best year-to-date ETF candidates to achieve diversification are the BMO Nasdaq 100 Equity Hedged to CAD Index (ZQQ/TSX), BMO Equal Weight U.S. Health Care Hedged to CAD Index (ZUH/TSX) and Horizons Global Dividend (HAZ/TSX).

iShares S&P 500 Index Fund (CAD-Hedged) (XSP/ TSX) provides greater diversification benefit than the RAFI-following iShares US Fundamental Index Fund CAD hedged (CLU/TSX) or iShares Russell 2000Index Fund (CAD-Hedged) (XSU/TSX) at this point. iShares MSCI EAFE (Europe, Australasia, Far East) Index Fund (CAD-Hedged) ( XIN/TSX), t he unhedged iShares MSCI Emerging Markets Index Fund (XEM/ TSX) and iShares BRIC (Brazil, Russia, India, China) (CBQ/ TSX), which is hedged as far as U.S./Canadian dollar exposure (but not from the underlying countries currencies into USD) to both the Canadian and U.S. dollars, all look to be significantly correlated to our market. Granted, neither XEM nor CBQ are on a fully comparable basis, given they aren’t fully Canadian dollar hedged (XEM isn’t hedged at all), which should give them greater diversification benefit, not lower. This speaks to the influence emerging markets and BRIC countries have played in terms of Canada’s commodity story, and to sector composition similarities in our respective equity markets.

Despite a low correlation number, Japan remains significantly challenged by an overvalued yen, as well as resulting competitive position of some of its key companies. As a result, iShares Japan Fundamental Index Fund (CAD-Hedged) (CJP/TSX) remains very much of a contrarian play and one we’d see as a special situation.

Bottom line: Despite an understandable reluctance on the part of Canadians to diversify abroad, and perhaps even more so in the United States, using correlations as a starting point to identify where it might make the most sense to diversify, the U.S. technology and health care in particular, dominates alongside an international dividend focused ETF.

Investing further afield, either across developed markets, emerging markets or BRIC means ignoring the fact that much higher correlations suggest the benefits of diversifying there might be significantly lower than expected.