Sunday, December 28, 2014

Why is Canada underperforming the U.S. stock markets – Asset Allocation

A few years ago, between 2008 and 2011, many stock markets performed similarly and asset allocators where saying that investors should diversify their portfolios by sector rather than by geography. Now, just a bit later, the divergence between Chinese, European, Canadian, and U.S. markets is remarkable, or in Asset Allocator lingo the correlation between said markets is poor. When you dig deeper, you may notice that it are the Materials and Energy sector that performed poorly in Canada and that e.g. our Banks performed well if not better than U.S. banks. If you compare the performance of many Canadian oil and gas companies with those in the U.S., say compared to Exon-Mobil, you may notice that the latter performed better than its Canadian counter parts.  Why?  The answer lies in diversification and asset allocation.
Exxon –Mobil not only explores for oil and gas like most of its Canadian peers, it also refines and sells hydrocarbon products to the consumer. It doesn’t only produce oil and gas from land-locked Alberta, it also does so from the U.S. and many other areas of the world. Exxon-Mobil is a truly diversified oil and gas company and although its price did fall a few percentage points; its Canadian counterparts were often decimated with losses in the 20% to 70% percent range because of their lack of diversification; their specialization into either oil or gas, their specialization into a region (Alberta, BC and Saskatchewan).
The divergent economic performance of various geographies was also striking this year and now, with the fall in oil prices, it may diverge even more in 2015, with oil-importing economies outperforming the hydrocarbon (and other resource) producing economies. For a while, that is; my guess is that oil and gas demand will improve with the economy and the current, much heralded surplus of oil production is barely a million or 2 million barrels compared to a worldwide supply of 90 million barrels per day. With current oil prices dropping below the cost of production or below the price required by countries such as Saudi Arabia, Venezuela and Russia to maintain economic and political stability it should not take long before the ‘surplus’ melts away as snow under the Calgary Sun during a Chinook. But then, I am an optimist – I really have no clue.
There is the other side of the coin, ETF funds representing major market indexes such as the S&P500, the TSX, or the Han Seng index once again outperformed 96% of mutual funds and most retail investors.  The combination of diversification and low transaction costs has once again outperformed most funds with active management. I haven’t checked our own Moderate Dividend and Low PE portfolio yet, but I guess, it has performed OK as well. The reason of this outperformance lies in diversification and time in the market.  This becomes even more obvious if you avoid transaction costs such as buy and sell commissions, account fees, and… minimize taxes.  Especially capital gains taxes are critical as they basically represent an interest free loan from the government on your best performing stocks.  And… unlike mutual funds (outside your TSFA and RRSP), when you lose money, the government shares in the pain in the form of a capital loss tax credit. Mutual funds are collecting their fees regardless whether you win or lose but the government shares a bit in your pain.  Isn’t that sweet? J J
Many U.S. and other stock markets are now in their 6th year since the lows of 2009 and have often gained 200% or more from their lows; this bull market is definitely becoming long in the tooth. You may feel inclined to build up your cash position. The unavoidable question is how much?  What is the price or better the opportunity cost of holding cash?  This raises other questions about allocation such as what in terms of portfolio performance the cost is of holding on to a loser?
If you have winning investments averaging a return of 13% and you have diversified your portfolio with an average stock comprising no more than 5% of the total portfolio value, then how is the total portfolio affected if you were 1, 5 or 10% in cash? The answers are 12.87%, 12.35% and 11.7% respectively (see figure below). On the other hand, if you had one 5% holding that lost 20% in addition to the cash your total performances would 12.54%, 12.03% and 11.38%. You can experiment yourself with other combination of allocations.  If you hold cash, it limits your upside versus being fully invested, but having cash, even when you lose everything else, provides you a chance to fight another day. The same with a stop-loss. If you limit your investments to a maximum of 5% and sell as soon as an investment falls 20% then the effects are barely noticeable. But on the other hand if you had all invested in one big winner, you could have been rich. But what are the odds of that? 
The odds of picking a winner and having the nerve of running along with the profits until you are rich are like winning the lottery; well…  ?  Pretty close. What do you think are the odds that you will perform better than the market when more than 90% of professional investment managers cannot? Even Warren Buffett, after his death, plans to put his holdings in market ETFs! However, do realize, that even with all your stock holdings invested in ETFs, you will underperform the markets because ETFs hold no cash while your portfolio typically does.
There may be times, when market prices have fallen so deeply and when brilliant companies are so cheap that purchasing them directly becomes a no brainer.  Like buying Microsoft for $18 in 2009. But those times are few and long in between. Some commodities may lend themselves to humongous profits on occasion, but never buy them unless there is a clear turnaround. Gold has not yet turned around; oil has not turned around. Take your hand out of your money pocket and wait for the turn around, which could be years away. Only then, when it is obvious that a brilliant company is way too cheap, think about buying. Do not be in a hurry, and realize that because of your maximum 5% limit for your portfolio holdings your profits, just like your losses are limited. So, if you miss that profit opportunity it won’t impact your performance dramatically.

 Right now, regional performance is quite divergent.  The U.S. is on a tear – and typically during times of cheap commodities a manufacturing and service economy like the U.S. outperforms Canada easily. Once economies overheat and supply shortages of commodities develop will it be Canada’s time to outperform. Europe trails the U.S. but possibly not for much longer – it is also likely to outperform commodity dominated countries.  Next will be the emerging economies like China and India and Brazil.  For now focus on putting some money in U.S. ETFs that track the S&P500; buy lesser amounts in Europe and Canada which are cheaper.  When the market in the U.S. gets too expensive, switch your allocations elsewhere and don’t forget to take some profits from time to time.  About that more in later posts.


  1. Hi, Great post and very informative.

    I wanted to ask you; if you could advise someone on a career path or a specific job-related skill to learn, what would it be?

    Thank You

  2. Hi Kim or is it Kiwon?

    Thanks for your comment. My answer is today's (Feb 2, 2015) post.