In a recent column, The Globe & Mail’s Rob Carrick (see Beware the limitations of buying the index, May 11, 2012) pointed out that investing in just the TSX Composite index might leave an investor with an unbalanced portfolio because of the index’s concentration in just three sectors: financials, energy and materials. The criticism is a valid one because, as you can see from the chart below, resource companies make up more than half the index and financials make up another one-third of the index. (As an aside, the sector breakdown of the S&P/TSX 60 index, which is tracked by the iShares S&P/TSX 60 ETF – TSX: XIU is pretty much the same as the broader Composite index).
This limitation of the TSX Composite Index is one reason why passive investors diversify their portfolios globally. The US Total Stock Market, for instance, offers much better diversification. The three dominant sectors in the Canadian market make up less than a third of the US stock market. The US stock market also offers exposure to sectors such as Information Technology, Healthcare and Consumer goods that have a much smaller representation in the Canadian index.
The MSCI EAFE Index which provides exposure to developed stock markets in Europe and the Pacific region is also well diversified across sectors. Financials and resources make up just 40 percent and the index has significant allocation to stocks representing Consumer goods, Utilities and Telecommunication services.
A globally diversified index portfolio such as the Sleepy Portfolio, which is split between Canadian, US, EAFE and Emerging Markets has a much better balance between sectors when compared to the Canadian stock market. The allocation to financials and resources drops to less than half the portfolio compared to three-quarters for the Canadian-market only index investor. And the allocation to sectors such as Consumer goods, Information Technology and Healthcare is also boosted substantially.