What are we looking for?
Canadian-listed broad market ETFs that skirt concentration through capping or equally weighting.
The screen
Recently, Rob Carrick noted the launch of a new ETF that tracks the performance of the S&P 500 index with an interesting feature that caps exposure to one specific name at a 3-per-cent weight. When we also consider Tim Shufelt’s recent discussion around how certain well-known investors criticize the impact that traditional market-cap-weighted index funds affect the capital markets, perhaps the idea of reducing exposure to top-heavy indexes merits a quick look. For investors, capping or reducing exposure to one specific stock has the theoretical benefit of increasing diversification and hence reducing risk in the portfolio. However, equal weighting has the effect of suppressing returns when the superstars of the index continue to surpass investor expectations. Mr. Shufelt’s article discusses this in some detail, noting that meteor-like performance of top names is backed by explosive earnings growth that isn’t present in the smaller names. In other words, perhaps market efficiency is doing its job, and the index is merely a reflection of the economy. The truth is probably somewhere in between these two extreme points of view.
Today, I used Morningstar Direct to have a look through broad market index ETFs available for sale in the Canadian market that offer a similar capping feature that Mr. Carrick mentions in the linked article, or are by design equally weighted as opposed to market-cap-weighted. Sector-specific and leveraged/inverse leveraged products were excluded in this search.
What we found
The funds that qualified in the screen are listed in the table accompanying this article, alongside MERs, trailing performance, inception dates, sector exposure, and ratings. For comparison, several popular market-cap-weighted benchmark indexes have also been included. The far right column indicates a measure called maximum drawdown (in this case covering the past three years of performance), which measures the value lost from peak to trough during market corrections. Readers will quickly observe that the Canadian capped-index products seem to perform identically to the S&P/TSX Composite Total Return benchmark, owing to the fact that the cap on these products sit at 10 per cent per stock. For reference, the Royal Bank of Canada RY-T (the largest stock by market cap in Canada) currently represents 6.6 per cent of the S&P/TSX Composite Total Return index. This wasn’t always the case though, however. Experienced investors will remember well the rise and fall of Nortel Networks, which at its peak represented 35 per cent of the index.
This article does not constitute financial advice, it is always recommended to conduct one’s own independent research before buying or selling any of the funds or ETFs mentioned in this article.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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