Diversification’s dirty secret

Posted on: October 11, 2011 in: Canadian Equities, Dividends, Emerging Markets with 0 comments

iShares CDN S&P/TSX Cap REIT ( Ticker: XRE )


One of the pillars supporting modern portfolio management is diversification. However, with markets around the world suffering equally, you could be forgiven for thinking that the pillar has crumbled and brought your portfolio down with it.

But let’s not jump to such a hasty conclusion. It could be that what looked like diversification in good times turned into concentration in bad.

On the surface, many portfolios look diversified. Obeying the dictum, “Don’t put all your eggs in one basket”, many investors hold a good mix of Canadian, U.S. and international stocks. That helps improve returns in good times.

But global equity markets have a bad habit of moving in step with each other just when you would rather they marched to different beats. In the language of Bay Street, correlations increase in bear markets. This tendency undermines diversification’s protective role.

The last six months are proof. The S&P 500 is down 15%, the S&P TSX 60 is down 20%, the MSCI EAFE, which includes developed markets outside the United States, is down 23% and the MSCI Emerging Markets is down 30%.

It is clear that simply investing in broad market indices across many countries does little to protect against bad times. As all markets become more globalized and interconnected, as corporations become more multinational, this tendency will strengthen.

Then where does that leave diversification and more importantly, the future of your portfolio?

Ironically, it turns out that diversification may come from within. Rather than diversify across countries, it may be more effective to diversify across sectors, be they domestic or international. In fact, sectors within a market often have much lower correlation to each other than the broad market index does to its global counterparts.

The S&P TSX 60 has a correlation of +0.84 to the S&P 500, +0.80 to the MSCI EAFE and +0.85 to the MSCI Emerging, with perfect correlation being equal to +1.00.

However, its correlation to its parts is lower, excepting energy and financials – no surprise given their dominance of the TSX.  The Canadian Energy sector has a +0.90 correlation to the S&P TSX 60, Financials are +0.75, Materials are +0.68, REITs are +0.66, Utilities are +0.50 and Telecoms are +0.45.

Returns across sectors are just as varied. Over the last six months, Energy is down 25%, Banks down 15%, Materials down 17%, REITs down 1%, Utilities and Telecoms both up about 3%.

REITs, utilities and telecoms are also less volatile and pay higher dividends than sectors like energy, materials and financials. That makes them good candidates for troubled times.

Last December, we began reducing the riskiness or “beta” of our portfolios. We reduced our allocation to the iShares S&P TSX 60 ETF (XIU-TO) and cut the iShares S&P TSX Materials (XMA-TO).

We added the iShares S&P TSX REITs ETF (XRE-TO) and the Claymore S&P TSX Canadian Preferred Shares ETF (CPD-TO) for their lower volatility and high dividends. Since then, both XRE and CPD both have helped improve the total portfolio’s returns.

The current dividend yield on XRE is about 5.25% and about 4.90% on CPD and their total year-to-date return is 8.76% and 1.92%.We expect that with interest rates low and with little chance of an increase by the Bank of Canada in the near future, both ETFs will continue to perform well.

The other sector to consider is utilities. iShares recently added a S&P TSX Utilities ETF (XUT-TO). It has returned about 3% in gains and dividends since its launch in April. It may be another candidate for calming a portfolio, though its size is small at only $8 million in assets and it is concentrated with only 11 firms in total and 65% of the allocation in the top four companies.

Allocating by sector is not as simple as allocating by country. Nor are there as many good choices available in Canada, though the selection is better in the United States.

But as globalization causes equity markets to move more and more in tandem, the sector allocation decision will become more important. And the dictum may change to “Don’t put all eggs in your basket, add bread and potatoes too.”

Disclaimer: We may hold positions in any and all securities mentioned in this report.


archerETF Metrix XRE
Category Cdn Equity
Benchmark S&P TSX 60
Total Holdings 13
52 Week High $15.12
Recent Price $14.11
52 Week Low $12.66
Avg Daily Volume 0.23 Million Shrs
Avg Daily Volume ($) $3.25 Million
Total Market Cap $1.18 Billion
ETF Annual Fee 0.55%
ETF Trading Currency CAD
ETF FX Exposure CAD
Annual Volatility 20.7%
Correlation to S&P 500 64.0%
Return to Risk Ratio 1.10
Use of Leverage No
Use of Futures No
6 month Return -1.32%
1 Year Return 8.65%
2 Year Return 47.30%
3 Year Return 43.43%
Dividend Yield (TTM) 5.24%

The archerETF Global Tactical Portfolio

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archerETF offers Global Tactical Portfolio Management.

Our outlook is Global: we invest across countries, sectors, commodities and other asset classes to improve returns. Our management is Tactical: we strive to select the right opportunities at the right times in response to changing market conditions to manage and minimize portfolio risk.

Please call us for more information.



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© 2011 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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