The TSX in 2009: fewer, bigger companies = less diversification and more concentration risk

Canada's prime public equity market the Toronto Stock Exchange has been progessively shrinking and concentrating over the last few years. It isn't just the credit crisis at fault. Look at the figures below on additions and deletions to the headline index called the TSX Composite (source is the Standard and Poor's download table of adds and deletes, which seems to be somewhat incomplete since my backwards calculation doesn't quite jive with official figures I found for a couple of points in time, but the trend is nevertheless clear).


The Composite includes or excludes companies based on several criteria, notably liquidity and market weight (i.e. if the shares don't trade often enough and the market cap is too small compared to the overall market then they are out). The shrinking Composite reflects fewer companies taking up more market space.

Though I have not traced the numbers back further than 2007, there is even some evidence that the overall equity market in Canada is shrinking. The total of TSX-listed issuers dropped from 1613 from the end of 2007 to 1570 on December 31st 2008 and 1555 on January 31st, 2009 (from the TSX 2008 Yearly and January 2009 Monthly Trading Summaries). The same downward trend is evident for the number of issues (securities) listed on the TSX.

Causes:

• fewer IPOs (none in the last half of 2008, according to this PriceWaterhouseCoopers press release)
• a continuing slow stream of buyouts causing delistings (11 in 2008 by my count of the S&P deletes), a few of which seem to be due to income trusts selling out

No doubt the credit crunch exacerbated the situation in 2008, which PWC says will not change much for the first half of 2009, but the longer term trend suggests something else must be at work. What that reason is I don't know (possibly partly the influence of huge pension funds deciding to go progressively more overseas to invest?) but it isn't good for the average individual Canadian equity investor. Why?

Insufficient Diversification - Popular ETFs that track the TSX are more concentrated than ever. The iShares TSX Composite (symbol XIC) has about 20% of its value in the top five holdings alone and 73% in only three dominant sectors - energy, financials and materials. For investors who work in those sectors and whose job security goes along with prospects for their industry and company, their financial fortunes are distinctly concentrated and less diversified than they should be.

Potential Actions for the Investor

• complement XIC with iShares Small Cap Index Fund (symbol XCS), which has only 9% in its top five holdings amongst a broad base of 207 companies, about 130 of which do not appear in the Composite index; the negative is that there is still over 60% in the same top three sectors as well as the doubling up of the 70 or so overlapping companies
• diversify internationally in the US or elsewhere, where other sectors like manufacturing, health care and consumer products are better represented

Update March 14: The trend continues. GlobeInvestor reports that S&P will add 6 and drop 12 companies from the TSX Index as of March 23, a net loss of 6 companies in the index.