Wednesday 1 September 2010

The S&P TSX 60 Index vs Claymore Canadian Fundamental ETF and Active Stock Picking

Take a look at the holdings of the supposedly passive iShares S&P TSX 60 Index ETF (symbol: XIU) and you will not find a number of companies that I would expect to see based on the philosophy of not actively selecting stocks but simply mimicking the overall stock market according to relative market value or capitalisation. The description of XIU on the iShares website says "The Index is comprised of 60 of the largest (by market capitalization) and most liquid securities listed on the TSX ...". Go into GlobeInvestor, do a stock search of all common stocks, then sort by the handy Market Cap column heading, compare the top 60 there with the XIU holdings and you are in for a surprise.

Missing from XIU are no less than eight stocks listed on the TSX amongst the 60 largest by market cap according to GlobeInvestor as of close of business September 1st:
  • Newmont Mining (symbol: NMC) in 13th spot by market cap
  • Great West Lifeco (GWO) 18th,
  • Power Financial (PWF) 28th
  • Boliden AB (BLS) 29th
  • Domtar Canada Paper (UFX - that's what GlobeInvestor says, though maybe it should be UFS) 32nd
  • IGM Financial (IGM) 45th
  • Ivanhoe Mines (IVN) 51st
  • Fairfax Financial (FFH) 52nd
Why is this so? The main reason is found not on the iShares website but in the index provider Standard and Poors' Canadian Indices Index Methodology document which states this about the TSX 60 Index: "It has 60 constituents and represents Canadian large cap securities with a view to matching the sector balance of the S&P/TSX Composite Index." If S&P merely followed market cap for the top 60, there would be much heavier weight in the financial services sector stocks. The Composite Index is only 30% financial services so the 60 Index is artificially made to look like it.

That's why such small companies as Inmet Mining and Yellow Pages Income Fund, neither in even in the top 100 by market cap, show up in the 60 Index.

In contrast, another ETF which weights its stocks by size according to fundamental economic factors, the Claymore Canadian Fundamental Index ETF (symbol CRQ), has a substantially larger allocation to financial services - about 45% lately.

For an investor seeking to mirror the sector weighting of the overall Canadian economy, XIU comes closer than CRQ, since Financial services (including two other sectors - Real Estate and Management) make up only 20% of Canadian GDP (2008 figures - see Industry Canada data here).

The fact that CRQ's weighting scheme is based on actual historical accounting data, i.e. hard numbers, shows to what extent publicly-traded stocks in Canada are comprised of the financial industry. Private companies must thus make up a disproportionate share of other economic sectors. The Canadian public market is lop-sided.

For an investor seeking to go where the money is, or has been in the recent past, in terms of dividends, cash flow, sales and book equity, then CRQ comes closer than XIU since that is the basis on which CRQ picks stocks.

But to say that XIU is a totally passive fund, which therefore conforms best to an ideal, is not really true. XIU is not inherently superior to CRQ. Choosing XIU or CRQ comes down to which alternative investment strategy works best - XIU's strategy being based loosely on market cap (which in turn is based on the market's opinion of relative future value) and CRQ's based on past results being maintained in future. Which strategy works best is a matter of practical investigation.

Just finished a chat with a very pleasant gentleman at S&P Canada who said that the financial companies in the above list were indeed excluded to keep the financial sector weight in line with the TSX Composite Index. Three others - Newmont, Boliden and Domtar - are not Canadian companies, a criteria which also forms part of the index composition. The last, Ivanhoe, has too small a float. iShares needs to improve its inaccurate summary description to include the fact that aligning to Composite sector weights is a criteria and that only Canadian registered companies, not merely TSX-listed companies, are included in the S&P TSX 60 / XIU.


larry macdonald said...

Good find. Wasn't iShares also misleading (or selective) in how they reported tracking errors for foreign ETFs? Wonder what else they are fudging. Makes one wonder if regulators need to crack down on their level of disclosure.

Canadian Couch Potato said...

Great post. There is a misunderstanding among many investors that S&P's market-cap indexes are entirely passive, but this has never been true. The S&P 500 is subject to discretion as well: it has never been the 500 largest US companies by market cap, as many people think.

I would argue that there may well be some diversification benefit to this, especially in a country like Canada, whose market is already skewed to three sectors. I would put it in the same category as the capping rule, which limits any one company to 10% of the index. I don't think anyone wants to see another Nortel, even if that would be the truly passive thing to do.

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