When investing in the Canadian stock market you do not have to overweight to the major sectors. A criticism of the Canadian market is that it is concentrated in just a few sectors. When you apply a cap-weighted format where the larger companies get even more weighting in the portfolio, that ‘problem’ is amplified. As a Canadian ETF investor you have the option to equal weight the top Canadian companies. Today we’ll have a look at Horizons’ equal weight TSX 60 ETF.
Here’s a simple outline of cap weighting courtesy of Investopedia.
Larger companies by way of value (share count x share price) get more weighting in the fund. For example, here’s the top 10 of the S&P 500 ETF IVV from iShares.
We see Apple and Microsoft dominate the index with a combined 9.4% of the total index. That will distort the sectors weights as well. We see that those two tech behemoths have more weight than the entire consumer staples sector.
In Canada the cap weighting methodology moves investors to the financials and energy. Here are the top holdings for the TSX 60 ticker XIU.
Give them equal weight.
You can use equal weight ETFs for Canadian and US stocks. In the US Invesco offers the S&P 500 in equal weight fashion. The ticker is RSP. You’ll find that US listed RSP in the ETF Model Portfolio page on Cut The Crap Investing. That’s part of the Greater Growth option.
If we equal weight the S&P 500 holdings you will then give Apple a .20% weighting. And that allocation will drift until the next portfolio re-balancing. In the US, that index and ETF does have a market beat history.
And Seeking Alpha author Ploutos will demonstrate an even greater level of index out-performance by way of back tests.
The alpha is generated by way of a combination of value hunting and the size premium. When you equal weight an index you will often move monies from companies with lesser current earnings yields and move the funds to companies with greater earning yields. Equal weight will also have more monies invested in ‘lesser cap’ companies.
Momentum vs value and lesser cap.
Remember, the cap weighted strategy is more of a momentum strategy. It invests more in companies that are the market darlings. With equal weight rebalancing monies are moved from market darlings to companies that are often more out of favour. That can find greater long-term value.
Equal weight is likely to under-perform in periods of extended bull market runs. It’s ‘magic’ mostly shows in modest to severe market corrections.
Here’s equal weight RSP as Portfolio 1 vs the cap weighted IVV as Portfolio 2.
We see a greater draw down in the market correction (you have to have even more guts for this) but a vigorous out-performance coming out of the financial crisis. Keep in mind that the the start date for the ETF is 2004. It begins soon after the early 2000’s correction. It launched out of the gate already loaded up with more value stocks.
We see the notable out-performance coming out of the financial crisis.
The Canadian equal weight.
When we look at Horizons’ equal weight holdings, we won’t find Royal Bank of Canada sitting on its perch. Nope, you’ll even find 4 Canadian tech companies in the top 10.
And the equal weighting will do much to ‘fix’ the Canadian sector weighting problem. Financials no longer dominate. We see more from tech and consumer sectors. Healthcare even makes a showing. Where the equal weight adds is to basic materials.
And here’s the TSX 60 sector weights.
The Canadian tech sector (OK it’s only 10 companies) has been on fire in recent years. Has that enabled some out-performance?
Nope, it’s a virtual tie over the last 5 years. The equal weight TSX 60 index is in baby blue. The cap weighted TSX 60 is in dark blue.
And it’s a virtual tie over the period from inception of December 2009. Of course all of the above occurring during a period that only offered minor corrections.
That said, we do see the equal weight index moving into the lead after those minor corrections. Momentum eventually takes care of that and gets things back to even Steven.
But then the higher fees will also come into play. iShares TSX 60 ETF has an MER of .18%. The management fee for Horizons equal weight index ETF is .40% plus taxes. We’d need to see some solid out-performance to make up for the difference in fees.
Will equal weight shine in a major correction?
It’s quite possible. We see that tendency in the US and in Canada. But who knows when or if a major correction will arrive. The small corrections do not appear to provide much opportunity on the value hunting side. Certainly if one practiced active asset allocation (tsk tsk many would offer) they might add more to the equal weight ETFs during periods of modest and major corrections.
You’d then have to time your exit or perhaps a rotation to bonds if you hold a balanced portfolio. If equal weight outperforms during the recover period you would be moving great gains to the bonds.
All said if you’re going to embrace the strategy you are likely best to commit and add on a regular schedule over the longer term.
Equal weight thoughts.
The equal weight methodology in Canada does not appear to fix up the sector ‘issues’. Many of the big Canadian companies and areas of sector dominance such as financials have offered out-performance over the decades. Once again, any value in the value hunting and lesser cap slant might come in a real correction.
Historically the approach worked in the US. You’ll find more insights on the equal weight performance in this article from PWL .
Canadian equal weight comes to a close.
We won’t get the opportunity to see if this approach might work in Canada. Horizons announced on the night of this post that the fund is set for closure. Impeccable timing, eh?
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