Concentration Risk In The S&P/TSX Composite
By: Peter Chiappinelli & Sarah L. Westwood
While the Canadian stock market has risen as a result of the global demand for energy and raw materials to record performance, the over-concentration of the S&P/TSX Composite should be considered. Peter Chiappinelli and Sarah L. Westwood, of Putnam Investments, examine the issue.
Canadian institutional investors should take a closer look at the risks posed by growing sector and security concentration within the S&P/TSX Composite Index (TSX Composite) and formulate strategies to mitigate these risks. Investors need only recall the ‘Nortel’ effect and the risks of over-concentration. This article briefly examines the risks within the TSX Composite and considers three strategies designed to address these challenges.
Heightened global demand for energy and basic materials has driven up the stock prices of energy- and materials-related companies. This phenomenon has helped to drive strong relative and absolute performance of the energy- and materials-rich TSX Composite Index, which returned 23.4 per cent on an annualized basis for the three years ended September 30, 2005. By comparison, the MSCI EAFE and the S&P 500 returned 12.8 per cent and 10.9 per cent, respectively, over the same period.
The advance of energy and materials sectors has also significantly increased their concentrations within the capweighted TSX Composite, dramatically increasing volatility. For example, Exhibit 1 shows the double-whammy of the growing weight and increasing volatility of the energy sector within the TSX Composite from June 2001 through September 2005.
The combined energy, materials, and financials sectors comprise more than 70 per cent of the TSX Composite, which differs markedly from the equity benchmarks of other developed markets. Using the sector weightings within MSCI World Index as a benchmark, the weightings of the energy, materials, and financials sectors within the TSX Composite currently represent overweights of 17.5 per cent, 9.2 per cent, and 7.2 per cent, respectively. By any measure, these sector bets represent a significant concentration of risk.
Canadian institutional investors will likely follow one of three ‘tracks’ to help mitigate these risks. Track one is for those who will remain largely committed to their current Canadian equity allocation. Track two will be those strategies that will take advantage of the recent elimination of the FPR (foreign property rules) and move to more global equities. And the third track will be those who take an innovative ‘hybrid’ approach – called portable alpha. In this article, we will highlight an example from each of these tracks.
Track One: Stay with the TSX Composite
Investors who remain committed to their current allocation to Canadian equities may want to consider an equal-weighted TSX. Equal-weighted indices are by no means the norm, but there appears to be growing interest in these types of strategies. Pension consultants are actively exploring equal-weighted indices and the U.S. market has recently launched an equal-weighted S&P 500 ETF.
An equal-weighted TSX Composite has some interesting attributes.
First, based on data as of September 2005, each security had a weighting of approximately 47 basis points in the equalweighted TSX Composite. This approach would significantly reduce the energy and financials bet inherent in the capitalizationweighted TSX. Historically, as shown in Exhibit 2, equal weighting would have reduced risk without significantly affecting returns based on data from March 1999 through September 2005.
Secondly, equal weighting would have the added benefit of allowing active managers to more fully exploit excess return opportunities among mid-cap companies. For example, if a manager chose to over/underweight Maple Leaf Foods Inc., this decision would have a greater impact in the equal-weighted, 47-basis-point scenario than in the capweighted scenario in which this company represents only 10 basis points of the TSX Composite Index. The appeal of equal-weighted indices with active managers is that they can more fully exploit any insight they might have.
Track Two: Strategic Shift to Global
The elimination of the FPR enables another method of risk reduction. Implementing a phased strategic shift from the TSX Composite to the MSCI World Index or a combination of the MSCI EAFE and the U.S. S&P 500 is another strategy for potentially reducing risk while enhancing returns for Canadian institutions.
As illustrated in the efficient frontier graphed in Exhibit 3, based on the typical current allocation of Canadian pension plans, increasing exposure to non- Canadian equity would have increased returns while decreasing risk for the 25 years ended September 2005. As shown by the various points on the graph, this strategy could be implemented gradually with each increment potentially decreasing risk while adding to return. It could also have a tactical component, depending on the investors’ expectations for the performance of the TSX Composite.
Track Three: Portable Alpha. Keep a Canadian bet a, but look for alpha outside of Canada
Portable alpha may sound complicated, but the concept is relatively straightforward – it allows investors to exploit alpha from one asset class and move it to another. Exhibit 4 illustrates a relevant example that may help clarify. Suppose a Canadian investor wants to maintain his or her beta exposure to the TSX Composite, but, due to the elimination of the FPR, can take even more advantage of alpha opportunities outside of Canada, where those opportunities may be more robust.
The U.S. small-cap equity market is a relatively inefficient market that is well suited to a portable alpha strategy. The median active manager has outperformed the Russell 2000 Index by 436 basis points for the five years ended September 30, 2005.* By hedging out the Russell 2000, through the use of futures or swaps, the excess return, or alpha, is now available to be ported on to the desired benchmark, the TSX Composite. The net result would have been TSX + alpha from U.S. small cap.
You see why we’ve called this a hybrid approach – the investor maintains the TSX as their core exposure, but the alpha comes from outside of Canada. Portable alpha programs are innovative new approaches to active management and are changing the face of institutional management around the globe.
The risks posed by the increasing concentration of the TSX Composite have grown substantially. The good news is, at the very same time that these risks have been rising, the FPR has been eliminated and innovative new strategies have emerged to offer Canadian institutional investors a range of viable options for addressing this challenge.
Peter Chiappinelli and Sarah L. Westwood are with the strategic research team at Putnam Investments.
*Source: Wilshire Associates and Ibbotson. Prepared for use in Canada by Putnam Investments Inc. [Investissements Putnam Inc.] (Operating as Putnam Management in Manitoba). The views expressed represent the current, good faith views of the author(s) at the time of publication and are provided for informational purposes only. Past performance is not a guarantee of future results. Any person who is not an investment professional should not act or rely on this material. S&P/TSX Composite Index is an unmanaged capitalizationweighted index of common stock of companies incorporated under Canadian jurisdiction that are listed on the TSE.
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