June 22, 2021
  • June 22, 2021

Diversification is a free lunch

By on May 31, 2021 0

Diversification is often referred to as the only free lunch when it comes to investing. A portfolio made up of constituents capable of moving in different directions may have better risk-adjusted returns than its constituents. Allocation to different asset classes can also minimize pain during market crashes.

Consider the first quarter of 2020. As COVID-19 became a pandemic, the stock markets entered a synchronized dive – from Toronto to New York, London to Shanghai, Sydney to Sao Paulo and points in between. Canadian stocks lost more than 20% in the first quarter of 2020; the US market fell by a similar amount in US dollars. Developed market equities outside of North America lost 15% in value and emerging market equities 17% (both in Canadian dollars). It was the fastest decline since the Great Depression.

While stock market correlations went to 1 in times of crisis, as they say, bonds provided a real diversification advantage. Consider the behavior of Morningstar Index focused on Canadian stocks and Canadian bonds during the bear market due to the pandemic in the first quarter of 2020.

The tendency for bonds to resist during a crisis is consistent with a long-standing trend. In a study on the behavior of asset classes during bear markets, Ian Tam, director of investment research at Morningstar Canada, examined a series of stock market crashes over the past 25 years using category averages. Morningstar Mutual Fund. As shown in Table 2, Tam observed that Canadian fixed income and global fixed income were incredibly resilient as stocks sold, often gaining ground in thefts to safety.

Room 2

What about stocks?

Stocks across geographies are more correlated to each other than stocks are to bonds. Several factors help to explain this, from the influence of global capital flows to the interdependence of the global economy. For example, less than half of Canadian stock market income actually comes from Canada, according to Morningstar estimates.

Then there is the dynamics of the sector. Energy and raw materials are deeply influenced by global commodity prices. Canada’s Barrick Gold (ABX), South Africa’s AngloGold Ashanti (ANG) and US Newmont (NEM) will all move together, as oil prices affect Canadian Natural Resources (CNQ), Australian Woodside Petroleum (WPL) and Saudi Arabia. Aramco likewise. Tech companies in all regions have benefited from the shift to work and home shopping during the pandemic.

In Table 3, it is not surprising to see the global equity markets positively correlated. Canada and the United States are the most similar stocks and emerging market stocks the most different.

Exhibit 3

But just because stocks in different geographies don’t diverge to the same extent as stocks and bonds doesn’t mean they don’t make an essential contribution to a diversified portfolio. Canadian investors, like their counterparts around the world, tend to be biased towards the home country, where the preference for the familiar local market can leave them overexposed to Canadian equities and fixed income assets.

Some country of origin biases can be justified on the basis of currency. When investors buy an asset outside of their home market, they take on the currency risk. If the Canadian dollar appreciates against the US dollar, euro or yen, etc., assets purchased in foreign currencies will be of less value when converted. Hedging is an option, but an investor who earns and spends in Canadian dollars and is considering retiring in Canada can be forgiven for wanting to minimize currency risk.

On the other hand, currency risk can also be viewed as currency diversification. When the Canadian dollar weakens, foreign assets are worth more to an unhedged Canadian investor. For example, the sharp decline of the Canadian dollar against the US dollar between 2011 and 2015 amplified the gains of US stocks from the perspective of unhedged Canadian investors.

As shown in Figure 4, Canadian investors with a strong preference for their home country have missed out on substantial gains in global equity markets over the past 10 years, particularly south of the border.

Exhibit 4

Market leadership could certainly be different in the future. But whatever the outlook, there are several structural reasons for diversifying globally. Canadian stocks represent less than 3% of global market capitalization as of April 30, 2021. This compares to nearly 57% market share for US stocks, around 27% for stocks in developed markets outside of Canada. North America (Japan and the UK being the two contributors), and around 13% for emerging market equities. An investor in Canadian equities who has a strong preference for their home country has a portfolio that does not reflect the set of global opportunities.

Also consider sector weights. As shown in Figure 5, the Canadian market has almost no exposure to healthcare stocks and much less technology representation than the United States, with its FAANG, or emerging markets, stocks, which contain the tech giants China and Samsung. in Korea. Meanwhile, Canadian investors are overexposed to energy and commodities relative to the universe of global equities.

Exhibit 5

It is also essential to see how the Canadian stock market has evolved over the past few years. The market has become more concentrated, with the top 10 components accounting for around 40% of the market. This compares to 26% in the United States, which is also heavier than before. Unsurprisingly, given this concentration, the Morningstar Canadian Stock Index has been more volatile over the past decade – measured by the standard deviation of returns – than benchmarks measuring the United States, developed markets. outside of North America and even emerging market equities. As shown in Figure 9, the most notable change in the Canadian market over the past 10 years is the remarkable rise of Shopify.

Exhibit 6

Shopify joins companies like Facebook and Tesla, which have gone from small players five years ago to one of the biggest companies in their home market, and so do Chinese tech phenomena Alibaba, Baidu, and JD.com. Since going public in 2015, the Canadian operator of the e-commerce platform is now the second-largest public company in its market, larger than the Bank of Montreal, which dates back to 1817. Shopify hopes to capitalize on the continued existence of BMO, and avoid the fate of former Canadian tech darlings like Nortel Networks, which made up over a third of the Canadian stock market during the tech, telecommunications and media bubble of the late 1990s before becoming the world’s largest bankruptcy in Canadian history in 2009, or Research in Motion, which was the country’s largest public company in 2008, when its BlackBerry device held about 20% of the global smartphone market, but is now a much smaller player .

Meanwhile, the major Canadian banks have become an even bigger part of the Canadian stock market in recent years. Banks enjoy many competitive advantages, including high barriers to entry, costs of switching and regulation. Yet their disproportionate share of the Canadian stock market increases the need for investors to diversify. Banks are all exposed to the Canadian economy and the housing market. While it is difficult to imagine threats to their entrenched positions, disruption could materialize, whether digital or regulatory. Australia, another market dominated by a small number of domestic banks, saw its banks shaken by a Royal Commission review.

Don’t turn down a free lunch

It is said that in a crisis the correlations go to 1. This reflects the tendency of panicked investors to act indiscriminately, pushing asset prices down across the board. In the first quarter of 2020, stock markets around the world fell in sync, but high-quality bonds held up very well. Investors diversified across asset classes liked the fact that some of their assets zigzagged while others zagged.

Meanwhile, diversified Canadian investors in global equity markets would have had higher returns in recent years than with an all-national portfolio. While changing conditions may decrease the attractiveness of global bonds or equities, strategic asset allocation helps protect investors from unforeseen events. The pandemic has shown that black swans can appear unexpectedly.

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