This article appears in the October 2023 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.
For Canadians, the domestic equities market is the comfort food of investing. Familiar names, the dividend tax credit and lack of currency risk are all valid reasons to hold a much higher weight in Canada than its modest share of about 3% of the world’s market capitalization.
However, investment strategists say there’s a tradeoff between home bias and adequate diversification. According to two prominent investment management firms that produced research papers on this topic, Canadians who curb their enthusiasm for the home market could enjoy better risk-adjusted returns over time.
A study released in June by Toronto-based Vanguard Investments Canada Inc. concluded that the optimal mix for Canadians within the equities portion of their portfolios is 30% domestic and 70% foreign.
A similar conclusion was reached in a 2022 study published by Franklin Templeton Investments Corp., also of Toronto. That study concluded that putting 25%–35% of the equities allocation into Canadian stocks was reasonable, with the higher end of that range appropriate for more growth-oriented accounts.
“There are good reasons to have some home country bias,” said co-author Ian Riach, senior vice-president and portfolio manager with Franklin Templeton Investment Solutions. “But you also want to balance that with the risk of the [Canadian] market being very concentrated, and so diversification makes sense.”
The case for going global rests not only on Canada’s small share of global markets, but also its composition. The Vanguard paper noted that the top 10 Canadian stocks, as of May 31, constituted 36.9% of the broad domestic market. By comparison, the 10 largest foreign stocks weighed in at 15.6% of the global equities market.
As for sector mix, Canada is highly overweight versus global markets in financial services and energy, and significantly underweight in IT, health care and consumer discretionary. “Canadian investors could benefit from the broader opportunity set presented by higher exposure to foreign assets,” the Franklin paper noted.
Vanguard’s paper concluded that the most efficient combination of risk and return for Canadians was to simply invest in a global portfolio with only a small Canada weighting.
But because of risk considerations, Vanguard doesn’t advocate a full-fledged global approach. Once the allocation to foreign equities exceeds 70%, volatility begins to increase.
“That is why we say that the optimal level for Canadians is to maintain a 30% weight on the Canadian equities,” said that research paper’s author, Bilal Hasanjee, senior investment strategist with Vanguard Canada.
The 30% recommendation was based largely on quantitative factors, including minimum-variance analysis. But the study also considered investor preferences, citing a 2022 International Monetary Fund study. The IMF calculated that equities portfolios in Canada held a combined total of 52.2% of their assets in Canadian stocks.
Vanguard’s analysis assumed broad asset classes weighted by market capitalization, so it did not specifically account for the impact of dividend tax credits.
The recommended 30% domestic allocation applied across asset-allocation strategies ranging from conservative to aggressive, provided that there was at least some allocation to equities.
The Vanguard Balanced ETF Portfolio, for example, has a target asset mix of 60% equities and 40% fixed income. Its 18% weighting in Canadian equities equals 30% of total equity exposure. The Vanguard Conservative ETF Portfolio, meanwhile, holds only 12% in Canadian equities. But that still represents 30% of the total devoted to equities.
No matter the investor’s risk profile, Hasanjee said, the allocation to Canadian equities, or the optimization of the volatility, is still 30% based on simulations across different asset allocation levels.
Franklin’s actively managed take on Canadian content, by contrast, is more nuanced. That paper’s analysis showed Canadians generally should have 30%–33% of their equities portfolios in Canadian stocks, said Riach, whose portfolio management responsibilities include the $7-billion Franklin Quotential Portfolios.
“From a dynamic standpoint, though, given that markets have different cycles, in our portfolios we varied that to below 30% at times [and] to above 35% at times,” he said.
Recently, the Franklin Quotential team’s allocation to Canadian equities was below the typical levels Riach cited. At the end of July, the Franklin Quotential Balanced Growth Portfolio, a mutual fund of funds, held 15% in Canadian equities. That represented about 25% of the equity content in this 60% equities/40% fixed-income portfolio.
Franklin’s year-old paper also included fixed-income allocation. In this asset class, Franklin favoured a 65% allocation to Canada and 35% in foreign securities as a starting point.
Riach said the bond market in Canada is very similar to the equities market in terms of concentration. Government bonds, both federal and provincial, constitute about 70% of the market.
As for the corporate component, Riach said more than 60% is concentrated in just two sectors: financial services and energy. “It pays to get some diversification and increase your opportunity set by going outside of Canada,” he said, although the paper recommended a greater home bias on the fixed income side than for equities.
Franklin’s recommended allocation to foreign fixed income assumes full currency hedging back to the Canadian dollar. “That actually gives us the ability to add more foreign exposure if we hedge that currency, because it takes that currency at risk out of it,” Riach said.