If you prefer to invest in index funds or ETFs, make sure that you don’t stop with offerings that track the Canadian market. Invest also in offerings that give you foreign exposure so that you can achieve portfolio balance and diversification.
If your goal is to build an equity portfolio composed mostly or entirely of index funds or exchange-traded funds, then achieving a balanced, diversified portfolio of funds generally becomes more crucial than if you were to build a portfolio of managed funds.
With managed funds, after all, you have a portfolio manager that will hopefully take action to rectify the situation if a portfolio becomes unbalanced by having too much exposure to particular industry sectors or geographical areas, say. With index funds or ETFs, you have no such luxury.
We recommend TD Canadian Index Fund-e for investors who wish to track the returns of the S&P/TSX Composite Total Return Index. Since the Index gives you one-step exposure to large, well-established Canadian companies, it has some appeal to conservative investors.
How the Index is not conservative
But there is one way in which the S&P/TSX Composite Index is not a conservative, well-balanced portfolio. It’s heavily concentrated with resource and financial stocks. Currently, the Index has about 32 per cent of its weight in financial sector stocks, 22 per cent in energy and 13 per cent in basic materials. The latter two sectors are comprised basically of resource stocks.
If you’re an ETF investor, this heavy concentration in just a few industry sectors makes it crucial for you to aim for a better diversification and balance in your portfolio. And this can be accomplished by adding well-diversified, foreign equity ETFs to your portfolio.
Take, for example, iSHARES INTERNATIONAL SELECT DIVIDEND ETF (NYSE-IDV). It seeks to track the performance of an index composed of relatively high dividend paying equities in the non-U.S. developed markets.
The ETF’s industry breakdown is detailed in the box on this page. Suffice it to say here that no industry sector in the ETF accounts for more than 20 per cent of the portfolio. And if the portfolio is well diversified by industry sector, the same can be said for its geographical diversification, which gives you broad exposure to developed countries in Europe and elsewhere.
Buy iShares International Select Dividend ETF to add diversification and balance to your ETF portfolio.
Remember, check balance
When we analyze the portfolio of a mutual fund or an exchange-traded fund, one of the first things we do is determine what percentage is in each of the main industry sectors of the economy. This straightforward test helps you quickly stop what can become a major portfolio problem. If your ETF, say, has too much exposure to just a few sectors, the portfolio will be vulnerable to setbacks in these sectors.
We consider such an ETF unbalanced. You’re, therefore, better off either avoiding the ETF altogether, or buying it as a part of a well-diversified ETF equity portfolio that provides balance between the various industry sectors.
To achieve balance, one good ETF to add to your portfolio is iShares International Select Dividend ETF, which we recommend on this page. Its industry breakdown is as follows:
Consumer Services 13.8%
Oil & Gas 9.2%
Basic materials 5.0%
Consumer goods 2.1%
Health care 0.6%