Recent market action indicates why it’s essential to hold Canadian
equity index ETFs as part of a larger, well-diversified portfolio.
Heavy concentration in just a few industry sectors makes Canadian
ETFs vulnerable to what happens in those sectors.

Market action of the past year or so has served to illustrate the
problems of passive investing in Canadian stocks. Because Canadian
indices are concentrated in just a few industry sectors, the
performance of exchange-traded funds that track them is bound to be
inconsistent over time.

Take VANGUARD FTSE CANADA INDEX ETF (TSX-VCE), for example. This ETF
attempts to track the performance of the FTSE Canada Index, a
market-capitalization weighted index, similar to the S&P/TSX
Composite Index, that tracks about 75 per cent of the market.

Over the past year, Vanguard FTSE Canada has gained 11.2 per cent. By
itself, this is a strong gain. But when compared to managed funds in
the Canadian equity category, it’s just a third quartile performance.

ETF has lagged considerably

Many managed Canadian equity funds have performed much better over
the same time. For example, Mawer Canadian Equity Fund has posted a
one-year return of 24.7 per cent, while Franklin Bissett Canadian
Equity Fund has gained 20.9 per cent.

In one respect at least, Vanguard FTSE has done quite well. With
nearly 41 per cent of its assets invested in the financials sector,
the ETF has benefitted from robust performance in this sector.
Indeed, on a year-to-date basis, financials stocks are up nearly 22
per cent.

But with nearly 23 per cent of its assets invested in the energy
sector, the ETF has been hurt by the underperformance of energy
stocks – though not by much. The real damage has been done in the
materials sub-sector, where the ETF currently has a 12-per-cent
weighting. These stock are down by nearly 29 per cent since the
beginning of the year.

By contrast, Mawer Canadian Equity and Bissett Canadian Equity have
both benefitted from active management. Their managers have
successfully sidestepped the carnage in the materials sector by
underweighing materials stocks, while benefitting from the strong
performance in the financials sector.

Given the lack of diversification in the Canadian market, then, you
should make sure that your Canadian equity ETFs form part of a
larger, well-diversified investment portfolio.

Recommendation:
Buy Vanguard FTSE Canada Index ETF as part of a larger, diversified portfolio.