Why My Canadian Centric Portfolio Is Much More Diversified Than Most Think

Let’s talk about a little something something folks in the finance industry like to call home country bias.

Basically, the logic goes like this. The Canadian economy, robust as it is, accounts for approximately 1% of the world’s GDP, and the Toronto Stock Exchange represents approximately 3% of world’s total stock market capitalization. Therefore, a truly diverse portfolio would only have a small percentage of its assets invested in Canadian stocks.

Canada’s economy isn’t just small. It’s also concentrated in just a few sectors. The TSX Composite is dominated by financials (banks mostly, but also our life insurers), energy, and materials. Many astute investors argue these are three of the worst sectors to invest in, with banks having a tendency of blowing up, and both material and energy producers being at the mercy of commodity prices.

Not only does the Canadian market overweight crummy sectors, but this comes at the expense of the ones investors want to own. Long-term winning sectors like technology, consumer staples, and utilities are underrepresented in the Canadian market. You can easily find names in those sectors, but investors won’t find the quantity, or, arguably, the quality of investments as they would in the United States or in other markets.

Here’s a snapshot of the the Canadian market’s sector breakdown versus the rest of the world’s:

Critics argue this downfall gets even worse once Canada considers its place in North America. We’re right next door to the largest economy in the world, and we’re similar enough we can easily understand what’s going on in the United States. Investors can also easily convert their loonies to greenbacks and buy shares in American stocks, companies that are arguably very high quality, dominate their industries, and are already diversified around the world.

Take Apple, as an example. The iPhone is everywhere, the company is solid, and its position as one of the most dominant companies in the world ensures consistent investor interest. When compared to a random Canadian tech stock, Apple appears to be a no-brainer. Why even bother fishing in the Canadian markets when it’s so easy to buy the best stocks trading on the the biggest market?

It turns out there are plenty of reasons why an investor might avoid a worldwide portfolio. Let’s take a closer look at a few, and some of the reasons why I think a Canada-centric portfolio works better than worldwide investing devotees might think.

Some reasons you might avoid worldwide investing

The first reason why an investor might want to avoid a worldwide portfolio is such a strategy goes through periods of underperformance. Sort of, anyway.

Let’s assume an investor was faced with a choice back in 2014, a timeframe we’re using because that’s when the ex-Canada equity ETFs started trading on the Toronto Stock Exchange. They can pick between the following ETFs:

a) a TSX 60 ETFb) a S&P 500 ETFc) an ex-Canada ETF (specifically Vanguard’s version, VXC)

Nine years later and the results are in. The Vanguard ex-Canada ETF beat out the TSX 60, but it was absolutely crushed compared to the S&P 500.

Total returns:

a) TSX 60 ETF: 83.95% or 6.89% per yearb) S&P 500 ETF: 232.98%, or 14.04% per yearc) VXC: 136.27% or 9.85% per year

This begs an easy question. Why put your assets in a worldwide ETF when that ETF has been absolutely trounced by a very simple strategy of buying the S&P 500? And, perhaps most importantly, will an investor be willing to continue that worldwide portfolio after close to a decade of underperformance?

It also begs the question of why bother putting your capital into a TSX 60 ETF, but we’ll tackle that one in a minute.

The other reason to avoid investing outside of Canada is currencies play a much bigger role in long-term returns than most realize. To illustrate this, let’s take a closer look at two identical ETFs that follow the S&P 500. The difference is one is Canadian Dollar hedged, while the other is not.

Here are results over the last decade.

VFV, which is the unhedged version of the ETF, handily beat its hedged counterpart because the Canadian Dollar has weakened significantly against the U.S. Dollar over the last decade.

This perfectly illustrates the problem with international investing. To really maximize your returns, an investor must decide on an investment and then decide on a currency strategy. That’s some pretty high level thinking, and I’d argue anyone who gets it right consistently is nothing short of lucky.

Now, after saying all this, I don’t think there’s anything wrong with a strategy that simply dollar cost averages into a worldwide ETF like VXC, especially for someone who has a 20+ year time horizon. Over the long-term, currency moves tend to even out. But they are a factor international investors have to deal with, and sometimes, they can go against you.

Why I like my Canadian centric portfolio

As it stands today, approximately 85% of my portfolio is invested in Canadian stocks. The other 15% trade on U.S. exchanges and mostly have exposure to the U.S. market. There are a few stragglers in there — the Mexican airport operators come to mind — but, for the most part, my portfolio has a really big Canadian focus.

So why is that? And especially after the TSX 60 has been pretty trounced by a lot of other markets?

I’m a Canadian investor who has retired on Canadian dividends. I chose this strategy because a portfolio stuffed with Canadian dividend payers is tax efficient, my bills are in Canadian Dollars, I don’t want to take on much currency risk, and I’m overall pretty bullish on Canada. I’d also argue my Canadian centric portfolio is more diversified than it would first appear.

Let’s talk about currency risk first. I’m the first to admit a Canadian investor with a portfolio full of U.S. stocks has gotten extra returns since 2013 based on currency alone. But if we zoom out a little bit more, we’ll find the exact opposite thing happened the decade before. Canada’s currency rallied against the United States between 2003 and 2013, which would have had the exact opposite effect. Combine that with weak U.S. stock market returns in the 2000s, and it meant pretty much a lost decade in owning U.S. stocks for Canadian investors.

By owning Canadian stocks that pay dividends in Canadian Dollars I avoid that risk.

I’d also argue my Canadian portfolio is much more diverse than it appears on the surface. Many of Canada’s top stocks have taken profits made from their Canadian operations and reinvested them into assets outside of Canada. Additionally, there are stocks listed on the TSX that are 100% exposed to other markets.

A few examples off the top of my head include:

• Canada’s banks, which are invested in the U.S., LATAM, and Southeast Asian markets

• REITs like HOM.un (100% U.S. residential real estate), MRG.un (about 70% U.S. residential real estate), and Slate Grocery REIT (100% U.S. grocery-anchored real estate)

• Retailers like Dollarama (LATAM exposure through its 50.1% ownership of Dollarcity) and Alimentation Couche-Tard (owns stores around the world)

• Utilities like Fortis, Algonquin Power, and Capital Power, which all have U.S. operations

• Pipelines like Enbridge and TC Energy, which both have a lot of assets in the U.S.

• Both Canada’s railroads also have assets in the United States

There are more, but you get the idea. Put it all together and I’d estimate an easy 20-30% of my “Canadian” assets are actually invested outside of the country.

Finally, as an active investor, I find I can only research a certain amount of stocks before I get overwhelmed. I choose to focus my energy on Canadian small and mid-cap dividend paying stocks, a niche that has been profitable for me in the past and I believe will be profitable for readers of this newsletter. Canada is a surprisingly inefficient market, and there are often incredibly cheap stocks hiding in the deepest corners of the TSX, just waiting for me to find them.

Canadian Dividend Investing is a reader-supported publication dedicated to finding hidden gems, dividend-paying stocks on the TSX other investors are ignoring. Just $15 per month (or $150 per year) gets you

• Two long-form (2,000+ words each) individual stock analyses, interesting opportunities I discover during my 30+ hours of weekly research

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• Two model portfolios, one aimed to maximize current dividend income and one aimed at identifying dividend growers, each with 25 different stocks

• The ability to ask me a question whenever you want

Why I’m bullish on Canada

The main reason why I’m so comfortable having such a large percentage of my assets in the Canadian market is I really am bullish on this country.

The world’s most prominent countries are facing a dilemma. With only a few exceptions, population growth is slowing in an alarming way. In fact, a few nations are beginning to sound alarms as their population has started to shrink in a pretty noticeable way.

Japan is arguably the poster child of this phenomenon. Its population peaked in 2010 with approximately 128M people. These days, that number is just over 123M people. If current projections come true, Japan’s population could dip below 100M by sometime in the 2040s.

Various other countries are facing similar problems, although their problem isn’t quite as dire as Japan’s. Birthrates in South Korea, Italy, France, Germany, and even China project that their populations will start falling soon. Canada is facing a similar problem.

Canada’s solution to this problem has been to throw open the proverbial doors and let immigrants in. We welcomed more than a million immigrants in 2022 and it looks like numbers will be fairly similar again in 2023.

I’m the first to admit that this much immigration has caused a few problems. Recent immigrants almost always settle in our largest cities, driving up already inflated real estate prices. They also cause further stress to already taxed pieces of key infrastructure.

But, overall, immigration is a huge benefit to Canada. Without it, our population doesn’t grow, and it’s really hard to grow an economy that has a slowly shrinking population base. It also brings in ambitious people with fresh ideas and different experiences, which inevitably make a country better.

Canada also has abundant resources, freedom of speech, an honest government, relatively low crime, reasonable taxes, and strong property rights. These are all good things to have, and there’s a reason why we’re attracting so many immigrants. Sure, this place has its problems, but overall it’s a pretty damn good place to live.

I’ve traveled a lot, spending significant time in the United States, Europe, and Asia. And, to be completely honest, most of the developed world is pretty comparable — in terms of living conditions. But Europe loses because it has massive taxes, and Asia loses because it’s too homogenous. That leaves North America as the place to be. It’s the only true melting pot.

That’s the main reason why I’m bullish on Canada.

The bottom line 

I’m certainly not opposed to the idea of having investments outside of Canada. Every person’s risk tolerance is unique, and ultimately we have to do the thing that lets us sleep at night.

So feel free to add some foreign exposure, whether it’s via a worldwide ETF or through individual stocks. I follow some really smart guys who are scouring these markets constantly, looking for opportunities. I’m happy to outsource that part of my research to focus on underfollowed Canadian names.

And, again, my Canadian centric portfolio is much more diversified than it appears on the surface.

Besides, my approach is working for me, and that’s the important part. I managed to retire from the corporate world before my 40th birthday largely on the strength of Canadian dividend stocks. They’ve helped me achieve my goals. Maybe they can help you with your goals, too.