As an investment professional I frequently get asked to comment on the growing prevalence of Exchange Traded Funds (ETFs) and how they can fit into portfolios. ETFs are an incredible tool to get broad exposure to a number of companies, markets, or geographies at a low barrier to entry, and without much thought for the investor. Because of this, they have been deployed by many investors who want to reap the benefits of long-term stock market growth while putting little thought into what they are ultimately investing in. This has been successful for many over the last decade when strong returns in equity markets have lifted many ships, but it hides a dangerous risk management question lurking just beneath the surface.

 

What are you getting when you buy an Index ETF?

The question is simple, but important. Index ETFs aim to track stock market indices as closely as possible, typically only trailing them slightly due to the cost to manufacture the product. They achieve this by taking real or synthetic positions relative to their weights in the index itself. Take the Canadian Stock Market for example. Investors typically track this using the S&P/TSX Composite Index. This index contains 220 Canadian companies and weights their values by market capitalization. The largest position in the index is Royal Bank of Canada at 6.63%[1], representing Royal Bank’s status as the largest company in Canada.

 

Consequently, the largest companies in any index will have an outsized effect on the returns of that index. The top ten companies in Canada make up just over 34% of the S&P/TSX Composite Index. A similar story plays out in the S&P 500 Index, the main index used to track the stock market of the United States. The largest position there is Apple Inc at 7.3%, with the top ten making up 34.9% of the index as a whole.

 

Is concentration an issue?

Well, that depends on whether you are comfortable with the risks that may or may not come with it. Companies get to be large because they are successful. Having these successful companies at the top of your holdings is not an inherently bad strategy. The top ten in Canada represents at least five industry sectors: Financials; Technology; Infrastructure; Energy; and Transportation. This provides good exposure to many distinct aspects of the Canadian economy and should have some differentiation when looking at company specific risks. The US top ten, on the other hand, consists of nine technology companies, as well as outlier Berkshire Hathaway. This top ten, while having strong past performance, certainly puts a specific bias on any passive portfolio tracking the S&P 500.

 

What options do you have?

As a passive investor, not much. Index ETFs represent an incredible opportunity to enter the market with a low barrier to entry. You could try to mitigate some of this top line risk by investing in sector specific ETFs to balance out the Technology exposure, but that quickly becomes an exercise in active investing, one that requires knowledge of the macro economy, micro trends, and general investing research. Building a solid portfolio of individually held stocks is by no means easier, but that is why professionals exist. Our job is much more than beating the market, as the market overall presents a slough of risks that may be appropriate for some, and not for others. Our job is to balance your return expectations with prudent risk management, helping you reach your goals without sacrificing sleep at night.

 

I am reminded of a recent conversation where I discussed with a client that there were no ways to magically make money, you cannot turn water into wine. What you can do is make a series of decisions that make sense for what you are trying to achieve and build something that will help you and your families for years to come.

 

If you would like to discuss how we can do this, we are always available to take your calls.