Broad Index With 25% Upside Over S&P 500

Includes: EWC, IVV, SPY, VOO
by: Infinity Group

Many people choose exchange traded funds for the low fees and exposure to broad markets. One of the more popular funds is the S&P 500 (NYSEARCA:SPY), and with the index reaching an all-time high, many are asking are we at the ceiling. Either way this is a good place to take some profits, especially before the summer break. But that leaves us with another dilemma of where to put our profits.

Being outside the box of the US and living on the north side of the box, allows a unique perspective. Due to currency issues and other reasons, investing in the Canadian version of the S&P 500 is fairly common (S&P/TSX Composite Index) for us northerners. With capital in both markets we generally see that the Canadian markets follow the US markets due to the close ties and regional economic conditions.

The S&P/TSX Composite Index is comprised of the top Canadian companies by market capitalization. Previously this index was the TSX 300 listing the top 300 companies, but has changed due to fluctuations in the number of listings.

Visually from the graph below, we can see the TSX index in red regularly lags the S&P 500 in blue. One of the more recent data points shows an opportunity. This is where the TSX and the S&P500 crossed each other in Oct 2011. From this point the TSX has gone sideways while the S&P 500 has continued to climb.

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S&P 500 vs Toronto Stock Exchange

In the past few months the difference between the two indices has increased significantly. There are two main reasons that the Canadian market has lagged:

  1. Quantitative Easing

The various rounds of quantitative easing in the United States have led to an increase in the various US equity markets. With bond yields at all-time lows and being artificially kept at these levels, the equity markets will likely experience continuous upward pressure. Due to economies of scale, the effort by the Canadian government to implement a similar program to devalue the Canadian dollar would likely not be as successful.

  1. Resource oriented

Canada has historically been known as a resource rich country, providing materials through exports to other countries. Recently this has been affected by the Canadian-US dollar foreign currency exchange rate, making it more costly to purchase Canadian goods. At times during the past two years the Canadian dollar has been worth more than the US greenback. Previously Canada has enjoyed an exchange rate of $0.80 to the US dollar.

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The graph below illustrates the margins that are occurring between the markets. A potential upside of 25% exists, if and when the Canadian market corrects itself.

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S&P 500 vs Toronto Stock Exchange

Many could argue that the reason the Canadian equity markets are doing poorly, is due to financial risks within Canada. This is not the case as Canada has routinely been commended by many countries on doing a great job relative to the world's financial markets. In fact our Bank of Canada Governor Mark Carney has been recruited to lead the United Kingdom as the Bank of England's Governor.

Stability in Canadian markets

Throughout the global financial crisis, Canada has been consistently rated as one of the best stable economies in the world. We did not go through a bank recapitalization period nor had an impact on our housing market. The Canadian federal government while monitoring the situation have not followed the United States in the quantitative easing program. The financial stability board stated recently:

The Canadian authorities have made good progress in addressing the FSAP recommendations on banking supervision, stress testing and the early intervention regime

Later in the same report:

The response of the Canadian authorities to the global financial crisis was swift and effective.

They adopted a variety of macroeconomic policies to buffer the impact of the crisis on the economy, increased supervisory vigilance, expanded liquidity facilities and pro-actively addressed emerging problems. The strength of the economy and of the financial system at the

onset of the crisis meant that no Canadian financial institution failed or required government support in the form of a capital injection or debt guarantees. On the contrary, Canadian banks

continued to raise equity in private markets throughout the crisis."

The resilience of the Canadian financial system during the global financial crisis highlights a number of key lessons for other jurisdictions - namely, the importance of having:

pro-active and targeted macroeconomic policies, supported by adequate fiscal space and a flexible exchange rate to help absorb external shocks; prudent bank risk management, particularly a stable and well-diversified funding profile as well as conservative loan underwriting standards; and a comprehensive regulatory and supervisory framework that effectively addresses domestic prudential concerns, including (when necessary) by adopting regulatory policies that go beyond international minimum standards.

How to invest in Canada

The iShares S&P/TSX 60 Index Fund (XIU.TO) is traded on the Toronto Stock Exchange and is probably the best exchange traded fund that mimics the index itself. The MER fee is low at 0.15%, yet access to the Canadian markets is required with Canadian funds.

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vs (XIU.TO)

Another option to access the Canadian exchange is through the iShares MSCI Canada ETF (NYSEARCA:EWC). This ETF trades on the US markets and is in US funds. At times there can be some variation due to the exchange rate and this is illustrated in the graph below. This exchange traded fund is not currency hedged.

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The management fee for the iShares MSCI Canada ETF is approximately 0.51% and is higher than the Canadian market ETF (XIU.TO), but for smaller portfolios and trading fees the US exchange traded funds are better values.

It should be noted that this ETF should be followed regularly due to the exchange rate. While it is possible for an 8% appreciation in the exchange rate approaching the previous $1.05 mark, it is unlikely. More probable is that the exchange rate will fall to the $0.90 mark over a 1 to 2 year period. Currently it is at $0.98 CAD/USD.

Comparable indices that can be substituted for the S&P 500 exchange traded fund are the iShares core S&P 500 (NYSEARCA:IVV) and the Vanguard S&P 500 ETF (NYSEARCA:VOO).

This opportunity will continue to exist until either or both markets correct themselves. For the Canadian markets through the iShares MSCI Canada ETF , a correction upwards in the 20 % to 25% range would not be unheard of, as in July 2008 the iShares MSCI Canada ETF was trading at those higher values.

Disclosure: I am long SPY, EWC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.