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By David Baskin

Pundits are once again commenting on the difference in performance between the Canadian and American markets, and no wonder. Since the market bottomed four years ago, the S&P 500 has gained 136%, while the TSX has risen 70%, only about half as much. Why the big difference, and what, if anything, should we do about it?

In order to make a decision, it is first necessary to understand how stock indices are put together. Each of the S&P 500 and the TSX Index are called “market cap weighted” indexes. Here is how the S&P works. Each of the 500 largest public companies in the United States is included in the index. Each company is given a “weight” or proportion in the index reflecting its market value compared to that of the entire index. At the moment, the most valuable company in the United States is Exxon Mobil (NYSE:XOM). Its market capitalization is about $406 billion. The market value of all 500 companies put together is about $14 trillion, meaning that Exxon Mobil represents about 3% of the value of the whole market. The 20 most valuable companies in the U.S. together make up about 30% of the whole index.

If the shares of Exxon Mobil went up 1% one day, the effect on the S&P 500 would be to move the index up by only 3% of 1%, or 0.03% – or .45 points on the S&P. If all the 20 biggest stocks went up by 1%, they would move the index by 20% or 1% or .2%, equal to 3.15 points.

The TSX works the same way, but with two very important differences. The first difference is that the top 20 Canadian companies make up 42% of the index. This is much more concentrated than the S&P 500 at 30%. The second big difference is the industry concentration.

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By far the biggest sector in the TSX is the financial industry, making up over 18% of the top 20. This compares to less than 6% in the S&P 500, making the big banks and insurers three times as important in Canada. The second biggest sector in Canada, not surprisingly, is energy, making up almost 10% of our top 20, compared to just over 4% in the U.S. Finally, the materials sector is very important in Canada, making up 5% of our biggest stocks, compared to a zero weighting in the S&P.

As crucial as what is big in Canada is what is absent altogether. The biggest sector in the S&P top 20 stocks is technology. Composed of names like Apple (NASDAQ:AAPL), IBM (NYSE:IBM) and Google (NASDAQ:GOOG), these stocks comprise about 8% in the U.S., while only 1% here. Healthcare makes ups 4% of the big S&P stocks, compared to zero weight in Canada.

Given these changes in the composition of the two indices, it is not hard to understand why they can move very differently. Technology and healthcare have been two very hot sectors since the market crash, and account for a large part of the move in the S&P 500. Four years ago, Apple was at $82 compared to $436 now; Google was at $289 compared to $814 today, and IBM has moved from $83 to $214. At the same time, Canadian commodity heavyweights have done very little for investors, with giant oil company Suncor (NYSE:SU) moving from $23 to $31, fertilizer maker Potash (NYSE:POT) going from $28 to $40, and Canada’s largest gold company, Barrick (NYSE:ABX), actually declining from $33 to $31.

The difference in sector weightings and the varying fortunes of, for example, energy vs. technology or gold vs. healthcare, explain why sometimes the TSX beats the S&P 500, and other times trails. However, from a portfolio management standpoint, it is crucial to understand that investing in Canada does not mean that a portfolio must mirror the makeup of the TSX index, just as a U.S. portfolio need not look like the S&P 500.

At present, our clients have no precious metal stocks, although they make up a big part of the TSX. About 9% of our equity holdings are in the Canadian banks and insurers, although they make up over 20% of the market, and our energy exposure is a meager 3% compared to over 30% for the entire Toronto market. Building a portfolio that looks very different from the TSX index has given our clients results that do not reflect that index.

In our view, a manager adds value by sector allocation as much as by picking stocks within each sector. It is not helpful, for example, to have the best gold stock if the entire sector is plummeting. For this reason, we pay no attention to the market weight of each sector within the TSX index, as we have no desire to mirror its performance. Our investment process starts by picking sectors we believe will do well, avoiding ones we think will do poorly, and follows by finding the best companies to buy within the sectors we like. In 2012, each of our equity holding asset allocation strategies had a return, which exceeded its benchmark, and the same has been true for the first quarter of 2013.

Disclosure: The author and clients of Baskin Financial Services may own shares in the companies mentioned in this posting.

Source: You Don't Have To Own The Index