Why Canadians shouldn’t turn down investing’s only free lunch

Review of asset-class performance during Covid crisis reaffirms case for diversification into bonds and global equities

Why Canadians shouldn’t turn down investing’s only free lunch

While many Canadian investors may hesitate to spread their portfolio across too many asset classes and geographies, new research from Morningstar suggests that those who don’t do so are missing out on a massive benefit, particularly in times of crisis.

“Diversification has often been called the only free lunch in investing,” Morningstar researchers said in a new report. “A portfolio made up of building blocks capable of moving in different directions can have better risk-adjusted returns than its component parts alone.”

The researchers noted that during the first quarter of 2021, Canadian 10-year Treasuries saw a near-doubling in yield from 0.8% to 1.5% in just two months; over the same period, the U.S. 10-year Treasury went from 1% to 1.7%. Consequently, the Morningstar Canada Core Bond Index shed 5.4% of its value, while the Morningstar Global ex-Canada Core Bond Index declined 2.6% in Canadian dollar terms.

But in the first three months of 2020, they said, bonds proved a valuable safe haven for investors taking flight from equities ravaged by pandemic panic. While Canadian equities lost as much as 35% during the period, the Morningstar Canada Core Bond Index actually gained more than 1.7% in the first quarter of 2020.

“The pattern of bonds holding up during a crisis is consistent with a long-running trend,” the researchers noted.

Citing previous research by Ian Tam, Morningstar Canada's director of investment research, the report noted that North American equities suffered losses ranging from -16.74% to -33.64% in Canadian dollar terms during the Asian currency crisis of the late ‘90s, the tech bubble of the early aughts, and the Global Financial Crisis of 2008-2009. During those periods, global equities shed between -8.99% and -36.35%.

In comparison, Canadian fixed income saw gains between 0.10% and 15.47%, while global fixed income returns were slightly richer, between 7.69% and 18.97%.

Diversification is useful not just across equities and fixed income, but also across geographies within the equities universe. In the recent decade ended on April 30, 2021, the report said, the Morningstar US Target Market Exposure Index advanced by more than 360%; the Morningstar Developed Markets ex-North America Target Market Exposure Index gained nearly 100%, while the Morningstar Canada Domestic Index rose by just over 80%.

“Some home country bias can be justified on the basis of currency,” the report said, acknowledging downside scenarios that occur when the Canadian dollar appreciates against the greenback, the euro, and other major global currencies. “On the other hand, currency risk can also be viewed as currency diversification. When the Canadian dollar weakens, foreign assets are worth more to an unhedged Canadian investor.”

The report also cited several structural reasons for Canadian investors to make space in their portfolios for global equities. Canadian equities represented just 3% of global market capitalization as of April 30, 2021. Aside from that, Canada’s equity market has virtually no exposure to lucrative sectors such as healthcare or technology compared to the U.S. or emerging markets, and has been seemingly unable to get away from its overexposure to energy and basic materials.

“It's also key to look at how the Canadian equity market has … become more concentrated, with the top 10 constituents accounting for roughly 40% of the market,” the report said, contrasting it with the 26% concentration in the U.S. “Unsurprisingly, given this concentration, Morningstar's Canadian equity index has been more volatile over the past decade— measured by standard deviation of returns—than benchmarks measuring the U.S., developed markets outside North America, and even emerging-market equities.”


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