When Investing Wide Goes Narrow

Ian Tam: What would you think if I told you to put one-third of your equity portfolio in a single stock? Most conservative investors would quickly agree that this is a pretty risky move and would be contrary to what age-old investment theory tells us about diversification and risk. But surprisingly, this is precisely what many Canadians did back during the dotcom bubble by simply investing in the index.

In August of the year 2000, Nortel Networks represented 35% of the TSX Composite Index after appreciating by 255% in the preceding 12 months. It then dropped by 92% in the 12 months during the crash driving the index down with it. This was a rather painful lesson for investors that were passively indexed to the S&P/TSX Composite and since then index investing has grown in popularity now representing about 14% of investments in funds and ETFs in Canada. Because passive funds have a much lower fee than actively managed funds, they are a great way to get exposure to a broad asset class. However, the lesson that Nortel taught us is that the benefits of diversification start to go away the more concentrated your portfolio becomes.

Today, the S&P/TSX 60 Index which is tracked by iShares is Canada's largest ETF with $8.5 billion in assets under management. If you are invested in this index, two-thirds of your investments are spread across just three sectors. The second-largest ETF in Canada by net assets is BMO's S&P 500 ETF which has about $8.2 billion in assets under management. This ETF holds a whopping 22% in just one sector, technology.

Although we are nowhere near the amount of concentration that we saw during the technology bubble, the two largest ETFs in Canada actually look fairly concentrated in a few sectors. So, investors that believe that they are fully diversified aren't really. It's important to keep an eye on your overall sector exposure especially during times of market turbulence when weightings in the portfolio can change rather quickly. This monitoring ensures that your sector exposure doesn't drift too far in one direction and hence will help you maintain sector diversification and reduce the overall risk in your portfolio. A portfolio look through tool like Morningstar's X-Ray can be a great resource to help with this type of analysis.

For Morningstar, I'm Ian Tam.