Dale Jackson

Personal Finance Columnist, Payback Time

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Here we go again. A relative newcomer to the TSX Composite Index party is dominating Canada’s premier index. Shares in online retailer Shopify Inc. have nearly tripled since April, surpassing the stodgy Royal Bank of Canada as the country’s largest publicly-traded company. 

New blood is a good thing, but investors who get exposure to Canadian equities through market-weighted exchange-traded funds (ETFs) that track the TSX may not have their money where they think. Holdings in market-weighted ETFs are based on their current market capitalization and are automatically adjusted as share prices change. Shopify now accounts for nearly seven per cent of the TSX Composite compared with RBC’s 5.8 per cent weighting and TD Bank’s 4.7 per cent stake.

That gives Shopify a great deal of sway on the TSX and exposes ETF investors to risks they might not be aware of.

As an example, shares in RBC are trading at 12 times trailing earnings and TD trades at 10 times earnings. In comparison, the price-to-earnings ratio – a critical gauge that ties prices to past earnings – doesn’t even register in a meaningful way for Shopify because earnings have been inconsistent. Shopify’s forward P/E ratio based on its outlook for future earnings is a whopping 557 times earnings – a best guess in a pandemic-plagued global economy. 

We’ve been here before over the past three decades with Nortel, Research in Motion (now Blackberry Ltd.), and more recently Valeant Pharmaceuticals (now Bausch Health Companies Inc.): all taking an outsized weighting in the TSX for a short period of time.

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Add that to the fact that the TSX is already under-diversified. It accounts for less than three per cent of publicly-traded equities, two-thirds of which are either finance or resource related – and a market-weighted TSX ETF might not be such a good investment.

Here are some alternatives if you are looking for broad Canadian equity exposure.

Sector ETFs

ETFs that track specific sectors are available on the Canadian market. If Canadian financials or resources are what you want there are ETFs that exclusively track Canadian financials (banks and insurance companies), resource sectors such as energy, or small caps. 

Canadian equity mutual funds

Actively-managed Canadian equity mutual funds can steer clear or limit the amount of index aberrations like Shopify if the manager wishes.

Active management, however, has a price. Annual fees average about 2.5 per cent of the amount invested if purchased through an advisor compared with a TSX market-weighted ETF, which charges less than one-tenth of a per cent. That extra fee adds up over time; resulting in less money invested and compounding over time.

Curiously, the average Canadian equity mutual fund underperforms the TSX Composite over several time periods by about the same amount as the average fee, which suggest many managers merely track the index as is and pocket the extra fee.

On the bright side, that means many actively-managed Canadian equity funds outperform the index even with the fee. To increase your odds of finding a winner you can try bypassing an advisor by purchasing the ‘D’ series of the same fund, which often has a fee that is a full per cent lower. Scandalously, many discount brokers only offer the ‘A’ series (advisor) and pocket the extra per cent for advice they never provide.  

Just buy the darn stocks

The good thing about a thin index is it’s easy to replicate one stock at a time. Every Canadian should have a healthy portion of Canadian equities in the portfolios, so why not just cherry-pick the good ones?

It’s a decision you might want to make with an advisor but a few no-brainers include the financial and telecom oligopolies protected by foreign ownership restrictions that generate consistent and generous dividends. Stand at the main intersection of most Canadian cities or towns and turn 360 degrees. You will see one or more of the big banks: TD, BMO, CIBC, Scotiabank or Royal Bank.

Similarly, check your latest television, phone or internet bill and the company is likely owned by BCE Inc., BNN Bloomberg’s parent, Rogers Communications Inc. or Telus Corp.

If you want to own Shopify, buy Shopify.  

Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email dalejackson.paybacktime@gmail.com.