Canadian Index Instruments - Pros and Cons

Last post we discussed what exactly is the TSX Composite Index. 

Most investments containing Canadian equities are in some way measured against that index.  Is this justified or not and, as discussed here, is an active or passive vehicle the best one to choose for an investor?

Let's talk about this for a minute with a hypothetical scenario.  Let's say that it is 1999 and you own the TSX Composite Index in the traditional market-cap weighted manner.  You own technology stocks, including Nortel Networks, JDS Uniphase, and others.  These technology companies comprise over 1/3rd of your Canadian Equity holdings.  Did you want that exposure?  How did that work out for you?  Is there a solution to avoid overexposure to one stock or a sector of stocks?

Enter the Capped Index or Equal Weighted Index.  These have been created so investors can track equity performance without the 'bubbly' excesses of overinvestment and hype involved with many stock market manias.  Investors are also able to purchase active or passive instruments that track these indexes. 

There are also other new entrants into the index creation methodology including factor driven, intrinsic value, low volatility, income weighted, fundamental weighted indices and more.  These all have instruments available for purchase that track them. 

Now that we are fully confused about all of these options and choices what is an investor to do?  What is the 'right' index to follow?

For example, if your objective is high income and low volatility than a strategy employing instruments that use those indices may be best.  If your objective is to avoid bubbly market excesses, maximize growth, and take advantage of the small cap premium and value premium than a strategy employing those instruments may be best. 

In short, finding a fee-based advisor who works with low cost index tracking instruments like Exchange Traded Funds could help the most, provided the advisor listens to your needs.  Most importantly, it is vital to match your objectives with the indices and instruments that most closely fit what you are looking for in light of proper portfolio construction methods.

Canadian Index Primer

When you hear the news that "S&P/TSX Composite is up 102 points today" most people have no idea what that means.  Today I hope to break it down so we can have further discussion about the instruments that replicate or compare against the index.

For starters the index is a creation of financial professionals for the purpose of having a widely agreed upon measuring stick which we are able to compare similar investments.  This allows people to see if the investment they have is under- or out-performing the index in question.  Here are some of the details about the TSX Composite Index -

Index Characteristics

Number of Constituents	237
Adjusted Market Cap (C$ Billion)	1,522.984
% Weight Largest Constituent	6.09%
Top 10 Holdings (Market Cap Share - C$ Billion)	524.864
Currency	CDN Dollars

Inclusion Criteria

• Listing: Only stocks listed on Toronto Stock Exchange are considered for inclusion in this index.
• Domicile: Only securities which are Canadian incorporated, established in the case of income trusts, or formed in the case of limited partnerships, under Canadian federal, provincial, or territorial jurisdictions are eligible.
• Market Capitalization: Stocks are assessed based on their float adjusted market capitalization. A company's float adjusted market capitalization is calculated by removing control blocks of 10% or more.
• Liquidity: Only stocks that are actively and regularly traded are considered for inclusion in any S&P/TSX index. A stock's liquidity is measured relative to liquidity thresholds

Sector & Top 10 - S&P/TSX Composite Index

Sector Breakdown

Sector	Weight %
Financials	33.97
Energy	25.02
Materials	13.88
Industrials	6.96
Telecommunication Services	5.57
Consumer Discretionary	5.30
Consumer Staples	3.07
Health Care	2.55
Utilities	2.04
Information Technology	1.65

Top 10 Constituents by Market Cap

Data is based on End of Day Values

Constituents	Symbol	% Weight
Royal Bank of Canada	RY	6.087
Toronto-Dominion Bank (The)	TD	5.093
Bank of Nova Scotia (The)	BNS	4.665
Suncor Energy Inc.	SU	3.234
Canadian National Railway Company	CNR	2.952
Bank of Montreal	BMO	2.727
Enbridge Inc.	ENB	2.533
Potash Corporation of Saskatchewan Inc.	POT	2.442
BCE Inc.	BCE	2.428
TransCanada Corporation	TRP

We can see a couple very basic facts about the 'TSX' -
1) It largely consists of financial, energy, and materials companies .
2) It contains 237 companies and the top 10 biggest companies make up over 30% of the index.

Up next . . . . how to buy the TSX.