Building a better Canadian equities portfolio

Actual fund performance over the past twenty years matches this performance of the indexes. The category return of Canadian Dividend and Income Equity Funds outpaced the return of the more diversified Canadian Equity Funds category. This category contains funds and ETFs focused on core market exposure and investment styles, including value, growth, low volatility and momentum.

However, this outperformance has not persisted.

Over the past five and 10 years, the Canadian Equity category has become the leader in response to the changing structure of the Canadian market, which has evolved in five important ways.

1. The outperformance of Canadian banks, a mainstay of Canadian dividend strategies, has diminished as their growth opportunities in Canada have dwindled and their expansion has centred on the competitive U.S. market.
2. The materials sector, which has been in a multi-decade bear market, has shown improved returns over the past five years amid global shortages and as the vital importance of critical minerals opens new opportunities.
3. The energy sector, which has recurring busts that have been a drag on the overall stock market, has moved into an era of capital discipline and shareholder focus.
4. Share buybacks have increasingly replaced dividends as a means of returning capital to shareholders, and many of the outperforming stocks of the past decade have nil to modest dividends but highly active stock buyback programs.
5. The technology sector, which just over a decade ago barely registered at slightly more than 1% of Canada’s stock market capitalization, is now nearly 10% and is likely to become an ever-growing sector in Canada. Technology has the lowest dividend yield among all sectors — close to nil — and had the highest return over the past 10 years, at 20.4% per annum.

In response to these changes, advisors may want to consider Canadian momentum-based strategies, which capitalize on the tendency of recently outperforming stocks to continue to outperform in the near term while losing stocks continue to underperform. Launched into prominence by a seminal study in 1993, extensive research over the past three decades has continued to find that, on average, past winners yield higher returns than past losers over shorter time frames.

Academics propose behavioural and risk-based reasons for the existence and persistence of the momentum premium. Behavioural explanations include herding, investor underreaction and overreaction, overconfidence, confirmation bias and anchoring. On the risk side, momentum strategies can be subject to crashes in times of extreme market volatility, frequently hold riskier growth companies, and may be exposed to greater liquidity risks.

In Canada there is ample evidence of outperformance of stocks with positive momentum. A recent 2020 study analyzing the performance of over 3,500 Canadian stocks from 1956 to 2015 using various ranking and holding metrics found that the top quintile of stocks outperformed the broad market by 22 to 83 basis points a month. Earlier studies, one published in 2009 covering the period 1988 to 2000 and another published in 1994 covering 1978 to 1993, found evidence of momentum in Canadian stocks.

On the index front, the Morningstar Canada Target Momentum Index launched in February 2012 has outperformed the Canadian market by 2.2% a year. The CI Morningstar Canada Momentum Index ETF tracks this index. The MSCI Canada Momentum Index has outperformed the broad market by 1.6% and 1.9% annually over the past 10 and five years, respectively.

In addition to potential enhanced returns, advisors should consider the following benefits from including momentum-based strategies in their Canadian equities:

• Improved diversification. The returns of momentum strategies are only moderately correlated to Canadian value and high dividend yield strategies. Based on MSCI indexes, over the past five years this correlation was 0.68 and 0.69, respectively, approximately the same correlation as U.S. stocks have to Canadian value and high dividend yield strategies.
• More consistent portfolio excess returns. Over the past five years, the excess returns of the MSCI Canada Momentum Index over the broad market had negative correlations with the excess returns of the Value and High Dividend Yield indexes — -0.53 and -0.24, respectively.
• Lower potential taxes. A well-designed momentum strategy lets winners run and sells losers quickly, creating tax deferral and capital losses, respectively. Although there are irregular years of high capital gains, in our experience this is offset by much lower ongoing dividends due to higher allocations to growth stocks. This tax profile is most appropriate for affluent clients, particularly when the gains can be distributed as tax-free capital dividends from a private corporation.
• Increased opportunity set. Momentum strategies with proper buy and sell rules can profitably participate in extremely fast-growing sectors such as technology, where fundamental analysis of smaller or newer companies has more limited utility. This orientation can help meet the preferences of growth-focused clients.

Like any investment approach, momentum-based strategies have periods of underperformance. But, given the evidence, advisors who want to improve their Canadian equities portfolios may consider this type of strategy.

Michael Nairne, RFP, CFP, CFA, is president and CIO of Tacita Capital Inc., a private family office, and manager for TCI Premia Portfolio Solutions. The firm uses momentum ETFs in its portfolio management.