Canadians invested solely in Canadian stocks that mirror the S&P/TSX composite index are particularly vulnerable to market vagaries. That’s because the energy, materials and financial services sectors together account for 74% of the index. If something goes wrong in one of them, the value of the whole portfolio can sink significantly.

Of course, the reverse is also true. When commodity prices are rising and the big Canadian banks and life insurers are doing well, returns will be great. That has been the case for the past three years, resulting in an average annual return for the broad market index of 19.6%. But clients have to realize the risk they are running.

Most investment experts believe sector diversification is important and suggest advisors and their clients aim for a sector mix similar to global weightings. That would mean only 41% of equity invested in energy, materials and financials. The weighting could be higher when prospects for resources and financials are particularly good, but the general rule of thumb is no more than 5% higher for each sector, which would mean keeping the three to a maximum of 56% combined.

In theory, you could get appropriate weights for the other sectors through Canadian companies. That would avoid the impact of currency moves, which wiped out most of the gains for Canadians invested in U.S. equities in 2003 and 2004. The Standard & Poor’s 500 composite index rose 37.7% during those two years, but the Canadian dollar rose 31.3% — which reduced the index’s gain to 5% when translated into C$.

However, Canadian companies can’t provide the desirable sector diversification. Not only does Canada have relatively few companies in the other sectors, but in some key subsectors, such as pharmaceuticals and automakers, it has no publicly listed firms. Furthermore, even if there are Canadian companies, they may not be the best companies in which to invest. That’s not surprising, given the fact Canada accounts for less than 3% of global market capitalization.

Of course, there is always the risk of further negative currency moves. But unless those are dramatic, the better return offered by a broadly diversified portfolio invested in the best global companies in each sector should more than offset that.

The question is which sectors outside Canada are most important for coverage if your clients are to be properly diversified. Leo de Bever, executive vice president of global investment management at Manulife Financial Corp. in Toronto, says investors should look at everything except resources and financial services. In those sectors, Canadian companies are “as good as any.”

Lloyd Atkinson, an economic and financial consultant in Toronto, thinks even in financial services you should look to the U.S. in certain subsectors. These include institutional money managers, which have very strong growth prospects, given the amount of additional money that will have to go into pension plans to make them economically viable. Atkinson is also looking south of the border for property and casualty insurers because Canada does not have many and the biggest, Fairfax Financial Holdings Ltd. , has been battered in recent years.

Karen Bleasby, senior vice president of Mackenzie Financial Corp. in Toronto, would add utilities to the list of sectors for which there is good coverage in Canada. She says the big gaps are in health care, information technology and consumer discretionary and staples. Canadian companies are also underrepresented in industrials, but the discrepancies are larger in the other four.

For example, the largest Canadian company in consumer staples is Loblaw Cos. Ltd., with a market cap of $15.3 billion. In the U.S., Procter & Gamble alone has a US$200-billion market cap, and there is a whole slew of other big names, including tobacco company Altria Group Inc., Wal-Mart Stores Inc., Pepsi Bottling Group Inc. and Coca-Cola Enterprises Inc.

Srikanth Iyer, vice president of research and director of portfolio engineering at Guardian Capital Advisors LP in Toronto, pinpoints not only sectors but also the geographical areas that have the best investment potential. His list:

> Automakers. Look in Japan, Iyer says. Japanese automakers are very efficient, with good profit margins and growth prospects, and very strong balance sheets.

> Other consumer discretionary. Go for U.S. companies. The only European company Iyer likes is Amsterdam-based Phillips Electronics NV.

> Industrials. The U.S. is still the powerhouse here.

@page_break@> Pharmaceuticals. Europe is the place for these. “They are like Canadian banks,” Iyer says. In the U.S., the pharmaceutical subsector is a more regulated space. In addition, the companies don’t have robust biotech activities. They get their products from biotech companies and have become distribution firms rather than manufacturers.

> Technology. The U.S. has a competitive advantage here. U.S. companies, says Iyer, “exhibit more positive earnings growth, and profit margins are significantly higher. On a valuation basis, they are a more consistent ‘buy’ than Canadian and European firms.”

There are also opportunities in the Pacific Rim, including Canon Inc., NEC Corp., Samsung Electronics in Korea and Uptronics in Taiwan. In the U.S., Corning Inc. is a company to watch.

Clients don’t have to buy individual companies to get exposure to global sectors. There are global and sector-specific mutual funds and exchange-traded funds. A lot of Canadian equity funds also invest globally to provide sector diversification.

Bleasby says global sector funds, of which Mackenzie has a number, usually are used if clients particularly like the sector and want additional exposure. “For most investors, general funds are the way to go,” she says. Bleasby cautions that global sector ETFs are not as large or liquid as the U.S. ones. Furthermore, ETFs invest in all the companies in an index, which includes weak firms as well as good ones.

Iyer suggests buying individual companies if the investor has sufficient assets to construct a well-diversified portfolio. But, he says, ETFs are a very efficient and inexpensive way to get diversification. IE