Is There a Better Way to Capture Canada?

Industry experts, including Warren Buffett, suggest investors should invest in indexes that include stocks such as Canadian National Railway Company (TSX:CNR)(NYSE:CNI), but a closer look at two of Canada’s biggest indexes says otherwise.

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An opinion piece appeared on a popular U.S. investment website recently that broke down the S&P 500 by market cap–not by specific components mind you, but rather by market weightings of the largest stocks in the index.

The author found that the three largest stocks by market cap in the $19 trillion index represented 10% of the overall market cap; the top 10 companies in the index by market cap accounted for 20% of the index’s total market cap, and so on up to 100%.

The point is that you’re not necessarily getting what you think you’re getting when you buy an index like the S&P 500. The same holds true for the S&P/TSX Composite Index and S&P/TSX 60.

Here’s why.

The argument for owning a broad index like the S&P 500 is that you’re buying a fully diversified portfolio of large-cap stocks that together can weather most investment storms better than a smaller, more concentrated group of stocks. And while Buffett argues that most investors should use this type of index fund for their own investment portfolios, his holdings are much less diversified.

So, if you had followed what he actually practiced a year ago and bought the Guggenheim S&P 500 Top 50 ETF, which represents the top 50 stocks by market cap in the S&P 500, rather than the SPDR S&P 500 ETF Trust, you would have achieved an annual total return of 3.03%, 241 basis points higher.

Now, let’s look at the Canada’s two biggest indexes using a longer period of time, say three years rather than one.

All 240 stocks on the TSX Composite Index achieved an annualized total return of 6.2% over the past three years through May 10. Its total market cap is $1.97 trillion. The TSX 60 Index, interestingly enough, delivered an annualized total return of 3.7% over this same three-year period, utilizing a total market cap of $1.45 trillion or 74% of the TSX Composite.

In other words, the smallest 180 stocks on the TSX have a total market cap of $520 billion, an average of slightly less than $3 billion per stock, while the 60 largest in the TSX have an average market cap of $24 billion, or eight times as great.

Now, narrow that down even further to the top 10 stocks on the TSX and you get an annualized return of 10.6% over the past three years, considerably better than either index.

But there’s a catch.

The performance of these 10 stocks I’ve highlighted, whose combined market cap is $729 billion, or 37%, of the TSX, is backward looking. The 10 largest today weren’t the 10 largest stocks three years ago. But the changes to the top 10 aren’t nearly as significant as one might think.

Moving out of the top 10 is TransCanada Corporation (TSX:TRP)(NYSE:TRP), Potash Corporation of Saskatchewan (TSX:POT)(NYSE:POT), and Barrick Gold Corp. (TSX:ABX)(NYSE:ABX).

Moving in is BCE Inc. (TSX:BCE)(NYSE:BCE), Canadian Natural Resource Limited (TSX:CNQ)(NYSE:CNQ), and Canadian National Railway Company (TSX:CNR)(NYSE:CNI).

The net result?

The top 10 stocks in the TSX from 2012 returned 6.2% on an annualized basis, the exact same return as the entire TSX Composite Index.

Is this a better way to capture Canada? I believe it is. Especially if you consider that the bottom 180 stocks of the TSX do very little to move the needle.

If you’re self-directed, you might want to consider buying the top 10 stocks in the TSX and rebalancing every January to reflect the changes over the previous year.

It’s buy and hold with a twist.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Will Ashworth has no position in any stocks mentioned. David Gardner owns shares of Canadian National Railway. The Motley Fool owns shares of Canadian National Railway. Canadian National Railway is a recommendation of Stock Advisor Canada.

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