Why U.S. Stocks Belong In A Canadian’s Portfolio – Part 2

In the first component of this two-part series, we explained that the sector concentration of the Canadian stock market means that Canadian investors would do well to purchase some securities from south of the border. Specifically, we recommended the Dividend Aristocrats as an excellent place to hunt for new investment ideas.

This is because the Dividend Aristocrats Index is underweight in the precise areas that the Canadian markets are overweight – making them a perfect complement to a Canadian investor’s portfolio. The sector breakdown of the Dividend Aristocrats Index is shown below.

It is very interesting to compare the sector weights of the Dividend Aristocrats to the sector weights of the Canadian stock market. The best benchmark of Canadian equities is the S&P/TSX Composite Index maintained by TMX.

The dominant sector within the Dividend Aristocrats is Consumer Staples, with a weighting of 24.5%. Consumer Staples contributes just 3.3% to the S&P/TSX Composite Index. The next largest sector within the Dividend Aristocrats is Industrials with 20.4%, which has a weighting of just 10.2% within the S&P/TSX Composite Index.

Similar trends hold true when you look at the Canadian index. Financials make up 35.6% of the S&P/TSX Composite Index and just 9.6% of the Dividend Aristocrats Index. It’s worth mentioning that the “financial” component of the Dividend Aristocrats Index contains no banks, while the financial sector of the Canadian stock market is almost entirely banks. The “financial” companies within the Dividend Aristocrats includes two insurers – Aflac (AFL) and Cincinnati Financial (CINF) – two asset managers – Franklin Resources (BEN) and T. Rowe Price Group (TROW) – and one credit rating agency and financial data provider – S&P Global (SPGI).

Moving down the list, the second largest sector within the Canadian stock market is energy, which has a weighting of 19.2% within the S&P/TSX Composite Index and a weighting of just 3.8% within the Dividend Aristocrats Index.

As you can see, there are significant sector diversification benefits for Canadian investors that decide to invest in the U.S. financial markets. But what if you do not want the additional complexity – portfolio management, foreign exchange fluctuations, security selection, and tax planning – that comes from owning stocks on both sides of the border?

Owning individual stocks is not the only way that Canadian investors can capture the benefits of owning U.S. stocks. We believe there are three different strategies that Canadian investors could potentially employ to invest in U.S. stocks. The first is direct ownership of individual securities, which is our preference and has been discussed throughout this article. We prefer direct ownership of individual stocks because it allows you to be very selective when it comes to valuation, dividend yields, and other financial characteristics. Said another way, owning individual stocks allows you to create an investment portfolio that is tailored to your specific needs.

The second way that we recommend Canadian investors invest in U.S. stocks is through U.S. exchange traded funds (ETFs). This provides instant diversification and allows you to own a broad swath of the U.S. stock market. While there is some selectivity available in U.S. ETFs – for example, you could decide to invest in the Dividend Aristocrats ETF (NOBL) – you are still investing your money into a predetermined strategy with no customization capabilities.

The last and most passive way that a Canadian investor can capture the benefits of owning U.S. stocks is by owning a currency-neutral ETF (which are traded in Canada instead of the United States). This provides the diversification benefits of purchasing actual U.S. ETFs, but removes the risk of currency fluctuations. An example is the iShares Core S&P 500 Index ETF (CAD-Hedged), which trades on the Toronto Stock Exchange under the ticker XSP. The downside to choosing to invest in currency-neutral ETFs is you will have far less options to choose from. More specifically, you will have difficulty finding CAD-hedged ETFs that track anything other than the major market indices like the S&P 500 or the Russell 2000.

To summarize, there are significant benefits available for Canadian investors looking to purchase U.S. stocks. More specifically, investors employing this strategy will benefit from significant diversification benefits and the ability to create a more globally-representative investment portfolio. If this appeals to you, then the three major options available to you are direct ownership of individual stocks, U.S. ETFs, or currency-neutral ETFs that trade on the Canadian stock market.

Nick McCullum of Sure Dividend, an investment newsletter provider aimed at helping people invest better through taking low-cost, long-term positions in individual stocks.