What Does the Index Own That I Don’t?
2021 was a quite a year. Covid continued to dominate our lives, despite mass vaccinations. Meme stocks such as Gamestop made headlines, as did the meteoric rise in the value of Bitcoin and other crypto currencies. One stand-out from 2021 was the continued success of equity markets particularly in North America.
And it was one of those years when index and portfolio returns tended to diverge. There are several reasons for that. Let’s consider a couple of them.
Asset Allocation
When we work with you to build your portfolio, we consider many factors. We consider such variables as your investment objectives, time horizon (i.e., when you’re going to need the money), how much volatility you’ve comfortable with, and what your tolerance for risk is. We also look at your entire personal and financial situation and then work to design a portfolio which is suitable and appropriate given all these factors. As a result, a client’s portfolio is rarely, if ever, 100% equities. There’s always a certain percentage (and this varies per the needs of each client) of fixed income (bonds/GICs) and cash (money market/high interest savings). These fixed income and cash investments will hold a portfolio back during a bull market like 2021; however, they serve to protect your portfolio and reduce volatility when the next inevitable bear market arrives.
In years like 2021, where equity markets had spectacular performance, it’s sometimes easy to feel like you’re missing out; and wish to adjust your portfolio to keep up. The truth is knee jerk reactions to short term market fluctuations is never a good idea. An investment strategy has been designed for you for a reason; and that is to provide you with a strong path to achieving your financial goals, regardless of what’s happening “today”.
Canada in 2021
When you hold a diversified portfolio, it’s exactly what it says it is - diversified. An opportunistic investor may choose to “concentrate” their holdings, or at minimum, take larger positions where they see value or opportunities that are being missed by other investors. This is one of the main reasons so many investors continue to hire portfolio managers over a pure index approach. At the same time, those same managers may also reduce the weighting in positions that they feel have become expensive or overpriced. This protects the investor from significant downside swings to their portfolio.
Canadian performance within various industries was not uniform across the entire market for 2021. Energy stocks were up by over 45%. Financials also had a very successful year and were up by 36.5%. Meanwhile, Metals and Mining was down 4.6%, Gold was down 9.6%, and health care was down 19.6%. Utilities and Information Technology came in at +11.6% and +18.5% respectively.
In a perfect world, you’d always be invested in the sectors that made the most money, and not be invested in the ones that lost, but of course that’s much easier said than done considering all these numbers are known in hindsight.
Consider an example; one of the more interesting stocks in the Canadian marketplace over the last couple of years has been Shopify. As of December 31st, 2021, it had grown to become the largest company on the S&P/TSX, achieving a 2021 performance of 21.18%. Very nice, right? But should Shopify be larger than companies like RBC or TD Bank given its revenue and net income is a fraction of those two banks? Sure enough, early in 2022, we find Shopify declining heavily (mid 20% decline).
As a side note, some of you may remember when Nortel was the biggest company on the TSX. That was around 20 years ago and shortly before it went bankrupt.
The point is this, when you own the index, you take what the index gives you. When you hire a manager, you know they are searching for good opportunities.
The Big Seven in the US
Continuing with this theme, let’s now jump down to the United States. One of the portfolio managers that we communicate with (Edgepoint) has done an analysis on the S&P 500. They compared the performance of the top seven companies within the S&P 500 to the performance of the remaining 493 companies over a two-year period ending November 30th, 2021. They found that these “Big Seven Companies,” made up of Alphabet (Google), Amazon, Apple, Meta Platforms (Facebook), Microsoft, Netflix, and Tesla delivered a return of 111% while the remaining 493 companies provided investors with a 32% return. The bottom line, most of the index’s return has been coming from 7 stocks.
A portfolio manager that you hire may not have chosen to own all seven of those companies. They may be more interested in searching for opportunities where securities are less expensive with better potential for growth, or less downside risk. Consider Netflix for a moment. This company, that is part of our “Big Seven” above, is currently down over 30% year to date in 2022 due to slower than expected subscription growth.
Conclusion
To sum all these examples up, you’ll always be able to look around and find investments that have higher short-term returns than you do. But chasing those type of returns has historically been a bad idea. Investors with a plan, who have a goal in mind, and who hire excellent managers have a habit of achieving the financial goals they set for themselves and doing it with as little risk as possible.
If you’d like to discuss your portfolio, please give our team a call to book an appointment. Taking your mind off the short-term and focusing on long-term gains is the best way to ensure you achieve the financial future you’ve worked so hard for.
If you’d like to discuss this topic further, please call us at (780) 426-2400, or e-mail us at gkoss@alignedcapitalpartners.com to schedule an appointment.
Thank you for being our client,
Gary Koss & the LGK Investment Team