You are probably overexposed to financials

The past five years have eliminated a major diversification risk for Canadian investors and replaced it with another, more subtle problem.

It's the dominance of financials, one of the top-performing segments of the Canadian market in the past five years. Your weekend investing assignment: Figure out how much of your portfolio is exposed to the financial sector.

Financial stocks account for just a bit more than one-third of the S&P/TSX composite index, and they're a massive presence in many Canadian equity mutual funds and exchange-traded funds, dividend funds and income funds. What investors likely don't realize is that their bond holdings could be likewise dominated by this sector.

Let's say you decide to add a popular ETF such as the iShares 1-5 Year Laddered Corporate Bond Index Fund (CBO) to your portfolio. It's a reasonable move, given that corporate bonds should be a little more resilient to rising interest rates than government bonds. Also, staying short term adds another layer of defence against higher rates.

The hidden risk in CBO is that it has 65 per cent of its assets in financials, including banks, insurers and entities that finance the purchase of cars and heavy equipment by consumers and business. Adding a fund such as this one to a bank-heavy stock portfolio undermines diversification by tying two supposedly independent elements of your portfolio – stocks and bonds – to the fortunes of a single economic sector.

Your portfolio might recover if that sector hits a bad patch, but can your nerves handle it? Remember, diversifying with stocks and bonds is supposed to reduce stress, not add to it.

Eric Kirzner, a finance professor at University of Toronto's Rotman School of Management, says he's not concerned about investors owning any one particular fund or stock portfolio with an emphasis on financial stocks. But it's a different story when they add a bond fund stacked with financials. "That's where you start getting into excessive concentration," he said.

Financials are one of the best-performing Canadian sectors in the past five years. Our big banks, in particular, set the standard for durability in the financial crisis of 2008-09. But bank stocks were still hit hard back then. Some shares were down as much as 50 per cent or more, and the dividend growth for which the banks were famous dried up for a couple of years.

Some bank-issued bonds fell in price back then as well. Not massively, but enough to work against some of the supposed safety of owning bonds.

Let's get real about the Canadian market – it has always been dominated by a few sectors while offering minimal exposure to others. Before the 2008-09 market crash, roughly half the S&P/TSX composite index was in energy and materials stocks, mainly miners of gold and metals. This worked out brilliantly until commodity stocks were flattened in the crash.

Right now, energy and materials together account for 37 per cent of the S&P/TSX composite index. But you don't see these stocks in dividend and income funds in the same concentration as financials, and they're not much of a factor in corporate bond funds, either.

Here are some quick examples of how dominant financials are in popular mutual funds and ETFs:

• The $17-billion RBC Canadian Dividend Fund had almost 46 per cent of its assets in financials as of its most recent portfolio update
• The $1.4-billion iShares Dow Jones Canada Select Dividend Index Fund (XDV) has close to 54 per cent of its assets in financials.
• The $948-million BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR) had 39 per cent of its assets in banks and insurers.

Checking the financial weighting in bond mutual funds is difficult because most companies disclose only the breakdown between government and corporate bonds. However, you can monitor the weighting in corporates and then check the actual holdings to see how prevalent bonds issued by banks and insurers are.

Bond ETFs are easy to assess because their sector weightings and holdings are continuously updated online. Similar to CBO in being heavily weighted to financials are:

• The $669-million BMO Short Corporate Bond Index ETF (ZCS), with almost 71 per cent of its assets weighted to financials.
• The $497-million Horizons Active Corporate Bond ETF (HAB), with just over half of its assets in financials.
• The $205-million Vanguard Canadian Short-Term Corporate Bond Index ETF (VSC), with almost 76 per cent weighted to financials.

Financial stocks and bonds can't be avoided in the Canadian market, nor should you even try to avoid them. "It makes a lot of sense to invest in financials," said Jim Hall, chief investment officer at Mawer Investment Management and co-manager of the Mawer Canadian Equity Fund. "They are very good companies, they have great business models and they're very well run. There are risks, but you get paid to take those risks."

Mawer Canadian Equity has a 38-per-cent weighting in financials, but Mr. Hall notes that the fund is actually under-weight on banks in particular. They account for 16.3 per cent of the fund, compared with 23 per cent of the index.

The main risk to bank shares is that a setback for the Canadian economy or the housing market causes a jump in the number of loans in arrears or default, Mr. Hall said. But his firm's analysis is that the risk is manageable. "We've run the numbers under some really bad scenarios and the banks are still fine. They're still liquid, they're still solvent."

Bonds are less risky than stocks in general, but bonds issued by financial companies wouldn't be immune to a sharp deterioration in the business environment. "Prices did decline for many financial issues during the credit crisis," Heather Mason-Wood, vice-president at corporate bond specialty house Canso Investment Counsel, wrote in an e-mail. In a quick survey, she found declines ranging from 5 to 14 per cent for one particular bank's bonds.

Some final thoughts on managing your financial exposure: One, look beyond Canada. U.S. and international markets are much less skewed to financials, and thus are an excellent way to add diversification. Two, keep an eye out for Canadian mutual funds and ETFs that are under-weight on financials: Some fund managers go light on financials, and some indexes tracked by ETFs have much less of a financials weighting than the S&P/TSX composite. Finally, set a realistic ceiling for financials in your portfolio and rebalance when necessary to maintain it. Prof. Kirzner says you can go as high as market weight – that's about one-third – to 40 per cent for your stocks and equity funds. If you add bonds issued by the big banks exclusively, he's okay with a total 50-per-cent portfolio exposure to financials. "It's the only sector that I'd do that with."

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