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Do Canadian Stocks Reflect Emerging Markets?

February 22, 2011 Leave a comment Go to comments

Two of the hot investing topics for the last 5 years have been emerging markets and commodities. As we all know, when you buy a Canadian stock index you’re getting a fair bit of commodity exposure. A new post on Canadian Capitalist shows how a little experimenting revealed that Canadian equities have also historically had a correlation to emerging markets (obviously with a few less 100% gains).

I’m not into commodities but for the last couple of years I have at times thought about how I could approach emerging markets and whether they’re worthwhile. In addition to the usual investing risks they feature such fun things as large legal/regulatory risks, different accounting standards, and simply not knowing what’s really there. They also have a history of shutting down stock markets which we haven’t seen in North America. If there is a safer way to profit from them that could be very attractive.

Emerging markets will put up really big gains now and then, but for something with more transparency and less risk you might be surprised to find that a plain old Canadian index can give you exposure! Conversely you shouldn’t think that you’re diversifying by buying the company the drills the oil and the company that burns it.

It’s not hard to write the story for the connection. It could be as simple as saying that growth in emerging markets fuels demand for commodities, which causes Canadian resource stocks to do well. In fact they may be more closely linked to emerging market GDP growth than actual emerging market stocks. For many reasons GDP in a country does not necessarily translate to profits for public corporations in that country but the misconception may has driven many investment decisions.

It’s not all that simple – as the excellent book Debunkery shows even a small difference in correlation can be used to get added returns – but generally informed investors may be making a mistake similar to someone who doesn’t care about their investments and buys 5 funds covering the same market if they aren’t aware of things like this. Of course this is based on historical correlation (and not even over 10 years) so it’s not guaranteed.

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