Market Matters

Market insights from the portfolio management team at Seven Hills Capital Corp.

Market Matters – October 15, 2024

Absolute Returns vs. Diversified Portfolios

Our Portfolio Management Team recently had a spirited discussion on how to best present market data to our clients. The goal of *Market Matters* is not just to inform, but to educate our clients on relevant investment and economic news and explain how it shapes our portfolio management decisions. With more than 1,100 ETFs currently trading in Canada, our job as active money managers is to sift through this investment minefield and select “best-in-class” ETFs. We marry this with a tactical asset allocation strategy to construct model portfolios that align with our clients’ risk-return profiles and help achieve their long-term financial goals.

Most typical investment newsletters showcase tables highlighting the absolute returns of major market indices over various time periods—day, month, year-to-date, or 12-month returns. However, we believe presenting data in this way poses two problems:

1. This data is widely available elsewhere, and at Seven Hills, we pride ourselves on adding value rather than repeating easily accessible information.

2. Absolute return figures from major indices can be misleading without context, especially when compared to a client’s specific portfolio.

Let’s dive into why context matters and how relying on absolute returns without considering broader factors can mislead even seasoned investors.

A Look at Absolute Returns

The allure of absolute returns from index-tracking ETFs such as QQQ (Nasdaq 100), SPY (S&P 500), DIA (Dow Jones Industrial Average), and XIU (S&P/TSX 60) is hard to deny, especially in the bull market of the past decade. QQQ, for instance, has averaged an impressive annual return of 18.5%. But this performance is largely due to its heavy exposure to technology stocks like Apple, Microsoft, and Nvidia, which together account for nearly 25% of the index. The meteoric rise of these tech giants mirrors the broader shift toward a digital economy fueled by cloud computing, e-commerce, and AI.

However, the first lesson in prudent portfolio management is diversification—what we call the “golden rule” of investing. Concentrating too heavily on specific sectors, no matter how successful they seem, introduces *non-systematic* risk (risk tied to individual companies or industries). Think of it like having all your eggs in one basket. Any economic shock—whether it’s tariffs, supply chain disruptions, or regulatory changes—could send the entire basket crashing.

Diversified Returns: A Broader Perspective

A diversified portfolio, by comparison, spreads risk across various sectors and asset classes. Consider SPY, which tracks the broader S&P 500 and provided an average annual return of 13.8% over the last decade. It’s more diversified than QQQ, with significant exposure to technology (36%), but also financials (15%), consumer services (12%), and healthcare (11%). Yet even SPY isn’t immune to concentration risk: technology and financials alone account for more than half of the index’s weight.

The Dow Jones Industrial Average (DIA), with its focus on 30 blue-chip stocks, returned a more modest 12.0% annually, reflecting its more conservative, stable approach. Meanwhile, XIU, tracking Canada’s largest companies, lagged with an 8.5% annual return. This is due in part to its higher concentration in financials (36%) and energy (18%)—sectors that often lack the explosive growth of U.S. technology stocks. It’s also worth noting that Canada’s equity market represents only about 3% of the global investable universe.

Cumulative Returns of SPY, QQQ, DIA, XIU (2014-2024): This line chart illustrates the growth of a hypothetical $100 investment in each of the four ETFs over the past decade.

Source: Yahoo Finance, Bloomberg, Morningstar

The Importance of Risk: Absolute Returns Aren’t the Full Picture

While absolute returns grab headlines, the hidden factor is often risk. Higher returns almost always come with higher volatility. For instance, QQQ’s tech-heavy exposure made it highly susceptible to market swings. During the 2022 correction, QQQ lost nearly 30% as rising interest rates hit growth stocks particularly hard. Similarly, SPY and DIA saw drawdowns of around 20% during the same period, reflecting inflation concerns and central bank tightening. XIU, tied closely to commodity prices, is vulnerable to swings in oil and metal markets.

This brings us to a key point: a portfolio based entirely on equities is rarely suitable for long-term wealth building. The volatility of equity markets can lead to severe drawdowns, especially during economic downturns.

The Role of Fixed Income: The Bedrock of Stability

While discussing absolute returns, we must remember that clients rarely hold portfolios composed purely of equities. Fixed income investments—such as bonds, GICs, and preferred shares—are critical in managing risk and volatility. Historically, a balanced portfolio, with 60% in equities and 40% in fixed income, has provided average annual returns of 8.4% with far less volatility than a portfolio composed solely of index-tracking ETFs like QQQ or SPY.

A well-diversified portfolio that includes bonds acts as a buffer during market corrections. Bonds help preserve capital, reduce overall portfolio volatility, and provide peace of mind during equity downturns. Think of it like a seatbelt—you might not need it when the ride is smooth, but when turbulence hits, you’ll be glad it’s there.

Risk vs. Return: SPY, QQQ, DIA, XIU vs. Diversified Portfolio: This scatter plot compares the risk (measured by standard deviation) and average annual return of the four ETFs and a 60/40 diversified portfolio.

Source: Yahoo Finance, Morningstar, Bloomberg

Diversification: The Key to Long-Term Success

Beyond bonds, including international equities, commodities, real estate, and even alternative assets such as private equity or infrastructure can enhance risk-adjusted returns. Canada’s XIU, for instance, offers some diversification benefits due to its lower correlation with U.S. technology-driven indices like QQQ. By diversifying beyond U.S. equities, investors reduce the concentration risks tied to specific sectors or geographies.

Key Takeaways

While the allure of high returns from major indices is undeniable, a diversified portfolio remains the cornerstone of long-term wealth accumulation. Relying solely on absolute returns ignores key factors like concentration risk, volatility, and sensitivity to broader market conditions.

At Seven Hills, our approach goes beyond tracking indices. We’re committed to building portfolios that allow clients to benefit from market growth while managing downside risk. Our focus is on creating tailored solutions that reflect each client’s unique risk tolerance, investment goals, and time horizon. With a disciplined, diversified strategy, we aim to help you achieve long-term financial success—while also sleeping soundly through market storms.

We help our clients navigate complex financial landscapes, ensuring their success and peace of mind.