XIU: Canada's Market Lags The United States For Good Reason, But It Won't Last Forever

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The iShares S&P/TSX 60 Index ETF has drastically underperformed the SPDR S&P 500 ETF Trust over the last 10 years.As the commodity sector comes into focus and the technology sector cools, I expect XIU...

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I see early signs that make me optimistic that it can happen.   Jordan FeegThe aptly named iShares S&P/TSX 60 Index ETF (XIU:CA) is the ETF that tracks the TSX 60, the largest index in Canada. While a 13% gain over the last year is nothing to sneeze at, the index badly lags the performance of the SPDR S&P 500 ETF Trust (SPY). Data by YChartsThis is not too much different than the historical trend as Canada's market performance has lagged the United States, especially over the last 10 years. Data by YCharts XIU has a superior yield of 3.1% compared to 1.3% for SPY, so distributions do account for some of the discrepancy in capital gains. The trailing P/E on XIU is 13.7x, barely half of the trailing P/E on SPY of 26.3x. I believe that this relative underperformance and comparatively low valuation on XIU can be summarized in three different reasons: 1. Relative weighting of technology within the U.S. and Canadian markets. 2. Canada's aggressively valued real estate market. 3. The tendency of Canadian investors to invest in U.S. listed and other international investments. I will dive into these reasons and why I think it might not necessarily hold true going forward. Reason #1: Relative weighting of technology within the U.S. and Canadian markets A comprehensive list of the TSX 60 can be found here. The index is heavily weighted in banks and insurance, utilities and telecom, oil and gas and mining. Technology makes up just 10% of the index, while the percentage allocation to tech within SPY is over three times higher. Of the 60 listings within XIU, Shopify Inc. (SHOP) is the only one that I would consider to be high beta in a similar way to the FAANG stocks. Anyone can look at the price performance by sector over the last year and figure out that indices have been buoyed by AI speculative hype. The financial sector makes up by far the largest component of the XIU at 35%. This includes all of Canada's \"Big Five\" banks, as well as insurance companies Manulife Financial Corporation (MFC) and Sun Life Financial Inc. (SLF). If we compare just the financial focused iShares S&P/TSX Capped Financials Index ETF (XFN:CA) to the U.S. counterpart Financial Select Sector SPDR Fund (XLF), we see that the Canadian financial sector has vastly outperformed: Data by YChartsWithout the contribution of the financial sector, there would have been hardly any growth in the XIU at all over the last ten years. A significant part of the drag has come from the mining and oil and gas sectors. Despite the price of gold being at nominal all-time highs, the demand for critical minerals remaining robust and the price of oil being above $80 per barrel. The next two charts display the price performance of six gold and base metals mining companies and six related to oil and gas production and distribution on the TSX 60. Five of these twelve companies have negative price performances over the last ten years. Data by YChartsData by YChartsBasic materials make up 8% of XIU and only 2% of SPY. Energy makes up 17% of the XIU and only 4% of SPY. Looking at those numbers in the context of the two charts above and then comparing them to the performance of the FAANG stocks, and it becomes obvious why XIU has lagged its U.S. counterpart. However, Canada is the capital of the world in terms of mining listings on its stock market and mining potential. I have a strong opinion of the electric vehicle industry. Critical metals are going to be needed if carbon emissions are to be reduced and it will need to be an \"all hands on deck\" approach. This will result in investment dollars flowing into Canada. In the meantime, the oil industry isn't going anywhere until the output and efficiency of renewables is significantly improved and governments take the green energy initiative seriously by looking at increasing nuclear power generating capacity. Couple that with a cooling off period in the tech sector, and I believe that investors can expect the XIU to close some of the performance gap with SPY in the near-term. However, the country can't just rely on being a resource extractor if it wants long-term economic success. It needs to foster innovation and growth to a much greater degree than it has. Technology and innovation are by their very nature going to be drivers of superior long-term growth for a country. One issue that stifles growth and innovation in Canada is that it doesn't have an interconnected technology incubator system like Silicon Valley. The good news is that I think this issue is slowly improving in the country. Being on the frontlines of the startup and microcap investment community in Ontario, I am starting to see more entrepreneurship and interesting ideas from young people out of university. Data shows that entrepreneurial sentiment remains strong despite worries over financing and cash flow while small businesses are leveraging technology to keep costs under control. I am personally involved with trying to improve the situation in Canada by exploring ways to make the incubator process seamless and I am optimistic that it will indeed improve. However, these types of grassroots movements will take at least 5 to 10 years before having an impact on the broader Canadian economy and XIU. There is another issue impacting Canada's productivity and ability to innovate within its economy. The \"brain drain\" of high performing tech graduates to the United States. Higher salaries and often lower cost of living in the U.S. offer Canada's tech graduates a very tempting lifestyle that just can't be had in Canada. If this brain drain is not slowed to a trickle, Canada will always have an uphill battle in matching per capita productivity and economic indicators as the U.S. That leads me to the next section. Reason #2: Canada's aggressively valued real estate market Largely thanks to policies undertaken by various levels of government that have had the effect of propping up demand and limiting supply of housing in Canada, the country's real estate market has gotten out of control. Expensive prices that used to be the domain of mainly the largest metropolitan areas have now spread across most of the country. Real estate has blown up to become over 20% of the country's GDP. This has resulted in an entire generation of young people being unable to afford their own home, exasperating the brain drain mentioned above. The real estate market has also sucked money out of the country's stock market, with 87% of Canadian investors preferring real estate over stocks. Portfolio theory state that investors will maximize returns at a given level of risk. The real estate market has almost seemed risk free, where investors have been able to buy up housing and collect rental income, while having little variance to the downside on the value of the housing but with plenty of variance to the upside. The Federal Liberal government is getting eviscerated at the polls - especially with voters under the age of 50 - it is starting to act on the housing affordability crisis. Supply side actions include more incentives to build while demand side actions include limits to immigration and changes to the international student process. The Conservatives, who are slated to easily win the next Federal election, have made housing affordability a key talking point. Though given that an election is estimated to be over a year away, details have so far been scant. Local governments are also fighting back on housing affordability and standard of living issues within their jurisdiction. The City of Brampton is launching a rental licensing pilot that will put greater oversight on landlords and curb illegal lodging. This pilot created a large outcry from the city's small landlords. If more cities enact these type of policies, that formerly riskless real estate investment strategy becomes riskier and more tedious. Investors will find other ways to make money than being landlords, or in many unfortunate cases, slumlords. The stock market will become relatively more attractive as people will realize that they need to undertake some level of risk in order to get a decent return. Policies to cool off the housing and rental market will also have a positive impact in slowing the brain drain as cost of living in Canada for young people will become more reasonable. XIU components would be the first to benefit from a movement from real estate into the Canadian stock market. A transition from real estate into index funds as well as into Canada's banks and utilities would be a more likely fit for real estate investors who are forced higher on the investment risk curve than penny stocks or even high flying U.S.-listed technology stocks. A drop in the real estate market would cause the banks to take a hit on their mortgage lending businesses. However, that trend has already begun and the banks have managed to weather that storm so far. Banks being encouraged to use more of their capacity for loans on business rather than real estate lending will have a further positive impact on the economy. Reason #3: The tendency of Canadian investors to invest in U.S. listed and other international investments In an open letter from investment management firm Letko Brosseau, there was a statistic revealed that was absolutely wild to me. Canadian Pension Funds have reduced their holdings of publicly traded Canadian companies from 28% of total assets at the end of 2000 to less than 4% at the end of 2023. The eight largest pension funds in Canada now invest more in China than they do in Canada. Canada has approximately 2% of the world's GDP. So one could argue that these funds still over-allocate to Canada at a global level, but not by much. Trends like this will stifle the growth potential of the TSX if they continue. Individual Canadian investors and retail traders have equal access to U.S. listings as they do Canadian, and most certainly take advantage of it. If investors take money out of Canadian real estate and put it into U.S. stocks, that might cool off the housing market but it won't do much for Canada's broad stock market indices and XIU. This letter was part of a larger campaign to push the Canadian government to amend rules governing pension funds to encourage more Canadian investment. It was signed by the top executives of several TSX 60 component listings including Rogers Communications Inc. (RCI), TELUS Corporation (TU), National Bank of Canada (NA:CA) and Metro Inc. (MRU:CA). These executives know that any increase in pension fund investment into Canadian equities will start with their equities. Just like real estate investors, pension funds would focus their investment dollars on TSX 60 component companies first. So one would expect XIU to be a direct benefactor of any government policy change. Rather than being an impossible hurdle to overcome, I view the hesitancy to invest domestically as more of a feedback loop with the other issues I mentioned. If commodities turn into a sector bull, money will flow back into Canada. If Canada can solve its brain drain and lagging tech industry (with housing affordability being part of the solution), then investors will want to invest here. I don't see how investment in Canada by pension funds can get much lower than 4% of total AUM. So if we are already at a trough, it can only go up from here. Conclusion I expect mining to outperform technology in the near-term. As XIU is relatively overweighted to mining and underweighted to tech compared to SPY, this will cause it to close some of the gap. In the longer term, I am optimistic that Canada's tech sector will become more robust as I see positive signs at the startup and university graduate level. Technology and productivity must improve if XIU is going to compete with the performance of SPY going forward. The period of easy money that has been made in Canada's real estate market thanks to government policies and the macro environment may soon be coming to an end. As investment in real estate no longer becomes \"risk free\", I expect money to flow out of that sector and into the stock market. That money could flow to international rather than domestic investment, but if the country shows itself to be a preferred destination for those dollars through a commodities super-cycle and improving productivity, this issue can be overcome.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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