How much Chinese forest land do you own?

How much of your retirement fund have you invested in Chinese trees? You may laugh, but your smile would probably disappear if you looked at the list of companies owned by the mutual funds in your retirement account.

How much of your retirement fund have you invested in Chinese trees?

You may laugh, but your smile would probably disappear if you looked at the list of companies owned by the mutual funds in your retirement account.

You wouldn’t be the only one rifling through your portfolio looking for the dreaded words “Sino-Forest.” Investors in Sino-Forest, a major player in Chinese forestry that is listed on the Toronto exchange, have looked on in horror as their shares fell from over $25 to around $2 in just a few weeks. That’s shaved around 90 per cent of the company’s $5.7-billion value as of last Christmas.

Short-sellers at a firm called Muddy Waters prompted the carnage when they released a report questioning the accuracy of Sino-Forest’s claimed assets in China. This is a big deal, since Sino-Forest said it managed almost a million hectares of Chinese forest. They also say they have rights to purchase wood on another 1.25 to 1.4 million hectares.

Sino-Forest has defended itself vigorously, and none of the allegations have been proven in court. But fresh Sino-Forest press releases and hastily translated Chinese documents on the company’s website have not calmed the markets.

Renowned investor John Paulson dumped his entire stake in the company, costing him a reported $750 million loss.

What do Chinese forests and unhappy hedge fund billionaires have to do with regular savers here in the Yukon?

Unfortunately for many investors, Sino-Forest was big enough to get into the S&P/TSX Composite index. This is the successor to the well-known TSE 300, which means many Canadian investors will have ended up owning Sino-Forest indirectly. In fact, as of last March Sino-Forest had a bigger place in the index than household names such as Canadian Tire, Loblaw and Westjet.

The managers of many pension and mutual funds buy the stocks in such indexes, not least because their performances are compared against them. Until last month, any fund manager who ignored Sino-Forest would have suffered against competitors. The company’s annual report for 2010 trumpeted the fact that Sino-Forest’s share price had outperformed the S&P/TSX Composite by 303 per cent in the previous five years.

Popular, low-cost index funds offered by the country’s biggest fund families and exchange-traded funds such as iShares’ popular $1.4 billion Canadian Capped Composite Index Fund would also have included Sino-Forest, since they automatically buy all the stocks in the index in proportion to their size.

The damage done may have been in the billions, but fortunately it wasn’t huge on a percentage basis. On March 31, Sino-Forest made up 0.38 per cent of the S&P/TSX Composite Index. Even if it ends up being a total loss, it would only vapourize $3.80 on a $1,000 investment in an index-tracking fund.

You would have been hit harder by the fall in Research in Motion (RIM). RIM was 1.55 per cent of the index in March, and its problems have vapourized about $10 billion in shareholder value since then. That’s around double the pain that Sino-Forest has caused.

Nonetheless, the Sino-Forest incident is troubling. How could an obscure company whose business is to buy and sell forests in distant provinces of China have made it into our pension funds? The 2010 annual report says it made money by buying trees for $45 per cubic metre and selling them for $79, mostly in China. Didn’t this strike any of our highly paid fund managers and equity analysts as an improbable business model?

Have our fund managers also got our savings invested in companies that sell swampland in Florida?

The episode illustrates two long-standing problems with Canadian investing.

The first is the relative small size of our stock market. Compared to London or New York, we just don’t have that many companies. Once you get out of the top 100, you get into some companies that are little known and by global standards are quite small. Companies like Flint Energy Services and CML Healthcare. Fine companies perhaps, but I have to admit I have never heard of either of them.

Index funds reduce risk by giving you diversification, but that isn’t so helpful if the smaller companies you’ve diversified into are quite risky.

This is one of the reasons why they have created the more concentrated S&P/TSX 60. But that doesn’t solve the problem if you were involved with one of the many funds who tracked the broader S&P/TSX Composite.

The second problem is how accident prone our capital markets seem to be. We had the Bre-X scandal in the 1990s, where the company’s Indonesian gold reserves ended up being much smaller than claimed. Many Canadian investors lost their shirts amid a welter of fraud allegations.

Then there was Nortel. As the bubble inflated in 2000 and 2001, the company got so big that at one point it represented around one-third of the S&P/TSX Composite. As a result, risk-averse investors who thought they were investing conservatively ended up owning a large concentration of what turned out to be a highly risky tech company.

A joke a few years later went like this: what was a better investment, $1000 of Nortel or $1000 of beer? The punch line was “beer, since at least you get the bottle deposit back.”

Sadly, the joke was right.

After the Nortel debacle, they invented “capped” index funds that put limits on how big a single company can get.

Unfortunately, the Sino-Forest implosion illustrates that conservative Canadian investors still need to be cautious. Sino-Forest was in the index. It had “buy” recommendations from equity analysts at respectable firms. And if regulators had any worries about the company, this investor didn’t hear about it.

It’s a reminder that the investor trusts the investment establishment in Canada at his or her peril. “Buyer beware” should be every investor’s motto.

Keith Halliday is a Yukon economist and author of the Aurore of the Yukon series of historical children’s adventure novels.