There have been no limits on foreign content in Canadian pension plans for the last two years, but few pension funds have made significant changes to their international holdings.
Yet the universal mantra is that Canada represents only 3% of the world, and in order to manage risk, investments should be diversified.
Investment Insider recently sat down with Phillips, Hager & North's Vice President and Chief Economist Patricia Croft to discuss why the majority of Canadian pension funds currently have "a home-country bias" and reasons why it may be the right time for them to revisit their asset allocation strategies.
Investment Insider: Patricia, in terms of diversification or risk management, how important is it for pension funds to invest in non-Canadian investments, and global equities in particular?
Croft: Certainly all the historical evidence shows that Canadian investors can expect to get a higher rate of return and/or less risk by increasing their holdings of foreign securities. And yet, what's quite remarkable is that since the foreign property rule was eliminated back in 2005, we certainly haven't seen that rush to the exits by institutional investors.
Investment Insider: That certainly confirms data we've seen from a number of sources.
Croft: I think the reality is that for the last four years, the place to be in terms of investment returns and opportunities has been in Canada.
Although we have had a lot of volatility in world capital markets over the course of August and into September, if you look at the four-year period ending August 2007, the compound annual rate of return if you invested in Canadian equities was 19.4%.
Now, if you had taken those same dollars and invested them in the MSCI World Index in Canadian-dollar terms, your return would have been 9%. And if you had gone into the U.S. market and the S&P 500 Index, again in Canadian-dollar terms, the compound annual rate of return drops to just 4.5%.
So that's a huge advantage to having maintained investments in the Canadian marketplace over the last four years.
Investment Insider: Do you think these were conscious and wise decisions by investment managers or in some cases have they have just benefited from inertia?
Croft: Well, it might have been inertia, but it turned out to be a good call. Actually, it has something to do with what is called "home-country bias." In fact, many investors around the world tend to have the bulk of their assets in the domestic market, and a lot of that just comes down to comfort.
But the other reality is just the performance issue, which is a significant reason why institutional investors are keeping a lot of those assets in the Canadian market.
Investment Insider: Other survey data that I've seen says over half of DB plans are expected to change their Canadian equity allocations within the next two years. Do you believe this will actually occur, or will the home-country bias continue to prevail?
Croft: I think it is a very interesting time for investors to be looking at that very question.
We've had a heck of a run in the global equity markets, led by the performance in Canada and in emerging markets as well, so I think a lot of people are now asking: How long can this bull market continue? We've done a lot of work on the question of what is the optimal foreign content for a DB plan and the answer, unfortunately, is, "it depends".
There is no "one-size-fit- all" answer with regard to foreign content — or hedging, which we'll talk about later on.
It also depends very much on your risk tolerance and, of course, your plan's funding status and other factors as well.
Investment Insider: Where do you think some of the money might go if institutional investors start increasing their foreign holdings?
Croft: In our own balanced fund over the last several years, we have been reducing exposure to Canada. I think the U.S. market in particular is starting to look very attractive on a valuation basis, especially if you look at normalized earnings.
But I also think it may not be a question of geography. If there is a reduction in the allocation of Canadian equities, perhaps where that money will find a home is in the alternative investment category — real estate, infrastructure, private equity and even hedge funds — in spite of problems they have encountered recently.
Investment Insider: What can pension funds do to protect themselves against the negative impact of currency fluctuations on their global investments?
Croft: That's a very timely question now as the Canadian dollar is worth more than the U.S. dollar.
In terms of what pension plans can do, many managers — including ourselves — offer hedged versions of their existing funds, so that's one way you can get around this issue.
The case for hedging is that currencies are extremely difficult to predict. The case against hedging is that over the long run, currencies are mean-reverting and hedging costs money — so why bother? However, by not hedging, you are implicitly taking a position on the Canadian dollar. And our view is taking a position on expected shortterm currency movement is the lowest- quality alpha decision that you can make.
What's a plan to do? Many plans have adopted the 50% hedge — the so-called "path of least regret." With this strategy, you'll end up being half right or half wrong, depending on your perspective.
Investment Insider: We have also seen in the recent subprime crisis that negative events in one market can be contagious and impact markets around the world, to varying degrees. To what extent will global investing actually result in diversification in an era of instant communications?
Croft: I think that's a very good point. The correlation of global equity markets tends to ebb and flow, but I would argue that right now we are in a period where global equity markets are highly correlated — and that's probably part of the broader trend towards globalization.
But again, it may be that in this environment the Canadian market is even riskier. Two-thirds of our market is in just three sectors (financials, materials and energy). So right now being in the very highly concentrated Canadian market late in a bull market could add an additional element of risk to a balanced portfolio.
Investment Insider: Can you give me examples of two or three different markets where returns over the past year have been significantly different, so institutional investors with exposure to these markets may have either hedged their risks or received enhanced returns?
Croft: Well, emerging markets again have had a tremendous run and fared very well in the summer turbulence we saw in the developed markets. The best example is probably China, but I would argue there are some special factors going on in China.
China is often described as a country that will grow old before it grows rich, and that's because of the implications of the one-child policy.
And although they've got an economy that is growing, because real interest rates are still negative everyone seems to be piling into the Chinese stock market instead of putting their money in the bank. It feels a bit like the Tech Bubble in 2000.
Investment Insider: Do you think that elimination of the foreign property limits presents new opportunities for foreign and international managers?
Croft: It could present opportunities. Arguments have been made that you need to be domiciled outside of Canada to do a good job investing in that arena, but I don't think that's necessarily so. In this age of technology and full disclosure, particularly in the U.S., you can have very successful Canadian managers managing global equities.
Investment Insider: What are some of the key factors pension plan sponsors and pension fund trustees should be considering when evaluating and selecting a global investment manager or managers?
Croft: Well, perhaps not just global managers, but any kind of investment manager. Trustees need to do their due diligence before making decisions about who will manage their pension fund investments. Key things to consider are sustainable alpha and the investment process. It should be all about transparency.
Investment Insider: Do you have any other comments you would like to add, based on our discussion generally about the current economic and business climate?
Croft: I think this is the opportune time for people to be thinking about these issues. Again, we've enjoyed excellent rates of return in the last four years in the Canadian marketplace, but the outstanding question is whether we are now at a turning point.
Consider reviewing your asset allocation strategies on a tactical basis and whether it makes sense for your pension fund to increase its allocation to global equities with less cyclical earnings and better valuation opportunities.
Investment Insider: Thanks Patti. It certainly sounds like it may the right time for pension funds to do some cross-border shopping!
