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© Copyright 2000 Rogers Media. The following article first appeared in the October 2000 edition of
BENEFITS CANADA magazine.
A world of good
Market forces have much more to do with the increase in global investing among Canadian pension
funds than changes to the Foreign Property Rule.
By Robert Bevan
With much fanfare, Ottawa declared in the last federal budget that it was increasing the foreign property
limit from 20% to 25%, with a further jump to 30% in 2001. So far this move has had a minimal impact on
Canadian pension funds' rate of foreign investment. Indeed, pension funds initiated the trend of increasing
foreign investment long before the federal government formally acknowledged the industry's need.
Pension fund investing has gone global--a trend driven by factors that have far greater impact than
Canadian income tax and foreign property laws. The movement is being driven by changes in the global
economy, which affect pension funds, money managers and both the buy and sell sides of the market.
In Canada, pension funds have traditionally relied on the domestic market as their main source of
investment income. For years this worked well and there were plenty of opportunities at home to generate a
good return. But as Canadian pension investments grew it became apparent that there was an increasing
drought of opportunity in the domestic equity market.
Pension funds were forced to acquire increasingly larger percentages of companies regarded as good
investments. And as money managers accumulated greater stakes in corporations, these interests could no
longer be considered merely as portfolio investments.
Money managers became significant shareholders in corporations and their own fortunes, and those of the
companies they controlled, became intertwined. The era of the activist shareholder took hold as pension
funds took a greater interest in the affairs of issuers. They began voting at shareholder meetings,
changing management, vetoing proposed transactions, even taking part in the pricing of new issues.
During this period, pension funds became aware of just how thin the Canadian market really was. Some
industries were simply not widely available. When they were, the pickings were slim. It became apparent
that the Toronto Stock Exchange (TSE) 300 composite index was not merely a sample of the stocks traded on
this exchange, but represented virtually all of the companies.
While other indexes like the Standard & Poor's (S&P) 500 and Morgan Stanley Capital International
EAFE are representative samples of their respective markets, the TSE 300 is simply the 300 largest
companies (by market float) traded on that exchange. Of those, only the largest 100 afforded the liquidity
required by all but the smaller, specialty managers.
The Canadian market is not only thin in that there are few companies traded, it also doesn't have the
breadth of industries that other countries offer (see "Comparing indexes," page 55). Many of the industry
groups offered by the U.S. market such as healthcare, retail and electrical equipment are either not
available here or are under-represented.
The Canadian market is also small. The total value of the TSE 300 was $940 billion at the end of June 2000.
In contrast, the total value of the S&P 500 at the same time was US$12.5 trillion. The market value of
the median company on the S&P 500 is roughly US$8 billion, whereas the median TSE company market value
is only $700 million.
The TSE 300's deficiencies were glaringly exposed last year when one of its most successful names, Nortel,
grew to represent over 32% of the index at the end of June.
The preponderance of Nortel in the Canadian market makes it more difficult to prudently diversify a
Canadian fund. Simply holding the market weight in Nortel would mean that more than 12% of a fund would be
in one stock if only 40% of that fund were invested in Canadian equities. Investments could exceed
statutory requirements for diversification under Canadian pension legislation (see "Prudent
diversification," below).
Holding a portfolio in which one name is so dominant changes the pattern of returns that the fund can
expect from a Canadian equity portfolio.
Pension funds that thought their asset mix was on the efficient frontier may find that the new Canadian
market has increased the volatility of their domestic equity returns without any increase in the expected
level of those returns.
Historically, larger funds have looked at other asset classes for diversification. More recently though
funds of all sizes are looking to foreign markets. Faced with the statutory limits on foreign content the
industry created synthetic foreign exposure using various means to comply with the regulations but give
them the foreign exposure they required.
Today, several Canadian money managers offer pooled funds which provide synthetic exposure to various
global equity markets without breaking tax limits.
Typically, synthetic funds provide returns based on foreign market indexes. However, active managers have
recently been able to structure arrangements that give the investor access to the returns of actively
managed foreign portfolios, with the goal of providing them with some added value over the bare index
return.
The strength of the global imperative is demonstrated by the fact that even after the federal government
raised foreign property limits there has been no flow of capital out of these funds. There likely won't be
any movement until the limits are raised considerably beyond 30%.
MANAGER EVOLUTION
The raising of the investment horizon on the part of pension funds has forced money managers to evolve.
Canadian money managers have had to develop or acquire international expertise. Until now, these managers
would simply add staff to offer either U.S. and/or international equity products.
Today, the international market itself has changed. Organizations have merged, acquired new entities and
expanded their businesses into international markets, and are competing on a world scale. Many corporations
have also gone global in their search for capital and listed their securities outside Canada. Of the 300
companies in the TSE 300 index, 142 to date are also listed in the U.S. More than three-quarters (78%) of
the TSE 300's market capitalization can be obtained on either the New York or American stock exchanges or
on Nasdaq.
Canadian companies with stocks on the TSE can now only be fully evaluated in the context of their global
competitors. Nortel, for instance, must be judged by the standards of Cisco and Lucent.
In large part, foreign investors drive the price of Canadian stocks. Once these analysts focus on a
Canadian company they can create more than enough pressure to push the price of the stock up or down.
In this environment, it's virtually impossible to accurately evaluate Canadian-listed stocks solely in
terms of other Canadian companies in the domestic market. For Canadian money managers, simply having a U.S.
or global investment team is no longer sufficient. The analysts must expand their horizons along with the
market.
They now have to focus on international industry sectors as opposed to simply small, non-representative
sub-sets of companies in a particular sector with stocks on the TSE. Indeed, money managers will have to
understand what impact changes in foreign economies have on the Canadian-listed companies that conduct
business in those countries.
While many successful Canadian money managers were once able to add value in a universe that consisted of a
cozy group of 60 to 100 stocks, they are rapidly learning that in the global universe their resources are
no longer adequate. The days of the Canadian equity manager with two or three investment professionals are
numbered. In addition, Canadian-based firms will have to increase their resources to compete with more
globally- oriented firms. In this light, the recent stream of mergers and acquisitions is likely to
continue.
The firms that will succeed in the new borderless world are those that integrate their investment staff
into global teams, realize that the Canadian market is rapidly being absorbed into the global economy,
assess the impact of foreign economies on Canadian-listed companies and evaluate Canadian-listed companies
against their global competitors.
Robert Bevan is a consultant with Towers Perrin in Toronto. bevar@towers.com.
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