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© Copyright 2000 Rogers Media. The following article first appeared in the March 2001 edition of
BENEFITS CANADA magazine.
International Investment: 2001 and Beyond
There are three key trends impacting Canadian pension fund investment. Globalization, globalization
and globalization.
Moderated by Kevin Press
INTERNATIONAL INVESTMENT ROUNDTABLE (left to right): Peter Muldowney, Towers Perrin; Denis Larose, William
M. Mercer Limited; Eric Kirzner, University of Toronto; Barbara Palk, TD Asset Management; Pierre Lussier,
Caisse de dépôt et placement du Québec; and Paul Owens, Colleges of Applied Arts and
Technology (CAAT) Pension Plan.
Home country bias? Get over it.
The message is clear for Canadian pension fund managers. Your historic preference for home-based investment
options will not serve you well going forward. Canada's foreign property limit has risen to 30%. Derivative
use continues to grow increasingly widespread. And the global economy is hiding behind fewer and fewer
trade barriers.
The world is your oyster. But with that increased opportunity comes extraordinary challenges for pension
fund asset managers. Japan is still in the doldrums. The Morgan Stanley Capital International (MSCI)
indexes are about to shift their weighting more heavily toward the U.S. And, truth be told, too many
derivative investment instruments are still too complicated for pension fund fiduciaries to properly
evaluate.
benefits canada's 13th annual roundtable assembles six leading Canadian investment professionals to help
put the international challenge into perspective for pension fund sponsors in this country. Eric Kirzner is
a professor of finance and director of the executive MBA program at the Rotman School of Management,
University of Toronto. Denis Larose is with William M. Mercer Limited in Toronto. Pierre Lussier is
vice-president, strategic management of asset mix at the Caisse de dépôt et placement du
Québec in Montreal. Peter Muldowney is a principal with Towers Perrin in Toronto. Paul Owens is plan
manager and chief executive officer of the Colleges of Applied Arts and Technology Pension Plan in
Mississauga, Ont. And Barbara Palk is vice-chair at TD Asset Management Inc. in Toronto.
The consensus around the table on the near-term economy was one of "cautious optimism." Despite recession
fears in the U.S. and Canada, the fundamentals remain strong.
Barbara Palk: We've got an accommodative U.S. Federal Reserve and a new Bank of Canada chief, who I think
is going to be accommodative. In both cases, we're going to see interest rates coming down. That's a very
good sign for the economy. Coupled with that, we have some good fiscal news in terms of tax cuts. All of
those things put the stock market and the bond market on a pretty good footing going forward.
Paul Owens: The days of the euphoric 1980s and early 1990s--when we had the long-term decline in bond rates
which generated a lot of real returns for bond portfolios--are largely behind us. We're at a stage now of
relatively permanent low interest rates for a bond portfolio. We're probably faced with lowering discount
rates this year, hence higher and higher liabilities. Hopefully, then we can see some stability in the bond
market so that it generates a reasonably predictable return.
Eric Kirzner: That is not stressed enough in the press. Commentators like to talk about the benign interest
rate environment--low interest rates--and how that can be constructive for bonds. But once you've already
established a low interest rate level, if interest rates remain low, you've got low reinvestment on the
coupons as they come in. That has a depressing effect on overall bond returns.
Pierre Lussier: We're in a significant slowdown. Nobody forecast that. But the bond market has been
anticipating a lot of that. So in the future I think it may be risky to be very long on the bond side,
since we figure that the growth of the economy will pick up within the next 12 to 18 months. The long-term
rates are going down so it will strengthen a bit of the economy too.
Kirzner: The bond market has become extremely complex. A pension manager has to take an active approach.
You've got the structural effect of low interest rates and the implications for reinvestment. Even though
quality spreads have come down from their absolute highs, they are still very high compared to historic
records. Hence underwriting skills and credit analysis has become a key factor. It would seem to me that a
pension manager can no longer rely on standard asset class returns in the bond category, but has to take an
extremely active approach in this environment. I'm slightly less optimistic about the equity market. So,
one of the real value add-ons for managers is going to be on the bond side, and understanding the whole
spectrum of bonds available internationally.
Palk: The time to really look at your bond portfolio in particular and use what we call the core satellite
approach is truly upon us. We've had a number of people historically who have said "forget it, we're just
going to index the entire bond portfolio." While that has worked for some, and may still work for some,
there are opportunities. High-yield is one. We don't have much of a high-yield bond market in Canada, but
there is a very deep one in the U.S. If the opportunity is there, from a pricing perspective for an active
manager to add value in high-yield, that might be a way to capture some foreign content.
Kirzner: My choice would be the index once I've chosen to go high-yield. I've talked to a couple of
high-yield managers, and they talk about numbers that are enormous, like 250 issues in order to diversify
in the high-yield category.
Kevin Press: Larry Lunn, of Connor, Clark & Lunn Investment Management in Vancouver, put forward the
theory in the "Top 40 Money Managers Report" in our November 2000 issue that active management outperforms
when markets broaden. We saw this as technology stock prices came down.
Palk: I think Larry may be right for a one- or two-year horizon, depending upon the asset class. But the
consistency of active managers as a group, across all asset classes, to be able to outperform is
statistically not there. So it behooves plan sponsors to revisit the question, revisit the proportion of
active and passive management that they want. Maybe what they had over the last two or three years has not
been enough, or maybe it's been too much. Just as one must re-evaluate his or her assets on a regular
basis, I think we have to re-evaluate the percentage of active and passive within our portfolio. Almost
without question, in the efficient markets there is room for some portion of passive management.
Peter Muldowney: You can't generalize. When we look at the whole issue we look at opportunities in the
various asset classes. What's different today is you have to be active about accessing the index. We all
went through an incredible period during which Nortel was such a dominant force. We could see the stock
concentration issue hitting every local market index except the U.S. What do I see going forward? For
Canada, and many other parts of the world, we'll have more of a global approach to equity investing.
Owens: We have reversed our domestic/foreign equity ratio in our asset mix policy. We're going to be
ultimately 40% foreign, 25% domestic, which is virtually a reversal of our original policy five years ago.
It's done along the basis of risk analysis. To have two-thirds of your equity portfolio concentrated in a
place like Canada, you're taking a very serious risk bet, in terms of a lack of diversification. The debate
on the active/passive issue has unfortunately produced more of a polarization than reflective thought in
terms of people being labeled proponents of one versus the other--as opposed to saying both are tools that
a plan sponsor can use in terms of risk tolerance. It goes back to what Barbara was saying, in terms of the
efficiency of the markets. Our view is that where the markets are efficient, then there's a good case to
have a passive component.
Denis Larose: I think the Canadian equity market is challenged going forward. Nortel is one issue. But
we're losing our blue chip companies. Imagine a couple of mergers with banks and insurance companies, and
what do we have? The TSE is a very top-heavy index. I think we might see globalization drive the large cap
performance. Maybe we have to distinguish by capitalization as opposed to by local markets. I think there's
room for Canada, but it's recasting itself. Canadian companies are competing on the global scene, and maybe
the investment philosophy of institutional investors should embrace that because that's how we're going to
build up portfolios.
Owens: The Nortel issue finally brought home to a lot of plan sponsors in this country that Canada is not a
miniature U.S. We are like the smaller European countries that are dominated by one or two stocks. I think
that was the catalyst that started to shift a number of sponsors in terms of their equity mix. We started
to say "my God, the TSE is not a little S&P. It's more like the Austrian, the Belgium, the Swiss, the
Finnish markets, dominated by a few big players." That changes psychology.
EUROPE PROVIDES OPPORTUNITIES
Owens: The euro will be a meaningful currency but I don't see it appreciating all that much. I think the
miracle in Europe is that they've been able to take 11 very different countries and build some type of
working economic structure. But it's nothing akin to the U.S. where you have a common economic structure, a
common political structure. We've changed our thinking [in Europe], where we use to invest by country. The
euro forced us to look at Europe as an entity, and now we're looking at companies in industries. Countries
tend to be a byproduct. There's been a major paradigm shift in our view as a sponsor. We're not saying "so
much goes to Italy and so much goes to Belgium." We're now saying "let's look at the electronics industry,
some of which may be located in the Netherlands, some of it in Switzerland." Europe provides a lot of
opportunities. The big multinationals are going to go through a significant restructuring, which we saw
happen in the States in the last decade. I think Europe is going to become more competitive.
Larose: That pretty much echoes what we've seen. There is lots of room for rationalization, which I think
is going to be a big driver. The reason is the low euro, and relatively small dependency on the U.S.
economy. That holds well for Europe. As well, globalization is changing how institutional investors look at
the world. As a region, I think it has potential in the next year.
Palk: It's important to look at the very long term when you look at Europe. We are seeing a structural
shift in the way money managers think. What used to be a country call is now becoming a sector call. If
they are interested in telecom, then they're not just going to stop at France or Germany. They're going to
look at the U.S., Canada, Japan and Europe. And then they make more of a sector call than they do an
individual country call. Certainly more so than a stock call. That's a good thing, but it's a long process.
It's not something that can change overnight. The index providers are finding that this is something that
they have to get their heads wrapped around too. We're seeing a difference in the way indexes are
constructed--particularly with the massive shift that will probably occur this year and next year in the
way the MSCI indexes are constructed.
Kirzner: I see this a little bit differently. I've been bullish on Europe for a very long time. I think I
would be concerned about making too strong a strictly sector play.
If I was talking to a pension fund, I would want to have a portion of my investment in an indexed core,
such as the Morgan Stanley Capital International Europe index. I would make the sector overlays for the
sector plays as well. I don't think I would go strictly with a sector play. I heard an interesting comment
from an economist--the euro will probably last, but the European Union may not. With all the political
differences that exist, it could one day break up. But a lot of people have committed to the euro. They've
actually seen the benefits of a single currency.
Lussier: The other thing we have to keep in mind concerning Europe and the euro is the quality of the other
countries in the European Union, the have-not countries. What will they do to the euro?
Kirzner: I don't see the European Union falling apart. There may be realignments. Countries may leave. But
ultimately, you've got a central bank that has to try to manage monetary policy on an integrated basis.
There are rich and fascinating cultural and social events that are involved in all of this that we have to
pay attention to, but I'm pretty optimistic.
Palk:Labour mobility is a key ingredient to the success of the euro-zone. And it's probably a fairly key
ingredient to the success of Canada. In both cases, it is not something that either area has embraced as
the United States has. It's nothing for somebody in San Francisco to pick up and move to New York because
the job opportunity is better for him or her in that place. There isn't that same psychology in the
Canadian or euro-land marketplace.
THE OUTLOOK FOR ASIA
Owens:You have some strength in certain areas of Asia, and I think you have some structural weaknesses and
impediments. Personally, I think Japan has a lot of rigidities and a lot of problems. And I don't think
that they will solve them in the short term. But I think places like China, Hong Kong, Singapore and
Australia have much greater opportunity.
Muldowney: An interesting comment that I heard about Japan was, "it's been bad for so long that it's a
smaller piece of the portfolio." So why worry about it? It's going to keep doing what it's doing, which
isn't a lot.
Palk: A number of people have been badly burned because of the Asian flu. It's making them reticent about
wanting to jump back in. It's a complex world, particularly when you've got good news facing you south of
the border, in your own country, Europe and the U.K. How deep do you have to get into Asia to complement
your portfolio? People are doing it to a degree, but they're not getting bullish.
Larose: We've seen managers invest in Japanese companies that have international competitive advantages.
The domestic economy in Japan is inefficient. It's not going anywhere. Outside of Japan, there seems to be
a lot of good things happening.
Muldowney: Things are happening, but it's slow progress. The real driver of the Japanese economy is the
Japanese. At the moment, they've just seen hell for so long, so it's going to take a while to come out of
it.
Lussier: Relative to other parts of the world, Japan is not shifting well. [There are] structural problems
caused mainly by the older demographics that they have. And there's no immigration into Japan, so they
cannot compensate. You also have the division of MSCI, that will be enforced in November of this year, and
then a chunk later on. It will take a significant amount out of Europe and Japan, in favour of the U.S.
mostly.
Larose: I think what we saw last year was a repricing of the emerging market equities for a worst case
scenario in the West--a recession. We see that now unfolding in positive rates of return this year. In the
long run there is a demand out there.
Owens:I think the experience is going to be similar to Europe, in that you have to get beyond the country
and start focusing on selective companies that have worldwide exposure and are somewhat insulated from the
vagaries of local domestic policy. There's a lot of volatility in the south, and still in Japan. Hong Kong
and Taiwan have high growth rates, but are they sustainable?
THE RIGHT HEDGE FUND
Lussier: Hedge funds will probably be a good way of getting absolute returns. But you have to be very picky
and find the right hedge fund. The right hedge fund is able, consistently, to come up with returns. This
type of investment is interesting, but you have to be picky--more picky than usual. Hedge funds are pure
talent. I buy this issue and sell this issue to get the spread.
Kirzner: You're buying the expertise of the manager. In fact, I like to view that as an asset class. If
you've got the right mix of conventional instruments, and you work on it hard enough, you should be able to
get your portfolio variance down to where you want it to be.
Owens: I think where plan sponsors understand what they're getting into--particularly the risk
parameters--they're ideal. We just went through an exercise where we reviewed alternative investments and
decided to stay very much to our ultraconservative stocks and bonds. We have nothing else, no real estate,
no private equity, no hedge funds, nothing. I think one of the reasons we did that is that there was a
sense of discomfort of moving into something we weren't quite sure of. As we age and become more
experienced as a fund I think we would explore these things down the road. But for the short term, I don't
see it happening. For those who can use it, and understand the risks, clearly they're viable. But it's a
decision each plan sponsor has to make. Everyone likes the upside potential, but I would have a heck of a
hard time explaining to my members that rather than making $200 million, we lost $200 million.
Lussier: It comes back to good judgment. Do you understand the business that the hedge fund is in? Is it
easy to understand? If you are not comfortable with it, if you talk to the guy and after an hour or so you
don't understand, you don't know what you're buying.
Muldowney: If you don't understand it, don't go there. You won't have a leg to stand on explaining why
something went wrong if you never understood it from a fiduciary standpoint. I think it would be great if
the hedge fund providers did a little bit more work on addressing these issues. We're looking for some
offset to the traditional asset classes. So help us come up with something that's possibly even a bit
simpler, but enough for our appetite at this stage of the process.
*** ***
Changes at MSCI
Morgan Stanley Capital International has announced adjustments to its equity indexes that will effectively
reduce the weightings of countries outside the U.S. and U.K. The changes are coming in two phases--the
first of which will be completed by Nov. 30, 2001. The second wraps up May 31, 2002.
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