It’s a great big world, and if the removal of the 30% foreign property restriction goes forward, Canadian plan sponsors will be free to look globally. However, historical data show that, compared to other world markets, Canadian equities were a good bet, despite key misconceptions some investors might currently have about them. In the absence of the foreign property cap, will Canada still make sense for plan sponsors? Looking at international trends and the positive performance of Canadian equities over the long term, a lot of industry myths can be debunked. The verdict: plan sponsors might not be so quick to leave home.

Myth #1: The elimination of the foreign property rule will signal a move out of Canadian equities – If global trends are any indicator of what pension funds in Canada will do next, the move out of Canadian stocks might not be that dramatic. For example, in countries without a foreign property rule(FPR), such as the U.S. and Australia, the domestic holdings of pension investors have remained relatively steady(see “Asset allocation– major pension markets,” below). Indeed, the data shown here indicate that, with the exception of the Netherlands, a significant home bias remains in many developed pension markets around the world. All told, if Canadian plan sponsors follow the lead of their global counterparts, a wholesale movement out of Canadian equities isn’t likely to happen in the near future.

Myth #2: The Canadian equity market is too small – While a home bias remains the norm in other countries, investors in Canada have long complained about the small size of the Canadian equity market and the fact it is driven by a much smaller concentration of stocks in just a few key sectors. Notably, Canada’s top 10 stocks currently represent almost 35% of the S&P/TSX Composite Index. That same index is only highly concentrated in three sectors: financials, energy, and materials. All told, these presently account for almost 70% of the market value of the entire S&P/TSX Composite Index. With so much of the performance of Canadian equity markets dependent on such a small number of companies and sectors, it is not surprising that investors wary about the kind of risks presented by such a concentrated market are looking to diversify by investing in international equity markets.

Myth #3: The volatility in Canadian markets has led to poor performance – Canadian markets are volatile. Despite the concentration factor, however, they have historically performed well—and have been surprisingly less volatile than other global concentrated markets. Long-term data show that Canadian equity market returns have actually been less volatile over the last 45 years than the U.S., as measured by annual standard deviation. In addition, over the last 35 years, they have remained less volatile in comparison with the non- North American markets as a whole; during that time period, the annual standard deviation of returns for Canada, the U.S. and EAFE have been approximately 16%, 17%, and 20%, respectively. Moreover, during the same 35-year period, the returns from U.S., EAFE and Canada have all been remarkably similar: roughly a 2% spread from best to worst, depending on whether you use local or Canadian dollar returns.

Myth #4: The Canadian market does well when inflation increases – Another misconception some investors have about the Canadian market is that it typically does well when inflation or commodity prices are rising. While this may have been true in the late 1970s, it wasn’t the case in the early part of that decade and there is no consistent evidence to show that the performance of equity markets in Canada was tied to such factors over the long term. That said, given the current weighting of energy and materials in the Canadian equity market(approximately 35%), it is reasonable to expect the market will have a greater response to factors such as inflation and commodity prices versus other markets over the short term.

ACTIVE MANAGEMENT IN CANADIAN EQUITIES
As the last few decades have proved, the Canadian market is not as volatile as some might think. But while Canadian equities have performed well compared to their U.S. and non-North American counterparts, the challenge remains: how to invest in the Canadian market and make the most of what it has to offer? While many Canadian investors are searching for alpha to boost returns in their portfolios, active management in Canada has always been an issue, driven as it is by the unique characteristics of a highly concentrated marketplace. However, with the right approach to management, achieving the optimal amount of diversification isn’t as difficult as it might seem.

To see how this can work, let’s look at the main drivers of a successful equity manager anywhere in the world: a strong, unemotional sell discipline; a strategy that sets them apart from the herd; and an ability to maintain a consistent approach while staying flexible enough to adapt to changing market conditions.

Here in Canada, however, key drivers for successful active equity managers also stem from the nature of our concentrated marketplace. For example, a manager without expertise and ability in one of the three key Canadian sectors(financials, energy, and materials)should send investors running for the exits. At the same time, a Canadian equity manager must be able to work within constraints bred by heavy weightings certain stocks have in the S&P/TSX Composite Index. Right now, out of the top 10 stocks in Canadian market, seven are in the financials sector with weights ranging from Royal Bank of Canada at 4.9% to Sun Life Financial, weighted at 2.4% of the index.

For an active equity manager looking to generate positive alpha, this presents specific challenges at the portfolio level. For one thing, a Canadian manager bullish on financial stocks would face a major problem because they would be trying to overweight stocks that already have a high absolute weight. Currently, financial companies represent 32% of the S&P/TSX Composite Index. Most managers aren’t comfortable going above this level in a portfolio— no matter how much they like the stocks.

While trying to overweight is tough, underweighting can be equally difficult. The high concentration of heavily weighted stocks at the top end of the scale means the weighting of some stocks in the index drops off dramatically. For example, following on the 60 top stocks in the S&P/TSX Composite Index, the 61st is currently Falconbridge(FL)with a weighting of just 0.33%. For an equity manager who is not positive about that company’s ability to perform, the small percentage makes it very difficult to underweight in a portfolio—you can’t get much lower than 0.33% without hitting zero.

The overweight-underweight dilemma means the ability of an equity manager in Canada to take concentrated active bets in the Canadian market is limited. This is a problem for active managers: constraints normally lead to sub-optimal outcomes in a portfolio. A viable alternative, however, is to construct a portfolio based on a relatively large number of smaller active bets. An ideal way to achieve this is to implement a multi-manager portfolio using individual managers concentrated in different areas and with complementary approaches. Such a portfolio allows an investor to properly diversify within the constraints of the Canadian marketplace, avoiding heavy overweights and small underweights.

Ultimately, the lifting of the FPR is not likely to have a major impact in the short term on Canadian holdings in domestic equities. Over time, Canada has had very competitive returns in comparison to other markets, with less volatility overall. The future will remain in finding new and innovative ways to actively manage the domestic market, coping with the challenges and adding alpha in the process.

Irshaad Ahmad is director, Institutional Services and Tim Hicks is chief investment officer with Russell Investment Group in Toronto.

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Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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