It’s possible that large private equity deals are impacting the investment choices available to the average Canadian institutional investor.

By the time this article is published, there will undoubtedly have been at least one new takeover bid for a prominent Canadian publicly listed company.

The flood of recent merger and acquisition activity is not solely the result of large foreign public companies using strong stock prices as a means to purchase Canadian firms to further expand their global franchise. The current low cost of debt has also led to an increase in interest from cash-laden private equity firms seeking out opportunities— BCE being a recent example of such activity.

Regardless of the takeover method, the net impact of this trend on the Canadian equity market is the same. It shrinks. As large marquee names disappear from the landscape, will the Canadian equity market continue to be the appropriate venue for a significant portion of Canadian plan sponsor assets?

The S&P/TSX Composite is a market capitalization-based index. As witnessed in the late ’90s, market capitalization indices can suffer from concentration issues. When the market capitalization of one security dominates, the total return of the index becomes inextricably linked to the fate of an individual stock(e.g., Nortel Networks). To address this single stock issue, a capped version of the index was introduced to limit the weight of any one stock to a maximum of 10%. However, with the financial, energy and materials sectors combining for more than 75% of the weight of the index today, concentration issues still persist. A sudden collapse of the long-running commodities bull market would have a meaningful impact on most Canadian pension plans.

Investing in domestic equities is often cited as a benefit to Canadian pension plans since the S&P/TSX Composite acts as a proxy for the Canadian economy. This may at first appear intuitive, but a closer look at the significant imbalance between the weights of the stocks and sectors in the benchmark and their respective contribution to the economy calls this benefit into question. Although this topic has been examined in the past, the volume and size of recent deals should give investors reason to review their alternatives, since the composition of the S&P/TSX Composite index may be altered with greater frequency and magnitude.

So what should Canadian investors do? One option is to diversify into the global markets. Canadian pension portfolios have long had a home-country bias, with typical allocations to Canadian equity between 20% and 30% of pension assets, while Canada currently comprises only approximately 3% of the world’s total equity market capitalization based on the Morgan Stanley Capital International All Country World Index. In some respects, this bias is, in part, a hangover from the days of the Foreign Property Rule.

Increased global allocations present the challenge of how to address the implied higher levels of currency exposure. The decision with respect to currency will generally depend on the ability to tolerate short-term currency fluctuations.

Is increasing the allocation to foreign assets the only option? One interesting development has been the emergence of fundamental indexing. Instead of basing an index on the market capitalization of the stocks, indices are constructed using some combination of financial metrics such as profits, book value of assets, sales or dividends. Further analysis is necessary to determine whether this type of index could provide some relief from the current S&P/TSX Composite index concentration issues.

Whether or not the recent pace of merger and acquisition activity continues, Canadian plan sponsors should review the issue to ensure effective management of their pension plans.

Andrew Waters is a senior associate with Mercer Investment Consulting in Toronto. andrew.waters@mercer.com

For a PDF version of this article, click here.

© Copyright 2007 Rogers Publishing Ltd. This article first appeared in the June 2007 edition of BENEFITS CANADA magazine.

 

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

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