Alpha-hungry plan sponsors are letting their managers out of the box—the style box, that is. And it’s not just about value and growth—increasingly, managers are being asked to go beyond borders when it comes to building an international portfolio. Last year international equity overtook U.S. equity as the most popular single product category according to Mercer Investment Consulting’s Manager Search Trends Report for 2005. Mandates such as EAFE and North America are now being blended into global equity approaches and, as a result, plan sponsors are leaving the asset allocation decisions up to their managers. As global investing lets down its borders, the new international view is leading the way.
“Globalization is happening in Canada and around the world,” says Carl Bang, president of State Street Global Advisors Ltd.(Canada)in Montreal. “[Plan sponsors] aren’t seeking regional mandates, rather they are looking for a global mandate and an active global strategy.” That globalized shift is being experienced across the industry.
John Akkerman, managing director with AllianceBerstein in New York, notes that he’s seen a major shift away from regional allocations on the part of plan sponsors as they look to combine traditional EAFE or emerging markets mandates into a single one. “They want to have a global portfolio with the ability to invest in the U.S., EAFE, emerging markets, etc.,” he explains. While there are still some regional mandates out there, Akkerman says, they are far fewer than in the past. “They’re now a very small part of our business.” Similarly, Robert Brunelle, senior vice-president with Hexavest Inc. in Montreal, notes that over the last year almost 90% of his client presentations have been for global equity mandates.
THE SHIFT TO GLOBAL EQUITY
Managers are giving several reasons for the shift to global from local market focus. Changes in the industry and in the ways that pension plans are being managed have helped to lead the way. State Street’s Bang believes that plans are now operating under very different constraints. Increasing deficits and liabilities mean that many are now customizing their approach more than they were in the past. As plan sponsors move increasingly into the realm of liability driven investing, they have become less categorical about allocations and the direction of their plans. And that, says Bang, has meant approaching asset management within a highly individualized context that matches a specific plan’s objectives.
Akkerman says the shift has also been driven by plan sponsor appetite for “best ideas” portfolios rather than broad core portfolios. Managers are being selected for the value that they can add rather than the style they represent. In addition, says Martin Leroux, vice-president, institutional investments, with Fidelity Investments in Montreal, the migration from a series of specialist mandates to a single global mandate makes the monitoring process a lot simpler. “It’s good from a governance perspective,” he points out. “It reduces monitoring requirements when it comes to managers which simplifies things for plan sponsors.”
Global capital markets have also come a long way over the last few years and their evolution is another reason for the blurring boundaries between regions. AllianceBernstein’s Akkerman explains that stocks have become a lot more generic than they were 10 years ago. Back then, investors used to make regional allocations to capture the performance characteristics of specific markets. Regional differences were pronounced, so plan sponsors needed to control their allocations for risk and return purposes. Today, says Akkerman, the influence of country-specific factors on a stock price’s return has diminished considerably. “Capital markets have globalized and, as a result, so has the basis on which we actually assemble portfolios,” he notes. “If you think that a manager has investment skill, then what you want to do is give him or her as much flexibility as possible. You set them free to use their skills on a broader mandate to generate more alpha.”
WHAT DRIVES GLOBAL PERFORMANCE?
But if regions and countries aren’t major forces in making global decisions, what factors do drive managers in choosing a diversified global portfolio? It all depends on what industry or sector you’re looking at. Fidelity’s Leroux points out that automotive and telecommunications are global plays. However, key industries like retail and pharmaceuticals can be impacted by regional factors such as the legal environment. Hexavest’s Brunelle agrees that there are many industries that are still highly susceptible to regional factors. When it comes to financials, for example, Brunelle has seen huge regional differentiation. He points to figures that, in local currency numbers, show widely ranging results for 2005 with the U.S. at 6.5%, Europe at 25.6% and Asia at 41%. “People argue that companies are becoming more and more global in nature,” says Brunelle. “We come across this all the time but we don’t believe it.”
As markets continue to become more globalized, you’d think that Canadian plan sponsors would be flooding out of Canadian equities and quickly upping their global allocations, especially without the foreign property rule to hold them back. The fact is, however, many of them are staying put in Canada, at least for the time being. And managers like Hexavest’s Brunelle find the continued home bias surprising—and somewhat worrying. While global markets represent broad exposure across industries and sectors, just a few core areas such as oil and gas and financials fuel the Canadian market.
Such concentration represents a very high level of risk. As Brunelle points out, “the Canadian market is concentrated in just a few sectors—it’s very risky. So on the surface it would seem to make sense to reduce their Canadian equity exposure and to increase their foreign equity exposure.” State Street’s Bang agrees that Canadian plan sponsors are sitting on a lot of concentration in the Canadian market—“it entails big risk. Today, focusing on broad diversification means looking globally,” he explains.
TO HEDGE OR NOT TO HEDGE
One thing that could be holding plan sponsors back is the high dollar and the presence of currency risk. “People didn’t pay too much attention to currency before the elimination of the foreign property rule,” says Fidelity’s Leroux. “Now, you have to manage your currency exposure and we’re seeing a lot of questions related to it.”
John Akkerman believes that currency management will be top of mind for plan sponsors looking to migrate into more global portfolios. “You’ve got to manage the disconnect between Canadian-based liabilities and a non-Canadian dollar asset,” he says. However, Leroux believes that it is going to take some time before people really start to address the question. “Right now there’s a lack of consensus,” says Leroux.
As plan sponsors around the world continue to move away from traditional style boxes and into a more global view of their portfolios, Canadian plan sponsors are now free to follow the trend. With no foreign property rule to hold them back, they can seek out the best opportunities internationally. While they appear to remain rooted in Canada, there is no doubt that change will happen—it’s just a matter of when, say managers. Whatever happens, it’s certain to be interesting—and international.
| GLOBAL GUIDEBOOK
Borders are dissolving when it comes to global investing. Now that managers are looking internationally at opportunities, where are their areas of focus going to be?
Despite the shift to more broad global mandates, emerging markets have held strong, particularly during the last two years. The push for globalization has made them a major destination for institutional money. John Akkerman, managing director, AllianceBernstein, notes that their popularity is due to a couple of factors. “The absolute returns have been stunning,” he says, which has attracted plan sponsors eager to boost returns. Robert Brunelle, senior vice-president with Hexavest Inc., says, for the last three years, on a local currency basis, emerging markets returned 28% versus 14% for developed markets. The positive performance, he notes, has been driven by a “vast amount of liquidity in the market” along with accommodative interest rate policies worldwide that have helped to fuel the growth.
At the same time, Akkerman says, emerging markets have changed a lot during the last ten years. “Today, these countries are much more stable and far less dependent on foreign inflows,” he explains, noting that emerging markets have come a long way since the currency crisis days of 1997. “A lot of these markets are actually running trade surpluses and paying back their debt.”
Many managers are now taking a more cautious view of emerging markets however. Highly cyclical in nature, emerging market economies tend to be fueled by commodity hungry countries. Says Akkerman, “If the commodity cycle is at a peak, [emerging markets] could be exposed to a correction.”
At the same time, the liquidity that has been present in these markets for years is “being mopped up by the central banks,” says Brunelle, noting that rising interest rates could mean bad news for more risky asset classes such as emerging markets.
EAFE – According to Mercer Investment Consulting’s 2005 Manager Search Trends Report, managers last year favoured EAFE equities, at 44% of searches. For 2006-2007, there are mixed views on how the region will perform. RBC Financial Group’s Economic and Financial Market Outlook for the period sees good upward momentum coming from the Eurozone and Japan, with a 1.9% year-over-year rate of growth in the first quarter of this year, lead by firm consumption and investment activity. European exports grew at a rate of 3.1% in the first quarter of this year and RBC says it expects robust global demand to continue to fuel growth in Europe.
However, Hexavest’s Robert Brunelle warns that a bumpy road ahead for China could mean problems in EAFE areas such as Japan. “We’re being prudent on Japan and, in general on materials and basic commodities,” notes Brunelle. “People seem to think that there’s no elasticity to commodity prices. And that China will buy them at any price. We don’t feel this is the case.”
Brunelle is looking to the U.K. to be a leader of EAFE growth in the months ahead. “We believe the U.K. is ahead of the curve in terms of where they are in the economic cycle,” he notes, explaining that the country’s central bank holds substantial credibility and that the mortgage situation in the U.K. is relatively healthy.
Going forward, inflation concerns could affect the EAFE region in the months ahead. For example, in the Eurozone, high energy prices pose upside risks to the inflation outlook, warns RBC. Increasing interest rates on the part of EAFE countries should, however, create a positive effect.
North America – A softening housing market in the region is likely to put a damper on consumer spending, according to RBC’s outlook. However, the greater impact is likely to be felt in the U.S. rather than Canada. The Feds’ pause on hikes in the U.S. was cause for concern for some, however many believe it will continue to raise rates in the coming months.
Overall, Hexavest’s Brunelle is more positive about North American growth in the coming months, noting that his firm is currently “slightly overweight” in U.S. stocks, particularly large cap companies with growth potential overseas.
Population: 188,078,227(July est.)
GDP: +3.4(Q1 2006)
Export partners: U.S. 19.8%, China 7.5%, Argentina 7.3%, Germany 5.2%, Netherlands 4.3%(2005)
Import Partners: U.S. 19.6%, Germany 8.6%, Argentina 8.5%, China 6.2%, Nigeria 5.6%(2005)
Opportunities: Brazil is a provider of commodities and is benefiting from increased exports to China(its second largest export partner, according to statistics). Like other emerging market economies, it’s been making major improvements in its creditworthiness, benefiting from a positive cycle of improving growth and debt dynamics.
Risks: A growth slowdown in key economies could mean that Brazil takes a hit on the commodities side. And a looming October presidential election could mean an incoming government that isn’t supportive of the country’s current market-friendly economic policies and structural reforms.
Population: 1,095,351,995(July 2006 est.)
GDP: +9.3(Q1 2006)
Currency: Indian rupee(INR)
Export partners: U.S. 18.1%, China 8.9%, UAE 7.9%, U.K. 4.6%, Hong Kong 4.2%(2005)
Import Partners: China 7.1%, U.S. 6.3%, Belgium 5%, Singapore 4.7%, Switzerland 4.2%, Germany 4%(2005)
Opportunities: With its highly educated, English-speaking workforce, India is becoming a major source of outsourcing for service companies and a major exporter of software services and software workers. The economy has posted an average growth rate of over 7% since 1994 and poverty has been reduced by nearly 10%.
Risks: During the last U.S. election, protectionist sentiments ran high. Future election platforms in the U.S. built on reversing the outsourcing trend could represent a risk to countries like India. At the same time, the World Bank is concerned about the combined state and federal budget deficit.
Population: 127,463,611(July est.)
GDP: +3.1(Q1 2006)
Export partners: U.S. 22.9%, China 13.4%, South Korea 7.8%, Taiwan 7.3%, Hong Kong 6.1%(2005)
Import Partners: China 21%, U.S. 12.7%, Saudi Arabia 5.5%, UAE 4.9%, South Korea 4.7%, Australia 4.4%, Indonesia 4%(2005)
Opportunities: Japan’s economy has been showing positive upward momentum in recent years, following decades of poor economic growth. Consumer spending has fuelled expansion in non-residential and residential investment and optimism is spreading through the economy. Unemployment is now at its lowest level since 1998 and Japanese goods are attracting strong global demand.
Risks: Steep government debt continues to be a factor for Japan’s economy. In addition, the aging of a significant percentage of the population is a long-term problem that will likely affect growth prospects down the road—20% of the nation’s population is over 65.
Caroline Cakebread is the editor of Canadian Investment Review. Caroline.email@example.com
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