© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the January 2006 edition of BENEFITS CANADA magazine.
Treading lightly
Before launching headfirst into the global market, Canadian investors need to look at how changes in asset allocation will affect their liabilities. Moving towards non-traditional solutions needs to be weighed carefully.
By Carl Bang

Last year, the Canadian government lifted its restrictions on foreign property investing. The news could not have come at a better time. That’s because the relaxation of foreign property controls will have wider and more positive implications on asset allocation and investment strategies going forward.

Canadians can now better access sectors that essentially do not exist domestically, including pharmaceuticals, consumer stocks, healthcare, and information technology. They can enter the realm of alternative investing.

There is no doubt that Canadian pension funds need all the help they can get. Since the stock market crash of 2000, pension funds went from a general surplus of more than 20% of pension fund assets to a deficit, with funding ratios of just over 80%, according to the C.D. Howe Institute. And the Bank of Canada estimates that Canadian pension plans lost more than $200 billion of surplus.

Canadian funds are also lagging behind in investment allocation. Globally, in order to improve the risk-reward characteristics of the entire portfolio, plan sponsors are looking for asset classes with positive expected returns and low correlation to other assets(which means the securities will move in relative tandem). Investors are seeking new types of alternative investments.

Take the Yale University Endowment Fund, for example. In 1989, it experienced a significant shift towards increasing and expanding alternative investments. The focus was placed on finding investment strategies with low correlations, which offered opportunities for higher returns. Other large investors, such as General Motors, Harvard University and Stanford University, followed suit.

Due to foreign content restrictions, Canadian pension funds have been slow to move to this new paradigm of investment management. The typical Canadian plan allocates 30% to non-Canadian equities, but a little more than 5% to alternative investments, according to the Pension Investment Association of Canada’s Asset Mix Report.

Before going forward, however, pension funds must take several things into consideration—particularly the relationship between assets and liabilities. With massive surpluses a thing of the past, sponsors have to make contributions to their schemes.

For companies, this is causing a swing in earnings. Currently, the accounting requirements that highlight these losses on a company’s income statement are stricter in the United Kingdom and Europe, where assets and liabilities have to be marked to market. In all probability, the U.S. and Canada will change their standards to reflect the gap between assets and liabilities, a move that is likely to affect how corporate pension funds tie asset allocations to asset liability management and the impact on earnings. It will affect how Canadian pension funds consider global assets. As pension funds look to the global markets for solutions, they must also consider what the allocations will do to their liabilities.

There are also other considerations to be made. Over the past two years, there has been a tremendous strengthening of the Canadian dollar versus the U.S. dollar, by over 25%. This raises questions as to whether investors should be adding foreign assets on a hedged or un-hedged basis.

As well the general level of volatility in capital markets must be weighed. Volatility has been declining steadily for the last two years. And finding consistent and large alpha generation globally in developing markets has always been difficult. Today, it is even harder. A number of active strategies need volatility and low correlations to do well. Given the current environment, it may make sense for Canadian investors to take their time searching out a preferred source of alpha as well as the general level of risk premium paid in global capital markets presently. Over the past year, general risk premiums have been falling drastically. In this environment, it obviously makes sense to cautiously look at global opportunities, and to take time getting into position.

Canada has a large component of commodities in its equity indices. With strong global growth, commodities have been making record returns. But, there are two schools of thought on commodities. One is that they have reached their peak in price level, and will now decline. The second is that due to the increased level of demand, price appreciation can be expected to gravitate towards new highs. If this is the case, it may make sense to be selling part of our Canadian equity, to capture a good portion of this price appreciation.

Given the current market, Canadians will also have to look at non-traditional solutions for help, such as international assets where economies are growing at higher rates than the developed world. Presently, Canadian pension funds remain significantly underweighted to emerging markets. Canadian pension funds’ international allocations going forward will depend on each fund’s risk tolerance. For those pension funds that used derivatives to circumvent foreign property rules, they may now convert to cash strategies without penalty. Funds can now access the foreign markets directly and save up to 50 basis points in derivative transaction costs.

In this new environment, they are empowered to better craft investment strategies. And less likely to gravitate to less efficient markets and be allocated into enhanced and active EAFE(Europe, Australasia, and the Far East)and emerging market strategies where alphas tend to be larger. Investing in active international small capitalization stocks may be appropriate for some funds.

Without restrictions, the Canadian equity strategy will likely evolve into a North American sector strategy. There are some sectors that Canada does not have, to any large extent, which will help with diversification. For example: consumer products, healthcare, and information technology are limited. Canadians have for all intents and purposes been absent from global fixed income markets. But in this new world, they offer an attractive opportunity for increased diversification, and returns which tie in nicely with the liability side of the equation.

The bond market in Canada has been a captive market. With this ability to invest in global credits, Canadians can enhance diversification and improve the overall credit quality to their bond allocations. Moreover, active bond mandates will probably evolve to include high yield debt, emerging market debt, and international bonds.

There is also likely to be a move towards international specialist and regional specific mandates with currency management taking on a more significant role. It is important to be cognizant of the fact that the Canadian economy is already exposed to international markets, with 35% of the earnings of the S&P/TSX Composite Index coming from international sales, according to Bloomberg.

Now more than ever, plan sponsors in Canada have the opportunity to invest in sectors and locations that were not available to them in the past. The lifting of limits on foreign property investing should help plan sponsors get back to the positions they found themselves before the stock market bubble of 2000.

Carl Bang is president and managing director of State Street Global Advisors in Montreal. Carl_Bang@ssga.com