Institutional Investing In An Unconstrained Environment
By: Harry S. Marmer
Early speculation about the impact of the elimination of the foreign property rule suggests Canadian pension funds may simply remain where they are for the time being. In ‘Out Of The Box,’the newest feature in Benefits and Pensions which invites authors to stray from current thinking and traditional thought, Harry Marmer, of Franklin Templeton Institutional, suggests it might be more prudent for Canadian pension funds to take advantage of this new environment now.
On December 17, 1991, the foreign investment limits were legally changed allowing Canadian pension sponsors to invest up to 20 per cent of the book value of their assets in non-domestic assets by the year 1994. In 2000, the limit was increased to 30 per cent. Now, in 2005, there is no limit! It has been a long and winding road to finally reach the stage we are at today with the recent budget proposal to effectively eliminate what was an unnecessary and parental rule for sophisticated investors.
Until this point in time, investors who desired greater non-domestic exposure were forced to use derivatives or convoluted pooled on pool strategies. In the former, they gave up alpha and in the latter they sacrificed simplicity while encountering unnecessary legal/ consulting fees.
The elimination of the Foreign Property Rule (FPR) changes the playing field of the Canadian institutional landscape. How will the three key players of the ‘institutional troika’ – sponsors, consultants, and money managers – respond to an unconstrained opportunity set? What are the implications for policies, strategies, and tactics? We open this door now.
What would sponsors do today with the foreign investment limits eliminated? If survey results are used as a leading indicator then the answer is not much! More specifically, a recent poll of sponsors found that “721⁄2 per cent of Canadian pension plan sponsors do not expect to increase their plan’s policy weight in foreign investments.”2 We may be missing something here. Perhaps the sponsors surveyed only have a small percentage of their equity investments in Canada. Therefore, the proposed elimination of the foreign investment constraint has no immediate beneficial impact.
However, of the sponsors surveyed, less than 18 per cent of the respondent’s plans were invested beyond the foreign investment limit. How about money managers? Well, there is more activity expected here in comparison to sponsors. However, based on two survey results, the rule of the day is still inaction as about 45 per cent of the managers surveyed stated that they did not plan on increasing their foreign investments with the elimination of the FPR!3
What’s Going On?
So what is going on here? The benefits of a globally diversified portfolio have been proven over and over again and yet Canadian institutional investors are significantly underweight this area.4 Why have PIAC, ACPM, and other leading industry thought leaders embraced this concept and been fighting for years to eliminate the FPR if the rule of the land appears to be inaction once the limits are gone? Perhaps the survey results are off?
More likely, this ‘international diversification puzzle’ reflects the ‘home bias’ of investors who for a variety of reasons are reluctant to invest significant assets outside their domestic market.5 There is robust empirical evidence that finds the home bias is not just a Canadian investor issue, but also a globally observed investor phenomenon.6 The main reasons raised for this currency risk, increased transactions costs for non-domestic investing, and greater knowledge and understanding of local companies.7 Is there hope? In a word – absolutely.
The sponsor survey was conducted just after the budget proposal was announced. Therefore, sponsors would not have had the opportunity to consult with their consultants, committees, money managers, and other advisors. The good news from the consulting front is that one of Canada’s largest houses recommended to clients to “revaluate what proportion of the overall portfolio will be held outside of Canada.”8 The investment manager responses should also be taken with a grain of salt. After all, about half the managers surveyed are ‘domestically grown’ – in other words, they have built their non-domestic capabilities organically or have outsourced these requirements by hiring third-party managers to execute this manufacturing. Consequently, these managers would also have a home country bias.
The first order impact of this changed environment for sponsors is on their investment policy statements, specifically asset mix policy. Some will argue that there is an immediate need to undertake new asset/liability studies. Frankly speaking, from an asset space perspective only, the elimination of the FPR should clearly be viewed as a wonderful opportunity for investors to build more efficient and effective portfolios. At a minimum, investors can more efficiently reduce total asset risk volatility. At a maximum, they can search more effectively for higher expected yielding allocations. In the latter case, sponsors interested in further gearing their policy mix should undertake an asset/liability study to determine a prudent course of action.
From a purely asset mix viewpoint, what equities should be modeled? The ‘devil’s advocate’ would argue there is very little point in including a separate asset category for Canadian equities in this exercise. After all, we all know the mantra that Canadian equities have averaged only two to three per cent of world market capitalization. 9 Why bother? The usual response is that “our liabilities are in Canadian dollars and, therefore, we need to have our equities or a significant proportion of our equities in Canadian dollars.” This is what I call the allowance rationale. I want to receive my allowance in Canadian dollars because I am spending Canadian dollars. This is true if your spending needs are immediate and local. What if you wanted to save your allowance for 20 years? Would you still invest a significant proportion of your money in Canadian equities?
While on the surface this response for significant Canadian equity exposure seems reasonable, it misses the whole raison d’etre of including equity investments in pension funds. Pension funds invest in stocks to improve the odds of earning returns beyond the actuarial discount rate or the immunized risk matching solution. Investing in equities, whatever the category – whether Canadian, U.S., international, or global – creates relatively the same asset/liability mismatch. 10 In other words, there is no compelling evidence that Canadian equities are more significantly correlated with Canadian pension liabilities than global equities.
The Currency Red Herring
What about currency risk? Obviously, investing outside your local country creates currency risk but this is only one dimension of a three-dimensional problem. Currency exposure is not only a risk factor, it also provides exposure to expected return and diversification properties. If risk is your only concern, then currency markets offer the breadth and depth to eliminate this concern through passive hedging. While the choice of an ‘optimal’ hedge ratio for this passive approach will be continually debated for the foreseeable future, whatever this hedge ratio is can then be built into your investment policy mix.
Similarly speaking, the diversification and expected return properties of currency exposure can be appropriately handled using a decision-making belief model – no hedge, partial hedge, full hedge, or active currency overlay.11 The bottom line is to have a policy that reflects your belief system – unhedged, partially hedged, fully hedged, or active.
If you are still not convinced that the currency is a ‘red herring’ issue for investors, let me close the topic with the following thought. Since the mid- 1980s, one of the most persistent puzzles in international finance is understanding what drives foreign exchange rates. All empirical results indicate that the best predictive model for exchange rates is a random walk, that simply predicting that the current exchange rate will remain unchanged has better predictive results that other exchange rate models based on fundamentals. “By and large, there remains no well-accepted ‘traditional’ model of exchange rate determination.” 12 This is perhaps why the view persists that, in the long run, a diversified basket of currency returns are a wash.13
The elimination of the FPR will not only lead sponsors to review policies, they will, as well, most likely spend time retooling their manager structures. Two areas where we believe sponsors should seriously consider allocations are global or international small cap and global fixed income. From an equity perspective, most nondomestic structures today are built as either global or U.S. and international components. In the latter case, investors with sizeable assets may also consider a U.S. small cap specialist. Asmall cap specialist is usually not considered for either global or international portfolios. This is a major hole in manager structure for we know that cap size is a major factor in helping us to understand stock returns.14 Ignoring small cap reduces both the opportunity set and the alpha potential of non-domestic portfolios. Given the structure of institutional research, there is no reason to expect this coverage to dramatically change in the future. The continued ‘neglect’ of small company research should mean that for this asset class, the persistence of alpha is highly sustainable.15
Fixed Income Is No Longer Boring
On the fixed income side, the ongoing trend has been for sponsors to treat this asset class as a liability anchor. In the past, sponsors were reluctant to spend their nondomestic allocation on foreign bonds mainly due to the fact that the alpha potential on global equities is much larger than that on global bonds. Nonetheless, with the elimination of the FPR, sponsors should strongly consider non-domestic bonds as an opportunity to build a more efficient portfolio even with fixed income as a liability anchor. Notwithstanding the use of Canadian fixed income assets as a liability risk management tool, the broad global bond opportunity set should help improve the return to risk relationship for Canadian- based fixed income portfolios as well as reduce the overall credit risk of these portfolios.
As well, global bonds provide Canadian based investors with the benefit of further reducing total portfolio volatility. The relatively low correlations between global bonds and other traditional asset classes provide an additional diversification advantage and should assist in reducing total portfolio volatility.
Money Managers: Where Are You?
Stating the obvious, the elimination of the FPR is ‘bad news’ for traditional balanced fund managers and domestic manufactures only that have not strategically decided their positioning in this new competitive environment. Similar to the sponsor decision-making, the impact on these firms will be gradual. The other side of the coin is that we should expect to see the presence of more global fixed income managers. Non-domestic manufactures will also gear up to provide small cap strategies.
On the DC market side, two questions I struggle with are:
- Will investment managers providing asset mix funds for the DC market, such as lifecycle or asset allocation products, significantly adjust the mixes of these funds to reflect this new free environment?
- Will the administrators overseeing these funds, add more non-domestic options to their line-ups?
For consultants, the elimination of the FPR means one thing – Ka Ching. The potential for billable revenue here is enormous as consultants may be engaged by their clients for advice on a number of issues and topics including:
- investment policy review
- asset liability analysis and recommendations
- new asset classes to consider
- currency policy
- manager search, structure, and monitoring The golden days for consultants are back again.
For a variety of reasons, the Canadian institutional market tends to move in what appears to be a glacial fashion.16 Nonetheless, it does move. Since 1990, when the average balanced fund manager had about 10 per cent of their mix outside of Canada (seven per cent U.S. and three per cent international), today on average 26 per cent is invested in foreign equity (an even split between U.S. and international).
Exhibit 1 compares the top 10 holdings between the global index and the Canadian index. Naively taking 10 per cent of assets and investing in the global arena will yield you nine world class companies while doing the same in Canada will lead you to two financial services company. Good common sense tells you that you would be better off going the global route.
I am as patriotic as the next Canadian, but my bet is that five years from now, the amount invested outside of Canada will be closer to 50 per cent than it is to 30 per cent. At that point, we will have reached the end of the long and winding road.
Harry S. Marmer is senior vice-president, institutional investment services, at Franklin Templeton Institutional (hmarmer@franklintempleton. ca).
1. This article benefited from the comments of the following individuals: Peter Jarvis, Denis Larose, Paul Saury, David Service, Jill Taylor, Terri Troy and Jay Wiltshire,
2. ‘The Elimination of the Foreign Property Rule,’ Chandra Price, Benefits Canada, April 22, 2005. This article is based on the Aon Pulse Survey results on the elimination of the Foreign Property Rule.
3. Both Mercer Investment Consulting and Hewitt Associates surveyed money managers. In the Hewitt survey, 46% of the managers stated they would not adjust their mix while in the Mercer survey 43% claimed they would not adjust their mix.
4. The pioneering work on the benefits of a globally diversified portfolio goes back to 1968 to a research paper written by Herbert Grubal entitled ‘Internationally Diversified Portfolios,’ American Economic Review, 58, pages 1299 to 1314. From a Canadian perspective, please refer to ‘Optimal International Investing Asset Allocations Under Different Economic Environments: A Canadian Perspective,’ by Harry S. Marmer, Financial Analysts Journal, November-December, 1991, pages 85 to 92.
5. For an excellent survey of the home bias phenomenon, see ‘Trying to Explain the Home Bias in Equities and Consumption,’ by Karen Lewis, Journal of Economic Literature 37, 1999, pages 571 to 608.
6. Kalok Chan, Vicentuiu Covrig and Lilian Ng find robust evidence for a home bias in 26 developed and developing countries in their article ‘What Determines the Domestic Bias and Foreign Bias? Evidence from Mutual Fund Equity Allocations Worldwide,’ Journal of Finance, Vol LX, No. 3, June 2005, pages 1495 to 1534. In their article, they summarize some of the reasons advanced for this bias including investment limits, departures from purchasing power and hedging of human capital or other non-traded assets. They also suggest that stock market development and familiarity bias amongst other factors impacts this bias. From specifically a Canadian investor’s perspective, some of the home country bias can be due to superior performance of the Canadian equity market relative to the U.S. over the past couple of years. As well, survey results probably also reflect the views of small plan sponsors who have delegated the asset mix decision to balanced managers, who as discussed earlier, are less likely to place funds outside their area of expertise.
7. Refer to page 233 in ‘The Future for Investors,’ by Jeremy Siegel, Crown Publishing Group, New York, 2005.
8. Page 4 in the ‘Elimination of Foreign Property Rule: New Opportunities for Canadian Registered Pension Plans,’ Mercer Investment Consulting, March 2005.
9. As a matter of fact, Mark Kritzman makes the case that from a pure asset space perspective “the optimal allocation to Canada is 0%…” page 3 in ‘Canada Unbound, from Economics and Portfolio Strategy,’ by Peter Bernstein, April 15, 2005. Nonetheless, one does not need sophisticated modeling to conclude that the Canadian equity market is narrow and concentrated with a dramatically varying risk profile.
10. While one may argue that Canadian liabilities are driven to some degree by the Canadian economy, the Canadian equity market itself is not very representative of the Canadian economy. For example, the very large auto sector is not very well-represented in the Canadian market. I thank David Service for this very important insight.
11. This approach is discussed further in ‘Perspectives in Currency Management’ by Harry Marmer, Benefits and Pensions Monitor, October 2004.
12. This quote is from ‘Currency Returns, Intrinsic Value, and Institutional-Investor Flows,’ by K. Froot and T. Ramadorai, Journal of Finance, pages 1535 to 1566, June 2005. This article takes a stab at solving the exchange rate model issue, but it is too early to assess its impact on current thinking.
13. Templeton’s internal research suggests currency returns are a wash in the longterm, that clients were not better off with hedge portfolios in the long term. Support for this finding can be found in the latest published research by Professor Meir Statman, ‘Hedging Currencies with Hindsight,’ Journal of Portfolio Investing, Summer 2005, pages 15 to 19. Professor Statman’s research indicates that hedged and unhedeged portfolios during 1988 to 2003, had realized returns and risks that were virtually identical (page 15). Finally, Professor Jeremy Siegel, author of the popular book ‘Stocks for the Long Run,’ suggests, “in the long run, the returns on foreign stocks cancel out these currency movements. Over the long run, movements in exchange rates are determined by relative inflation between countries and stock returns will compensate investors for this difference in inflation.” Page 233, from ‘The Future for Investors,’ Crown Publishing Group, New York, 2005.
14. See ‘Size and Book to Market Factors in Earnings and Returns,’ by Eugene Fama and Kenneth French, The Journal of Finance, March 1995, pages 131 to 155.
15. This is discussed in more detail in ‘Why Small Is Still Beautiful’ by Harry Marmer, Benefits and Pensions Monitor, February 2005.
16. I discuss why the Canadian institutional decision-making process moves like molasses in Chapter 1 of ‘Perspectives on Institutional Investing,’ Rogers Publishing, 2002.
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