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Opportunity or Much Ado About Nothing?

By: Bill Solomon

While the proposal to eliminate the foreign property rule was applauded throughout the Canadian pension industry, the actual impact may be far less than expected, writes Bill Solomon.

The recent federal budget proposed the removal of the 30 per cent foreign content limit on registered savings plans such as pension plans, RRSPs, and DPSPs. Now comes the interesting part – how will such plans respond to this change in the rules of the game in how they manage their plans’ asset mixes and securities holdings? While most money management firms and plan sponsors welcome this proposed change in legislation, the resulting changes in the actual investment of registered plan assets remain unclear. In the past, when the foreign content limit was expanded (from the original 10 per cent in 1971; to 20 per cent from 1990 to 1994; and, subsequently, to 30 per cent – via 25 per cent – in 2000 and 2001), the change most commonly observed was an increase in the plan’s foreign equity content, with a corresponding decrease in the exposure to Canadian equities, leaving the equity/fixed income ratio relatively unchanged. Along the way, the makeup of this foreign component also changed.

EAFE Exposure
Initially, foreign content was primarily in the form of U.S. equities, but, gradually, EAFE exposure eroded the exclusivity of the U.S. position. The result was a more truly global foreign equity weighting over the past many years. Currently, the split for pension funds is about 15 per cent U.S. and 10 per cent EAFE.

With the complete removal of the foreign content limit, we believe that the resulting change to pension plans will, in fact, not be in the equity mix, but, rather, in the fixed income component.

For pension plans, many asset consultants have created efficient portfolios for their clients. Most of these portfolios suggest that an optimum mix would be in the range of 60 per cent to 65 per cent equities, with the balance in fixed income instruments. Clearly, the results will vary depending on the unique characteristics of each plan. Of this 60 per cent or so in equities, about 35 per cent is currently allocated to Canadian equities, with the balance allocated to U.S., EAFE, and Emerging Market equities.

In cases where the efficient frontier studies were done on an unconstrained basis (that is, assuming that there was no foreign content limit in place), the resulting asset mix did not vary significantly from the registered plan scenario. Often, a maximum foreign exposure of no more than 35 per cent was observed.

This suggests that many plans may already be at their optimum exposure to non-domestic equities. Accordingly, the removal of the foreign content limit may not have any impact on a plan’s appetite for foreign equities. This possibility is further supported by the fact that many pension plans currently have far less than 30 per cent exposure to foreign equities.

Fixed Income Exposure
Turning to pension plans’ fixed income exposure, we find that the 35 per cent to 40 per cent of assets currently allocated to fixed income (bonds, cash and t-bills, mortgages, and the like) has, to date, been invested primarily in domestic issues.

We believe that, with the elimination of foreign content restrictions, pension plan investors may find foreign counterparts to be attractive.

Debt of both U.S. government and corporate issuers, as well as sovereign debt of nations around the world, may become attractive to Canadian registered plans.

One area, in particular, which should enjoy considerable attention is foreign high yield debt. To date, this asset class has attracted little attention from Canadian pension plan sponsors. Perhaps the greatest reason for such apathy is the scarcity of domestic products available. Both the issuers and products available in the high yield sector in Canada are limited.

Looking globally (and, primarily, to the U.S.), the accessibility of high yield product increases significantly. Table 1 shows an estimate of the amount of investable high yield debt currently available.

As Canadian pension funds seek greater returns, the use of higher yielding fixed income instruments may become attractive.

There is also a wide range of sovereign debt that may be of interest to domestic pension plans. In the past, with a statutory cap on foreign content, there was a reluctance to invest in such instruments. With only 30 per cent available, plan sponsors opted to allocate their foreign content exclusively to the equity markets where the greater return pickups were available. Plan sponsors were unwilling to ‘waste’ their foreign content entitlement on the lower return pickups of the fixed income market. With the limit now removed, such foreign debt may be of interest to pension plans.

Hedge Fund Offering
There has also been considerable interest in recent years in the debt of emerging nations. Many ‘hedge funds’ have taken positions in such securities and, either alone or in combination with other strategies, have sold this as part of the hedge fund offering. We would expect to see a number of funds created which invest exclusively in this asset class.

As the correlation of high yield and foreign debt with Canadian universe bonds is quite low, pension funds will have the potential opportunity to increase their expected rate of return while reducing the overall risk (volatility) of the portfolio.

Finally, investment grade U.S. corporate debt may become attractive to Canadian pension plans. Many of the same arguments that are put forward to invest in U.S. equities (more issuers, industries not available in Canada, etc.) could lead Canadian plans to consider an allocation to U.S. corporate bonds.

Analysis done by one large investment counsellor has determined that the use of such additional instruments may not significantly increase the expected return of the fixed income component, but would meaningfully reduce the volatility of this component.

Another broad asset class that may attract attention is the group of strategies collectively known as alternatives. This group may include hedge funds, private equity, real estate, and, most recently, income trusts.

Of these, hedge funds have been considered to be foreign property. While there are many other reasons why pension funds may be reluctant to invest in hedge funds, their status as foreign property is no longer a factor and this may encourage some plans to reconsider their use.

Several managers of institutional assets have reported that the removal of the foreign content limit has had no impact on the composition of their traditional balanced funds. As previously mentioned, many funds were not using their entire foreign content entitlement and had long-standing foreign holdings far below the 30 per cent limit.

While this may not necessarily continue to be the case in future, for now it appears that the removal of the foreign content limit has been viewed by many managers as a non-event.

From that point of view, the federal government is to be congratulated on its timing – it has brought forward the change at a time when it is likely to have little or no impact on Canadian capital markets.

Not too long ago, a popular notion held that investors should direct as much of their investments as possible outside of Canada. The popular refrains were that ‘Canada represents only two per cent of world capital markets’ and that ‘global markets hold many investment opportunities that just aren’t available within domestic markets.’

Several strategies existed to achieve this objective, ranging from the use of life insurance company funds which held foreign property, but were deemed to be purely Canadian investments, to using the ubiquitous clone fund.

Of course, both of the above underlying statements are correct.

However, in our view, they were trumped by the fact that, the occasional trip to the sunny south notwithstanding, the vast majority of the liabilities of Canadian retirees and, therefore, the registered plans that serve them, were in Canadian dollars. Beyond the level indicated by a sensible efficient frontier work, are the market and currency risks inherent in these opportunities worth taking?

What really drove this mindset were the historical returns of the day which held the ‘promise’ of superior returns relative to Canadian investments. (See Table 2)

How much of a ‘non-event’ might this proposed legislation have been had it been introduced at another time?

Consider too, that for many years socalled pension ‘experts’ have criticized the federal government for imposing an artificial limit on a pension plan’s ability to invest outside of Canada. They quote that this has ‘cost’ the plans billions of dollars in lost income. The removal of the foreign limit will now accomplish one significant result. It will silence these critics. It will be interesting to see how fund managers (especially those who were most outspoken in criticizing the foreign content limit) will adjust their portfolios to take advantage of the now unconstrained investment environment.

As well, it should be noted that in those countries which do not have a foreign content limit, typically less than 35 per cent of assets are invested outside of the home country.

While the removal of this limit is unlikely to create a buying spree of foreign equity, foreign fixed income products may very well be of interest to fund managers who, for various reasons, have shunned this asset class to date.

Perhaps the greatest beneficiary of the removal of the foreign limit will be the administrators of pension assets and RRSPs as they will no longer be burdened with the periodic calculation of the amount of foreign content. Furthermore, so-called ‘cloned’ funds which replicate the performance of a foreign property fund – at an additional cost – will also likely disappear.

If history is to be used as an indicator, whatever action is taken by fund managers will be gradual, measured, and cautious. After all, that’s the Canadian way.

Bill Solomon is an actuary, specializing in pension and investment consulting.

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