Three arguments for diversification

The group of voices calling on Canadian investors to diversify their assets is getting louder and more insistent. Good planners already know the value of diversification and have more than likely recognized the risks of continuing to ride the Canadian performance wave, but some clients might need a good argument or two to shake the home country bias and reallocate some of their portfolio assets.

The tendency to stay invested close to home in familiar territory is powerful and difficult to ignore, particularly when the home country’s market is performing well. The Canadian dollar though, has also thrown up an additional mental roadblock for investors — diversification hasn’t paid off in the past few years because the currency’s rapid appreciation has significantly eroded world returns. Although three year cumulative total returns on the MSCI World Index rose 78%, as of April 30, in Canadian dollar terms that return amounts to only 39%.

Those watching the Canadian mutual fund industry say the tide is turning, slowly on the retail side of the business, but many investors are still clinging to their highly concentrated portfolios.

Fidelity Investments managing director Bruce Johnstone says the typical Canadian client is 70% invested in Canadian equities. Not only is the market highly concentrated in only three sectors — financials, energy and materials, he points out that recent performance is also highly concentrated, likening market movements to technology sector performance in the past. “Canada is a narrow market, driven by a commodity that’s gone up four-fold,” he told a group of advisors gathered at a recent Fidelity road show in Toronto. “We’re not clairvoyant so we absolutely need to talk about diversifying.”

Although he says current conditions don’t necessarily mean things will end badly, there are a number of factors at work that should give investors some pause.

According to Johnstone, consumer spending drives roughly 56% of GDP in Canada and 70% of GDP in the United States. For the first time in history, pension plan contracts are being taken away, injecting an element of uncertainty into the consumer sector that wasn’t there before, at a time when consumer debt is hovering close to all time highs.

On top of this, businesses are starting to realize the profit potential that comes with outsourcing jobs to low wage countries. He says wages make up 70% of the costs of running the typical corporation and outsourcing those jobs will only get easier in the future. “We’re not in the ninth inning of this game, we’re in the second inning of this game,” he says. “It’s very comfortable to stay in your own market, but it’s time to start moving the dial.

Be price conscious

Even though cheap stocks can be found in the most expensive markets, the first argument in favour of diversification can be found in the high valuations presenting themselves in the Canadian marketplace.

“The cheaper valuation markets are the places where we are likely to find most of the bargains,” says Don Reed, president and chief executive officers at Franklin Templeton Investments. “Generally speaking, Europe’s the cheapest region on a price earnings yield basis and Asia is cheaper on a price to book and price to cash flow basis.”

Not only are stocks cheaper in other parts of the world, Canadian dollars are also buying more shares than they would have in the past. “The Canadian dollar is the strongest currency in the world. It’s even stronger against the euro and the yen,” says Reed. “If I bought a radio in the United States five years ago that cost $100, I’d spend $150 Canadian to get it. Today if I went and made that same purchase it would only cost me $112 Canadian. In the same way I can buy these stocks by putting up less money than I would have before on a relative basis. The strong Canadian dollar is a benefit to investors.”

Finding future performers

Johnstone points out that the Canadian market is more mature than others in developing countries and has already benefited from trends like deregulation, pension, tax and banking reform and wealth distribution. “These haven’t happened in other parts of the world yet. Why not get out in front of these trends? A lot of places around the world are growing faster than the industrialized world,” he says. “In the next 20 years, where’s the growth going to be?”

Statistically, managers say it’s unlikely that growth will continue come from Canada, particularly given the fact that Canada has outperformed global markets for five years, and has already gone through a major correction in recent weeks. “We all know that the persistence of that for another five years is actually very, very unlikely. Behaviourally we as individuals think we’d better stay in Canada, but that’s the wrong conclusion,” says Noel Lamb, chief investment officer of Russell Investments Group.

“Market timing is notoriously difficult to get right, but what you can say is that the odds of a five-year winning streak continuing for another five years, it’s statistically unlikely. We all need reminding of that.”

Filed by Kate McCaffery, Advisor.ca, kate.mccaffery@advisor.rogers.com

(05/23/06)

Kate McCaffery