Leaving home in a global world

Studies consistently show if investors stay in their comfort zones—their home countries—they’re sacrificing returns. In this second part of our global report, we delve deeper into the investment landscape

Canadian investors have had it lucky staying at home.

They’ve watched commodity prices leap forward as the developing world deepens its industrialization, buoying Canadian stocks. But they’ve also been punished in their international investments as currency traders have pushed up the value of the Canadian dollar.

That’s different from the ’90s, when Canadians were so anxious to reap the benefits of global investing that fund companies created clone funds. Investors could see returns being netted elsewhere—anywhere, it seemed, but Canada. They were also spurred by the falling fortunes of the Canadian dollar, which went into a tailspin as the decade closed and touched $0.63 in the early 2000s.

Compared to then,Canada has fared extremely well among developed markets. Its banks didn’t drive over the cliff with subprime mortgages. Oil, which was dipped to the single digits at one point in the late 1990s, is now well over $70. Similarly, gold was range-bound at about $250 an ounce. Now it’s north of US$1,650.

“Canadian market equities have done very well compared to most developed markets, so the question comes back, why should they want to underweight Canadian equities?” says Raman Aylur Subramanian, executive director of MSCI in New York.

But two-thirds of the Canadian market is made up of just three out of the 10 globally recognized sectors: financials, energy and materials. And few Canadian companies command instant recognition.

There’s Research in Motion, but singling it out only points to the hollowness of Canada’s tech sector. Our consumer brands are largely American or global. Even manufacturing is slim pickings in Canada, beyond Montreal based Bombardier.

While Canadians benefit from the globalization of commerce, they can’t often invest in it at home, notes Mary Anne Wiley, managing director and head of iShares distribution at Black- Rock Asset Management Canada Limited.

She says Canada lacks homegrown investing opportunities in healthcare, pharmaceuticals and technology. The brands we know, trust, and use every day—like Novartis, GlaxoSmithKline, and Apple—all have their roots beyond Canada’s shores.

“There is a level of globalization in many facets of our world, but I think a little less so in investing,” she says.

For investors, trust is a big factor in the decision to stick with the home team—though it can at times be misguided trust. “Everybody wants to buy what they know,” says David Garff, president of Accuvest Global Investors in Walnut Creek,California. “I’m going to buy Coke because I like Coke or I’m going to buy Apple because I love my iPad. I somehow understand that business better because I’m a consumer of that business.”

But, as Garff points out, unlike legendary investors such as Warren Buffett (who holds a huge stake in Coke), the majority of investors don’t actually know those companies.

Instead, they project what they don’t know: “Some faceless, nameless company in Malaysia may be the best business in the world,” he says, “but if I don’t know anything about it, all I can think about is the accounting frauds, the kickbacks those Malaysians supposedly pay to their politicians. I make snap judgments.”

Yet domestic companies have done the same: false accounting, political interference (think Potash Corp.), sudden shifts in taxation policies and wonky economic policies.

Canadian pension funds,meanwhile, hold half their equity assets in Canadian stocks and Investment Funds Institute of Canada data suggests investors hold more than 60%of their assets in Canadian equities. So far it’s worked. Why change?

The answer is long-term uncertainty. Better known as risk. The simplest argument for diversification is that while investors can’t control returns, they can control risk, particularly the risks of over-concentration. And Canada is a concentrated, undiversified market.

On a global scale, it may well be the biggest small-cap market in the world—and it’s still only about 4%of the total. Our banks, mines and oil companies dominate our economy, but there are bigger banks, miners and oil companies in other countries.

Diversification, the only free lunch in investing, encompasses a number of dimensions. Market capitalization is one: small cap versus large cap. Geography is another: different countries have different economic cycles. Canada and emerging markets were laggards in the 1990s. Now they lead the pack. But there are also sectors. In the late 1990s, technology moved markets. Now, energy stocks are a driver.

So, how to diversify?

As country correlations have increased, MSCI’s Subramanian recommends a different approach to asset allocation. “Developed markets are driven mainly by global industry and style risk factors, and less by differences across countries or regions,” he says. “Compared to a domestic/international structure, global mandates enable managers to pick stocks from a global opportunity set, and accommodate investment bets on global sector and style exposures.”

Subramanian says this is increasingly the case with U.S. pension funds, thanks to the fallow returns after the financial crisis. They have gone global. In Canada, it’s less certain if investors are eager to embrace a more global mandate.

Then there’s the question of how a global mandate and an emerging markets focus differ. Country factors are still important but most international or global funds underweight developing markets, he adds. “Emerging markets, on the other hand, continue to have different risk and return dynamics, with local risk factors and country allocation as the dominant drivers.”

Some believe Canada is a leveraged play on emerging markets, given the weight of commodities. But Subramanian says emerging markets are not just a commodity story. There are consumer and technology companies that Canadians don’t have exposure to at home.

Similarly, BlackRock Asset Management Canada Ltd. highlights the increasing role of sector allocation. In a 2009 whitepaper, it notes, “Academic research increasingly points toward sectors as significant determinants of return in a global portfolio.

“Since this is less pronounced in emerging markets, the benefit of country allocation is still greatest in these markets. In addition, this implies that as emerging markets integrate more closely with the developed world, the importance of global sectors is expected to increase.”

Explains Wiley: “There’s a lot of different ways you can use sectors to benefit the portfolio. One is tactical—having an understanding of where we are in the business cycle, knowing that some companies or some sectors are going to do well in an expansion and others will perform well in a contraction. So there’s an opportunity to add value.”

The second, she notes, is to diversify or fill gaps and look beyond the three sectors that dominate in Canada and get exposure to sectors like IT, “which can be a very strong performer, though not well represented in Canada.”

Sometimes, a diversified country exposure doesn’t line up with increased sector exposure. BlackRock poses the example of overweighting the U.K. in a country asset allocation—which might make sense given the macroeconomic pressure on the euro. But, like Canada, there is a minimal IT weight in the U.K. indexes. In such a case, a country overweight, by default, becomes a sector underweight.

Over time, at least in academic studies, style, country and sector factors have changed positions in how much they account for global stock returns. Garff has found, to his surprise, that leading companies are more correlated to their country return than to their sector return.

His conclusion: “We see great opportunity in the differentiation between the countries. Regardless of whether it’s developed or developing, and even when the sector is more important than anything else, we still have great opportunity to try to generate lower volatility or outperformance.”

Country or sector—they can change places—but Canadians can’t have exposure if they don’t have all the sectors or countries in their portfolios.

Scot Blythe is a Toronto-based financial writer.