Seeking the optimal mix

(May 2006) Even though the foreign property rule has been gone for more than a year, many advisors are still reluctant to overhaul their clients’ registered account and boost foreign holdings. You might want to look to institutional investors for guidance.

Bruce Curwood is director of research and strategy for institutional solutions at Russell Investments Canada, the Canadian division of Russell Investments Group, a global investment advisory firm, advising more than $3 trillion in institutional and individual assets.

Aside from the use of derivatives to skirt the FPR, he says direct foreign property holdings among Canadian pension funds has traditionally stuck pretty close to the allowable limits.

“The legislative impact of the foreign property rules had been the biggest issue,” he says. “When you follow the institutional funds, and they’re pretty sophisticated investors, you can see their market values track pretty closely with the foreign property rule. That’s been the largest influence in Canada.”

He says the 30% allocation allowed under FPR was probably too low, while 97% — based on Canada representing only about 3% of the global market — is probably too high.

An optimal mix will vary from investor to investor, based on their individual risk profile, but Curwood says from a volatility standpoint, foreign stocks should make up between 60% and 70% of the overall equity portfolio.

Curwood points out the lack of depth in the Canadian market, where 75% of market cap is tied up in resources and financial sectors. The top 25 stocks alone make up 54% of the overall TSX index.

“Canada, when you really look at it in profile, looks somewhat like an emerging market to be quite honest,” Curwood says. “There are 17,000 stocks you can choose from outside of Canada. There are lots of good opportunities there, so why do we have so much in Canada?”

He admits that the past three years has proven beneficial to an overweight Canadian equity position, but points out that growth in the commodities sectors cannot be maintained.

“If you’ve been fortunate to ride a good wave and you’ve been extremely concentrated, that’s the point in time to diversify and take some risk away,” he says. “It’s not going to run forever. Even if you think oil and gold are going to continue up, it’s not going to be at the pace of the last three years…its decelerating.”

While many advisors and their clients are already sold on the merits of a globally diversified equity portfolio, fixed income investing appears to be another question altogether.

Some investors have said their bond allocation is their “guarantee” and that they do not want to take on currency or political risk in the guaranteed part of their portfolio. Fair enough.

But Curwood points out that a strictly Canadian bond portfolio will miss out on opportunities not available in the domestic market. He has recommended to his institutional clients a foreign allocation of 25%, with the currency risk hedged out.

“We think that’s a better way to go. It opens up the world of opportunity in bonds for you — all the things we don’t have in Canada — but takes away the currency volatility,” he says. “That kind of approach seems to be the best of both worlds.”

Many investors may have concerns over currency volatility, but Curwood points out that the currently high Canadian dollar allows investors to shop abroad at a discount.

He says hedging out the currency risk may be advisable if the foreign exposure is above 20% and the investor has a short time horizon, but that over longer periods, currency fluctuations balance out. With holdings below 20%, currency fluctuations can usually be taken in stride, as they are as likely to help the investor as harm them.

It would be hard to find a better institutional example for your clients than the CPP Investment Board, which announced this month that it would expand its foreign holdings. Already the nation’s largest investment pool, the fund’s managers said it would soon be so large that it would struggle to maintain its current domestic overweighting.

Currently, the $98 billion fund holds about a third of its assets outside of Canada, with most of that capital deployed in the U.S. and Western Europe. The planned foreign expansion will include forays into emerging markets.

“Many retail investors tend look in the rear view mirror as to where they are going to invest, and that’s where the job of the financial advisor is to show them the reasons why not to do that.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(05/19/06)