Seeking out the best risk adjusted returns for clients involves allocating investment dollars outside of Canada. For over a decade we have been educating clients on the benefits of investing outside of Canada.
Canadians are typically comfortable investing in domestic companies that are close to home, known as “home country bias.”
Perhaps this was ingrained into peoples thoughts from years ago. Prior to February 2005, Canadians were restricted to holding no greater than 30 per cent of their registered accounts in foreign holdings.
The 2005 budget changed the rules so that Canadians had the flexibility to invest up to 100 per cent in foreign investments if they wish.
Canada Pension Plan (CPP)
As of March 31, 2018, the CPP Investment Board managed $356.3 billion and is governed by the Canada Pension Plan Investment Board Act.
The board is directed to act in the best interests of all of us who contribute into CPP and to beneficiaries of current or future payments. It is instructed to invest “with a view to achieving a maximum rate of return, without undue risk of loss.”
One section within the annual report that is interesting is the historical comparison of the portfolio over time.
For example, in 1999 the board invested 100 per cent of the CPP assets in Canada. In 2006, the board had an allocation of 64 per cent in Canada and 36 per cent outside of Canada. In 2018, the board’s assets were 15.1 per cent in Canada and 84.9 per cent outside of Canada.
Global Diversification by Region
Source: CPP Investment Board 2018 Annual Report
We see many new clients where we have to transition their portfolios away from a 100 per cent Canadian dollar and 100 per cent denominated in Canadian holdings.
We normally start the conversation by showing the performance of other indexes around the world. We also explain how Canada represents only 3.16 per cent of the world’s market capitalization.
One just has to look at how the CPP Board and other large foundations, endowments, pension plans invest in Canada — all have a similar goal of achieving the best risk adjusted return.
It doesn’t give Canadians a huge amount of comfort about investing in Canada when our own CPP Board is reducing Canadian exposure every year.
MSCI ACWI All Cap Index
The MSCI ACWI All Cap Index represents holdings across 23 developed markets and 24 emerging markets. This index covers 99 per cent of the global equity markets.
The 23 developed markets include: Americas — Canada and United States, Europe and Middle East — Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Israel, Italy, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and United Kingdom, Pacific — Australia, New Zealand, Hong Kong, Japan, and Singapore.
The United States represents 54.23 per cent of the world’s market capitalization. Other market capitalization percentages include Japan at 7.9, United Kingdom at 5.39, and China is at 3.38.
As a portfolio manager we are able to purchase securities on exchanges around the world. With the U.S. representing 54.23 per cent of the world’s market capitalization, it is a good place to start.
U.S. equities can play a unique part for Canadians in a diversified portfolio. We are able to purchase publicly traded securities through designated stock exchanges as easy as purchasing a security in Canada.
Purchasing large companies in development markets is also straight forward. Several international names trade on U.S. exchanges as American Depository Receipts. An ADR is one system of purchasing individual foreign securities through an American trust company or bank, which holds the security in safekeeping.
We are also able to purchase stocks directly on foreign exchanges.
The 24 emerging markets include:
- Americas — Brazil, Chile, Columbia, Mexico and Peru
- Europe, Middle East and Africa — Czech Republic, Egypt, Greece, Hungary, Poland, Qatar, Russia, South Africa, Turkey and United Arab Emirates
- Asia — China, India, Indonesia, Korea, Malaysia, Pakistan, Philippines, Taiwa, and Thailand
The most popular way historically to obtain exposure to emerging markets is through mutual funds.
Some investors may own “international” and/or “global” mutual funds. There is a difference.
An “international” mutual fund generally refers to those that invest in securities outside of North America with no investments within Canada or the U.S.
A “global” mutual fund invests throughout the world, including Canada and the U.S. Always consider the fees and liquidity of each investment, especially mutual funds that have embedded costs.
Exchange Trade Funds (ETFs) are designed to closely track a domestic index, foreign index or specific sector. They provide easy access to a wide variety of Global and International Indexes.
When you invest in ETFs, you know exactly what you’re investing in as their components are generally disclosed every trading day.
The one negative component we have seen with ETFs is the relative performance of the index versus the specific ETF — often referred to as a tracking error.
Over the years we have seen these tracking errors being relatively small or large (both negative and positive). Despite this, ETFs have become a popular and simple way to add foreign market exposure which is highly diversified. They are also more cost-effective than mutual funds.
Our primary approach to emerging markets is to purchase individual equities in developed markets that have significant sales or divisions in emerging markets. This is the lowest cost approach and is also complimentary to holding all direct holdings.
Other reasons to look beyond Canada
If Canada’s relatively small size in world market capitalization doesn’t convince investors to consider looking beyond our border then let’s consider a few other factors.
1. Our model portfolios will typically have 30 — 35 individual companies. Why limit investment opportunities to the best companies in Canada when investors can expand that to the best companies in North America or the world?
2. Other countries may dominate in other sectors that Canada is weak in. By diversifying by geography you will also be diversifying by sector. US equities can provide exposure to sectors that Canada is weak in such as health care, consumer cyclical, consumer non-cyclical, technology and communication.
3. Economic forecasts between countries. Many countries are growing at a faster pace than Canada. By investing in different geographic areas then you are spreading out economic risk.
4. Political risk within countries can impact financial markets. Policy changes, corruption, and leadership changes can result in confidence levels changing in markets. By having your funds in different geographic areas, this risk is spread out. Trade agreements can also have an impact some countries more than others.
5. Diversifying currencies is another component of managing risk. For the last seven years, most Canadians who have purchased USD have also seen the benefit of currency gains. Of course there is the risk of currency losses if our dollar becomes stronger relative to other currency. We feel investors are maximum rate of return, without undue risk of loss”.
6. The competitive environment is also different country to county. For example, the technology sector in the United States is highly competitive which has driven some companies to excel to best in class and dominate overseas. Other countries have a less competitive environment. Sometimes a lack of competitive environment favours some companies in some countries. As an example utilities often are regulated and have a monopoly. It is not uncommon in some countries to see an oligopoly in some sectors. For example, in Canada they are always striving to get more competition in the telecom sector.
One of the sayings that still applies today with respect to geographic exposure — don’t put all your eggs in one basket. We recommend you talk to your Wealth Advisor about opportunities both in Canada and abroad.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138.