Life After The Foreign Property Rule
By: Joe Hornyak
Last February, the federal government’s budget dropped a huge bombshell on the pension industry in Canada. With no warning, the decision was made to eliminate entirely the Foreign Property Rule (FPR).
Prior to 1990, the FPR, which limited the amount that could be held as foreign assets in pension accounts, was set at 10 per cent of the book value of a portfolio. Beginning in 1991, the limit was increased gradually, two per cent per year over five years, to 20 per cent. Over the period 2001 and 2002, it was eased to 30 per cent.
The purpose of the FPR, wrote David Burgess and Joel Fried in their analysis ‘The Foreign Property Rule: A Cost-Benefit Analysis,’ was to increase the value of the dollar and reduce its volatility, decrease the cost of capital in Canada, and decrease the extent of inequality inherent in pension plans. However, they argued that on the basis of evidence from the “easing of this regulation from 20 per cent to 30 per cent, we find that it accomplishes none of these objectives. There was no measurable impact on the exchange rate predicted from the Bank of Canada’s forecasting equation; the capital outflow from the change amounted to no more than two days trade in the foreign exchange market over the period 2000/01.”
As well, Canada’s equity markets did significantly better internationally while the FPR was eased than in the prior two-year period.
Finally, they said “closer inspection reveals that the rule exacerbates income inequality by imposing the largest costs on lower middle-income groups. We estimate that the increase in the FPR from 20 per cent to 30 per cent increased Canadians expected income by between $500 million and $1 billion dollars annually by permitting greater portfolio diversification. The complete removal of the FPR would increase income by an estimated additional $1.5 billion to $3 billion dollars annually.” Co-incidently, over the past couple of years, Canadian equity markets have been the strongest in the world and the Canadian dollar has risen to heights not seen in decades. In fact, both are proving to be obstacles against Canadians taking advantage of the elimination of the FPR and investing more abroad these days.
Still, interest in foreign investments is growing. A Greenwich Associates report suggests that more than 40 per cent of Canadian institutions expect to increase their use of U.S. treasuries and high-grade corporate bonds as a result of the elimination of the FPR. The 2005 Canadian Fixed Income Study says while U.S. bonds will be the biggest beneficiaries of the investment shift, almost 40 per cent of survey respondents say they plan to increase their use of European investment-grade corporate bonds, more than 30 per cent plan to use more U.S. agencies, and more than 25 per cent expect to use more European government debt. Canadian institutions also plan to increase their holdings of foreign bonds from the current three per cent of total assets under management to five per cent.
Yvan Fontaine, senior vice-president, investments, at Addenda Capital, says the elimination of the rule means Canadian plan sponsors will get more latitude when it comes to investing money.
When the last easing of the limit took place, pension funds were, generally, in surplus positions. “The recommendation then was to sell Canadian bonds, to sell Canadian stocks, and to buy international stocks,” he says. This was because returns from U.S. and European stocks were five to 10 per cent higher than the Canadian stock market. Since pension funds had surpluses, taking more risk “was the way to go.”
Today, funds are not in surplus positions and are less willing to take risk. Fewer stocks and more bonds means “international bonds are finally going to pick up a little bit in Canada,” says Fontaine. In fact, signs of this have been seen since the beginning of the year as foreign issuers are coming out with Canadian dollar bond products.
Elimination of the FPR also gives Canadian investors more diversification possibilities. There are a lot of sectors in Canada where there are no issuers – retail, for example. Now, however, investors can get access to retailers such as Wal-Mart. This is going to allow them to get more diversification in their portfolios, says Fontaine.
For Canadian fixed income managers, elimination of the FPR is a good thing, says Fontaine. It has opened new opportunities for them to serve their clients and grow their businesses.
While the fixed income side of the industry is excited about the new environment, Mike Gillis, vice-president, institutional marketing and sales at SEAMARK Asset Management, says on the equity side “What we’re seeing initially, in terms of proposed or plan changes or reactions to the elimination of the FPR, is nothing.”
Waiting To See
“Everyone is waiting to see and one of the reasons people are waiting is that U.S. equities have done nothing over the last year and a half while Canadian equities have done quite well.”
Investors are also wrestling with the currency effect. “People are living in the short-term and I think it’s a mistake. As things change, I think personally, we’ll see more movement and I’m basing that on the fact the U.S. economy is just too big to ignore and the Canadian market is too narrow to maintain its high weighting in a portfolio. Just take the top four or five U.S. companies by market cap and you exceed the entire market cap of the TSX,” says Gillis.
What will drive this change is a combination of several forces. Money managers will start going to their clients saying ‘look, we want to perform for you, but in order to do that, can we start looking out into these areas?’ It may also be a reaction to outside managers trying to come into Canada, says Gillis. This will mean Canadian managers will need to find ways to satisfy the growing global interest being shown by their clients as they seek new ways to generate returns to meet pension fund obligations.
However, Gillis says the consultants have a role to play. “I think there is a shift going on in the industry. Return is so important now. Return was a given, at least return in terms of beating your actuarial assumption, for 20 years. Now, return is of paramount importance and the question is ‘how are you going to get there?’ I think it means that you look beyond one source for return, Canadian equities. Consultants are going to start telling their clients that they need to have broader U.S. equities and international equities. And you can’t just look at long-only. Maybe look at long-short, look at hedge funds, private equity, you have to look at a multitude of sources to try and get that return.”
Obviously, in this new environment, Canadian managers will have to adapt.
“Canadian managers are going to have to decide whether they want to be narrowly focused and have Canadian-only mandates or whether they’re going to beef up their foreign capabilities. There is an underlying assumption that we don’t have competitive abilities to manage foreign or U.S. equities. However, if I look at the managers in Canada, some of the best performers have been Canadian managers of non-Canadian assets.”
Joe Hornyak is executive editor of Benefits and Pensions Monitor.
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