Why Diversify?

Why Diversify?
by Brian Bruce

Most pension plan sponsors utilize their domestic asset classes when allocating the majority of their assets. Why would an investor consider another asset class? There are two main reasons. First, if returns are greater in a new asset class, it would be worth considering. Second, if the return was the same it would still be beneficial to add a new asset class if it lowered the overall volatility of the plan. This paper will address the issue of adding international equities to a Canadian pension plan to see if either of the above criteria is met.

Higher Returns
What have returns been over the last 30 years for Canadian and non-Canadian equities? Figure 1 shows that each of the last three decades has had a different asset class perform best. The seventies were slightly in favour of the Toronto Stock Exchange 300 index (TSE 300). The eighties strongly favoured Morgan Stanley Capital International's Europe Australia Far East index (EAFE), while the nineties strongly favoured the Standard & Poor's 500 index (S&P 500). The cumulative returns highlight how strong the non-Canadian performance was over the entire thirty-year time period. The TSE 300 returned 2431%, but significantly trailed both EAFE (5231%) and the S&P 500 (5841%).

Expanded Opportunity Set
Why have the equity markets outside of Canada performed so well, and will this continue? If the performance was due to unique events, it is unclear whether performance will repeat. If, on the other hand, the outperformance is due to structural reasons, it is more likely to continue. We suggest that the performance is due to the larger opportunity set of countries, sectors and stocks that are available outside of Canada. This is a structural difference that should persist.

Figure 2 highlights the differences in country returns available. Contrary to popular opinion, the returns of markets are not converging, as the spreads have been as high in the last two years as anytime in history. In terms of the best performing sectors of 1999, Canada was represented in only two of them. As well, in looking at the highest returning stocks in 1999, only three of the 80 that returned more than 100% were Canadian. Clearly, there are opportunities for superior return outside of Canada.

Less Risk
The second reason for adding a new asset class is that it would lower risk. Generally, higher returning assets are riskier as investors need to be paid more for assuming risk. In terms of standard deviation, over each of the last three decades the TSE 300 has been riskier than either the S&P 500 or EAFE. This is surprising, in light of the previous analysis that showed the TSE was the worst returning of the three indices.

A second way to look at risk is to see what correlation the Canadian market has to the U.S. and the developed markets. Lower correlations are desirable, as they indicate that markets have less movements in common. When an investor diversifies, it is desirable to find assets that don't all go down at once. A look at Figure 3 shows that, as expected, the correlation between the North American markets is reasonably strong at 0.76. However, a look at the correlation between Canada and EAFE shows that investing in the developed markets outside North America provides a much better diversifying asset class for a Canadian portfolio.

How Much?
The recent regulatory change allows Canadian plans to move from 20% foreign content to 25% and soon to 30%. The analysis presented here suggests that based on the limited opportunity set of investments in Canada, it makes sense to expand investments beyond Canadian borders. But even though it makes sense, do people in similar situations do it? A look at Figure 4 shows the foreign allocations for pension plans around the world. In many smaller, less diversified markets, allocations are significantly higher than 30%. Hong Kong leads the way with 70% allocations outside of its home market. Belgium, Ireland, Japan, the Netherlands and New Zealand are all at 30% or higher, with many more countries close to that level. This suggests that without regulations, investors in smaller markets believe that investment outside their home market provides higher returns and/or less risk.

How much should be invested outside of Canada? 20%? 25%? 30%? Figure 4 shows that many countries exceed 30%, but for a Canadian plan what is the exact risk/return trade-off? Figure 5 shows the efficient frontier combining Canadian equities with non-Canadian equities. The frontier shows that there is a significant gain in return while continuing to also lower risk for allocations up to 70% foreign. This result is an ideal situation for investors. There is no need to trade off additional risk to gain higher returns. With the regulated limit of 30%, it seems clear that moving to 30% not only is reasonable, but is the most prudent course of action for a Canadian plan sponsor.

Brian Bruce is the Director of Global Investments for PanAgora Asset Management in Boston

Transcontinental Media G.P.