IN PRINT ARCHIVE CIR Summer 2000
|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.
Expanded Opportunity Set
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.
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 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