Benefits and Pensions Monitor
Word Of The Day – The U.S. Dollar
By: Joe Hornyak
The word of the day for Canadian pension funds with U.S. assets is currency.
“Clearly currency risk mitigation is a large topic today and Canadian dollar and U.S. dollar currency risk is the focal point of a lot of discussions,” says Peter Arnold, practice leader, investment consulting, at Mellon.
Over the past two years, a Canadian dollar investor has effectively lost around 15 per cent each year on their U.S. asset exposure. For a typical pension fund, with an allocation of 10 to 20 per cent in U.S. equities, this equates to a one and a half to three per cent loss on the fund’s total assets, he says.
Part of the dilemma is the dramatic fashion in which the U.S. dollar dropped.
Lambros Piscopos, vicepresident, global equities at Natcan Investment Management, recalls that “We had about a 10 year depreciation of the Canadian dollar. We didn’t see 20 or 30 per cent moves in a year.” The speed at which the American dollar lost value gave few money managers and their pension fund clients a chance to respond, even if they wanted to. However, it could have been worse.
Arvind Sachdeva, chief investment officer, large cap equities, large cap value, at Victory Capital Management, says “In the late 1990s, foreign capital did come into the U.S. in a fairly significant way. However, when the U.S. equity bear market took hold in 2001 and 2002 and into early 2003, those portfolios flows actually started to reverse as foreign investors liquidated and curtailed significantly their investments in the U.S.” So the weakening of the U.S. dollar against other currencies didn’t have as much impact in terms of investment in U.S. equities and other asset classes as it could have.
Still, the combination of the weaker U.S. dollar and, just prior to that, the bear market came at a very “inopportune time” for pension plans with a strong appetite for return, says Arnold.
Compounding this is that lot of Canadian plan sponsors had tried to put as much of their allowable foreign content – first 20 per cent fund of fund assets and now 30 per cent – into the U.S. The U.S. market was actually one of the best performing developed stock markets through the 1990s. Canada, on the other hand, was a perennial underperformer.
Better Returns
“We actually did an analysis and over the previous 50 years Canada was the worst performing market, worldwide, after Italy in U.S. dollar terms. Obviously the U.S. offered diversification, but also growth and better returns,” says Piscopos.
Now, Canadian plan sponsors have to determine how much money they should have in U.S. content.
For Piscopos, the answer is easy. It depends on whether you’re looking at short-term or long-term. “In the short-term, it has had a negative impact. What most pension funds try to do, however, is not chase performance. They are not changing their asset mix and allocation based on short-term trends.”
Still, it’s hard to ignore the short-term when last year funds were getting an absolute return of three per cent from the U.S. when Canada and International did 10 per cent. And, looming on the horizon – when you have liabilities and these longterm obligations, and three per cent is not going to do it – is the promise of even better returns from China.
Another issue with investing in U.S. today is that valuations are not cheap. With PEs very high and interest rates low, stocks are expensive and bonds are expensive. That makes stock selection crucial, says Brian Goldstein, vice-president of Foyston, Gordon & Payne Inc.
Still, it’s hard not to be attracted to the U.S. as a long-term investment. “You have to bet on what the country is and it still leads in productivity. It still has the best infrastructure and the best accounting regulations in terms of visibility. As a market, it still offers great opportunity long-term,” says Piscopos.
The U.S. also offers world class management and world class companies in areas that are strong in terms of where a pension fund wants to be positioned for the future – healthcare and technology. The U.S. dominates in these areas. Eight of the top 10 technology companies worldwide are still U.S. based. In healthcare, outside of pharmaceuticals, you have to be in the States.
The value of the U.S. dollar also has a positive impact going forward on its economy. The U.S. has seen its trade-rated dollar decline 15 to 20 per cent, which means that its products on a worldwide basis are 15 to 20 per cent cheaper than they were a year before or two years before. That’s very good for the export side of the economy.
Start To Spend Money
Goldstein thinks eventually the industrial economy in the U.S. economy will benefit by the decline in the dollar. Many companies have cut back their capital spending plans over the last five years while their cash flows have improved immensely with the improvement in the economy. They’ve used that cash flow to pay down debt and accumulate cash as opposed to making massive capital expenditures. “If they see an improving export market for their product, they may start to spend money on their plants and equipment,” he says.
There are other, less talked about, potential catalysts for possibly very attractive returns from U.S. equities, says Sachdeva. These would have to do with some of the reforms that the administration is proposing for social security and taxes. There isn’t a lot of information on all of those subjects yet, “but as we move forward through the year, if there are some bold ideas from this administration on these two areas, it could be something that the market would respond to.”
Still, the cautionary warning is the consumer sector. As the dollar goes down, it makes imports that much more expensive for the consumer. The policies that have caused the budget deficits to rise and the U.S. consumer’s “presumed insatiable appetite for foreign goods” have bothered a lot of economists, says Sachdeva.
For Canadian pension funds, this experience has – in addition to small cap versus large cap, value versus growth, active versus passive, all the issues that pension funds grapple with in their investment program – raised the question of ‘should the fund hedge its U.S. exposure, partially hedge it, not hedge it at all?’
The Canadian dollar’s appreciation versus the U.S. dollar during this time means unhedged Canadian investors failed to effectively participate in the U.S. equity rally, says Arnold.
In deciding whether or not, and how much, to hedge, consultants would use correlation matrices to analyze historical and forecast data to determine how various asset classes, such as currency, have moved together and are expected to move together in relation to other asset classes. Over the past 25 years, Arnold says their analysis suggests that hedging would have had a detrimental effect on the correlation between U.S. and Canadian equities, but a slightly positive effect on the correlation between Canadian bonds and U.S. equities. If you assume roughly that the typical pension fund has had roughly the same allocation of Canadian equities and bonds, hedging would appear to be “awash in the wrong term.”
Bumps In The Road
Part of the focus on how much to hedge is what the plan wants to do, says Arnold. “If you simply want to take out some of the bumps in the road, partially hedging U.S. exposure on a strategic basis, might make sense.”
However, it’s also important to step back and say that ‘yes, currency risk is important, but it’s ultimately a question that needs to be taken in the context of a fund’s total plan-wide risk.’ While currency risk may be important, maybe it’s number four on the list of priorities. When you go back to issues like goals and objectives, manager structure, and what’s the important thing to achieve, currency might stand out today, but in the long-term it might not be that big a concern,” says Arnold .
Another approach to dealing with the currency issues is to use bottom-up stock selection. Goldstein says some investors may start looking at what’s happened in the currency market and look for companies that will benefit from the declining dollar.
Ultimately, investing in the U.S. is like investing anywhere. It comes down to the manager.
Goldstein says it is important to be consistent with respect to any style. “I don’t think that you would want a manager that’s doing different things in Canada, the U.S. and overseas. You want a manager that’s consistent in their style.”
The main objective is to identify managers that can actually do it skillfully and at a reasonable price, says Arnold. Regardless what the plan is thinking about doing, “you really can’t settle for second best. It’s a quality game.”
Joe Hornyak is executive editor of Benefits and Pensions Monitor.
Canadian Investors And U.S. Bonds
U.S. bonds may provide another option for reaping return from U.S. assets without actually making a permanent allocation to them.
Margaret Isberg, president of PIMCO Canada Corp., says Canadian pension plans don’t invest in foreign bonds to any great extent. “It’s the legacy of the foreign content laws that has caused people to have a home country bias with their bond allocations.”
Pension plans also have to be conscious of matching their liabilities. “Since the value of their liabilities fluctuate with Canadian interest rates, they can’t just say ‘oh the market is small here and it’s expensive, so we’re going to invest all our money in foreign bonds.’ That introduces an asset-liability mismatch.”
Currency only compounds the situation. Currencies are “notoriously volatile and they’re famous for defying logic and surprising you, à la the Canadian dollar,” she says. “Everybody thought it was undervalued for five, six, seven years, but it stayed that way. Then it became more fairly valued in a hurry.”
Despite the obvious risks of investing in U.S. and other foreign bonds, pension plans have some very good incentives to use them. Spread products (bonds that offer a yield advantage relative to Government of Canada bonds) in the Canadian market tend to be quite expensive. “There is a lot of money chasing relatively few opportunities. Outside of provincials, the main spread sector in the Canadian bond market is corporates and they are chronically expensive and dominated by just a handful of industries. Since there are not as many issuers, it is harder to diversify.”
One way around this is to use a core plus approach. While not well known in Canada, it is well understood in the U.S. Essentially, it refers to a style of bond management that respects and understands that if the benchmark is all Canadian bonds, then that’s what the mission should be. However, at the margin, it invests in other bond markets to generate more alpha. The plus is achieved by using non-Canadian bonds, such as corporate bonds in the U.S., either directly (on a hedged basis) or through the CDS market. “You can take exposure to U.S. and other global corporates without actually keeping the foreign interest rate or currency risk,” says Isberg. “You can improve the structure of your corporate holdings in terms of diversification by selecting from the larger global corporate universe.”
Canadian plan sponsors are starting to see that there is an opportunity to enhance returns by using a more discretionary or core plus-type of fixed income management where they invest tactically in non-Canadian bonds and other non-index securities. This enables them to take advantage of changing relative values and bond markets around the globe.
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