Friday, February 13, 2009

Canadian Institutional Investors Revisit the Fundamentals

By Joan Weber on

Faced with the most challenging environment for institutional investing since the Second World War, Canadian pension plan sponsors, endowments and foundations are going back to basics: revisiting the fundamental principles by which they run their portfolios, reviewing their asset allocation, scrutinizing their managers more closely, and strengthening due diligence processes. Provincial Canadian governments in particular report that they are looking carefully at how they might modify best practices to ensure the continued integrity of funds for their participants going forward.

Investment losses incurred in 2008 have left Canadian institutions concerned about their ability to meet their funding requirements, and in some cases questioning the very strategies they had been employing in their portfolios. Prior to the events of the fourth quarter of 2008, the share of Canadian institutions planning major revisions to their portfolios was actually on the downswing. Of the 277 Canadian pension funds, endowment and foundations interviewed by Greenwich Associates at the end of Q3 2008, 57% said they planned to make “significant” changes to their asset allocation over the next three years, down dramatically from 70% in 2007.

Rather than changing course, Canadian institutions were proceeding with plans to continue reducing allocations to domestic equities and to shift assets from passive and core strategies to active managers and specialists with the potential to generate alpha. Domestic equity allocations among all Canadian institutions fell to 18.7% of total assets in 2008 from 21.0% in 2007. “Institutions went into the fourth quarter of last year planning to continue their move out of domestic equities,” says Greenwich Associates consultant Dev Clifford. “But the fact that virtually every asset class got hit last year — including international investments and alternative asset classes — has called into question the benefits of the diversification push that has driven institutional allocation strategies for the past several years.”

Provincial Pension Funds: Leaders in Alternatives

Institutions in Canada last year continued to add to alternative allocations that were already larger than those reported in Europe or the United States. Canada’s public and provincial pension funds are among the world’s most active investors in alternatives. As of the start of Q4 2008, these funds had allocated more than a quarter of their overall assets to alternative asset classes, including 12.5% to real estate, 6.9% to private equity and 3.6% to hedge funds.

They allocated an additional 2.3% of assets to infrastructure and 0.6% to commodities. Canadian public and provincial funds have also been the leaders in the recent movement of assets out of domestic stocks and bonds. Heading into October 2008, allocations to domestic stocks averaged 16.0% among these funds, compared with 23.8% among Canadian corporate plans and 19.1% among Canadian subsidiaries of U.S. companies. At 28.2%, public/provincial allocations to domestic fixed income were also the lowest among Canadian institutions.

Corporate Pension Plans: Committed to Defined Benefit

Canadian companies remain committed to their defined benefit pension plans. As of the start of Q4 2008, DB plans held 91% of Canadian pension assets and companies expected that share to remain above 85% for at least the next decade. Although 27% of corporate DB plans in Canada had been closed to new employees as of that period, only 2% of corporate plan sponsors said they intend to close their plans in the next two to three years.

Canadian companies in 2008 reported an average funding ratio of 102% on their defined benefit pension plans. It is important to note, however, that Canadian DB plans are required to update their reported funding ratios only once every three years. In all likelihood that impressive average funding ratio has deteriorated significantly with market losses experienced in 2008.

Endowments and Foundations: A Conservative Approach

While U.S. endowments and foundations have traditionally been on the cutting edge of promising new asset categories, their counterparts in Canada take a conservative approach. At the start of Q4 2008, Canadian endowments and foundations had allocated half of their total assets to domestic fixed income. Meanwhile, their 23.5% allocation to foreign investments trailed that of both corporate and public/provincial pension funds. This conservative attitude was clearly evident in alternative asset classes. While public/provincial plans allocated more than 12% of assets to real estate, Canadian endowments and foundations allocated 1.8%.

The average 2.0% private equity allocation among endowments and foundations was a full three percentage points lower than that of corporate pension funds and nearly five percentage points lower than that of public and provincial funds. In hedge funds, the 2.8% endowment and foundation allocation topped that of corporate funds, but fell well short of the 3.6% allocation among publics and provincials. Canadian endowments and foundations on average did not allocate any assets to infrastructure or commodities last year.

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