Now that the foreign content limit has been eliminated, the rationale for putting foreign securities into domestic funds evaporates along with it.
Now that the contents of the federal 2005 budget are public knowledge, the analysis is under way. Many people have correctly pointed out that the increase in the personal exemption threshold is modest. Many have pointed out that the increase in RRSP contribution limits only affects a small percentage of the population. Many have pointed out that the elimination of the 30% foreign property limits on RRSPs and pension funds will at least lower costs by about 50 basis points (a basis point is 1/ 100 of 1%) for those funds that use derivatives beyond the old 30% limit. It’s all modestly positive, but generally motherhood news.
To my mind, the big sea change that no one is talking about as a result of this budget is the rationale that fund managers will now put forward for fund impurity. What will their excuse be now? Remember, the foreign content limit prior to the budget was not only 30% on foreign property; it was also 30% of all assets in 100% eligible Canadian property. For instance, one could legally get to 50% foreign content by simply putting 30% of book value assets into foreign property and then buying Canadian funds that were also 30% invested in foreign property. Simple math shows that 30% of 70% is another 21%, allowing an investor to get to 51% foreign content without incurring penalties.
Now that the foreign content limit has been eliminated, the rationale for putting foreign securities into domestic funds evaporates along with it. Some money managers have given various reasons for foreign assets being included in the first place. The most prominent being concern about liquidity and the ability to exit some stocks quickly. I never bought into that argument.
Active managers often go on and on about how they employ certain strategies to increase return, reduce risk, or both. They never mention that fudging their asset allocation is a big part of their modus operandi. Until now, they’ve always had a ready-made excuse for that fudging. They were doing so to get around unduly restrictive foreign content limitations.
I was speaking with fund manager Kim Shannon if the CI Canadian Investment Fund recently and I asked her for her thoughts. Her view is that the change won’t materially move either prices or valuations. She says it will be interesting to see how managers react, since many Canadian equity managers have always had a foreign equity component as their preferred method of circumvention. She also believes she could function well irrespective of which benchmark (blended or pure) is ultimately adopted.
I think most Canadian mutual funds put foreign property into their funds primarily to enhance risk-adjusted return. For instance, if the U.S. market returns 2% more on average than the Canadian market (which it has done, historically), then investing 25% of your Canadian mutual fund in U.S. stocks would lead to an increased return of 50 basis points (0.5%), all else being equal. As such, putting foreign stocks into Canadian funds is the portfolio management equivalent of steroid doping.
Let’s see how this plays out. Since managing a fund will always be done in a competitive context, many fund managers will likely continue to maintain foreign assets. Some managers are more concerned with how they do relative to their peer group than they are about actually demonstrating outperformance through security selection. Like with Jose Canseco in baseball, if every one else is “on the juice”, one often has very little choice but to follow suit.
John J. De Goey is a Senior Financial Advisor with Assante Capital Management Ltd., member CIPF and author of The Professional Financial Advisor. The views expressed here are the personal views and opinions of the author and not those of Assante and are not endorsed in any way by Assante. firstname.lastname@example.org