Why The Current Debate Over Domestic Share Ownership by Canadian Pension Funds is Flawed?

Last week, a group of 100 Canadian issuers and investors published an open letter urging Federal and Provincial Government officials to "amend rules governing pension funds to encourage them to invest in Canada."? The letter stopped short of asking governments to mandate a certain percentage of investment in Canada, but it did point out that pension fund holdings of public Canadian equities fell from 28% at the turn of the century to less than 4% currently.? The effort to jumpstart Canadian pension funds into owning more Canadian equities is led by two well-known and long time Canadian equity managers Peter Letko and Daniel Brosseau of the Montreal-based asset management firm bearing the last names of the executives. Letko Brousseau's efforts gained the attention of the Federal Government and led to meetings between the Department of Finance and pension fund executives which continued as recently as last week.?

There is a school of thought that increased investment in Canadian companies will result in higher valuations which, in turn, will reduce the cost of capital for Canadian companies and allow them to invest in Canada and thereby reverse the ever-increasing productivity gap with the United States.

Figure 1: CAD-USA GDP per Hour Worked

Source: OECD, TD Cowen

The knee jerk reaction from issuers and non-pension fund executives is "yes for sure, make it happen."? However, there is much more to this debate than a simple "let's do it."? This is a complex and evolving topic that we are frustrated is being simplified into sound bites to serve interests.? It is well known that Canadian pensions are best in class globally in part due to freedom from political interference that allows them to invest without constraints.? Over the period cited in the letter to the government, it is true that Canadian pensions diversified asset mix away from Canadian equities during this 25-year window.? However, there are several reasons for this result, some of which are listed below and potentially explain why more domestic ownership of Canadian stocks might not make sense.? At the very least, it might put into doubt the notion that more ownership of Canadian equities might translate into improved productivity:

1)???? With some exceptions, this 25-year period represented almost the entire window of in-house professionalization and sophistication of the so-called Maple 8 largest CAD funds, now with close to $2 trillion in AUM, along with the elimination of foreign investing limits.? Prior to the move to hire in-house expertise, these funds carried very little risk, often owning federal and provincial bonds and relying on implicit government guarantees in the event of funding shortfalls.? Naturally, given familiarity and ease of access, the early days of in-house risk taking often involved owning first Canadian public equities through passive exposure. Soon after, CAD pensions added US and eventually global equities.? Recall that prior to 2005, non-domestic exposure at first came mostly through (costly) synthetic instruments given foreign content limits, and this limited non-domestic equity exposure to beta.? The elimination of foreign content limits occurred simultaneously with pension funds moving to active risk exposure in equities as well as adding private equity to the mix. Note: some pundits suggested that re-implementing a foreign holdings limit would be necessary to bring CAD pensions back home.? For all the reasons mentioned in this article, that concept does not make sense.? Interestingly, given the increased sophistication of derivatives markets over the 20 years since foreign content rules were eliminated, the ability to synthetically replicate foreign holdings is both cheaper and easier to implement, even at the single stock or pair.? However, we believe that any rule implemented by the government would include look throughs to the underlying exposures to avoid the arbitrage which existed pre 2005 and was used by many funds, not just pensions, to increase foreign stock exposure.

2)???? Assuming 4% of AUM, the Canadian Maple 8 pensions own approximately $80 billion of Canadian stocks, which is almost 40% above Canada's weighting in the global equity market of 2.9% as measured by MSCI ACWI IMI.? Over the years of the 21st century, CAD funds have grown exponentially, in part due to investment income earned through risk taking.? As assets grew, the need for diversification increased at a time when access to global markets improved dramatically.? It could be argued that the move from 28% to 4% was more natural than deliberately ignoring domestic stocks;

3)???? In the case of Canada's largest Maple 8 pension, the CPP, which started diversifying with in-house professionals in 1998, the concept of "double jeopardy" is of concern – that is by owning more stocks in a country (Canada) in which the beneficiaries reside exclusively, this creates a risk that a weakening economy, if correlated to the local stock market, will result in underperformance in the equity portfolio at the same time as contributors to the fund are suffering job losses and overall contributions decline. In this case, it could be argued that less rather than more CAD stock ownership makes sense, the trade-off being that an increase in non-domestic asset ownership adds currency risk to the fund.? Again, this topic has layers, as currency risk for Canadian companies exists given the percentage of operations for Canadian companies outside Canada.? Note: Alberta would face similar double jeopardy concerns should it decide to exit CPP in favor of a provincial solution.? To avoid this risk, Alberta would need to avoid investing in local energy companies (similar to the policies of Norway's Sovereign Wealth Fund).? However, the idea of minimizing exposure to local companies might prove a problem conceptually to the supporters of an APP (more on this topic next week as we will analyze the recent CD Howe report outlining the risk and consequences of Alberta leaving the CPP);

4)???? The float market cap of the S&P/TSX Composite Index is about $3 trillion, of which over 80 percent is in the large cap S&P/TSX 60 Index.?? The notion of a domestic benchmark anywhere in developed markets representing an investment in the local economy has all but disappeared through globalization.? In fact, there is an argument to be made that large cap stocks in any country represent global stocks, given that large caps are most likely global companies with operations around the world.?? Further, Canadian large caps are concentrated in financials (banks and insurers) and energy companies.? Canada also is proudly known as the center of the mining sector universe (as evidenced by the 27,000 miners roaming around Toronto earlier this month at the annual Prospectors and Developers Conference).? However, most large cap mining companies listed in Canada have very little exposure to domestic assets (for instance, Barrick Gold owns one mine in Canada that represents approximately 1.5% of its NAV and Franco Nevada earns just over 11% of its royalties from Canadian properties).? In fact, these issuers are almost Canadian in name only and yet are considered part of the domestic benchmark, and part of the Canadian investing universe (rightly so in our minds as the capital markets infrastructure for the mining sector is all here, just not the assets).? ?Outside of large cap mining, it is possible CAD pensions could invest in smaller start up Canadian mining ventures.? However, these investments would not move the needle in terms of domestic exposure and would be considered way out the risk curve, probably equivalent to start up bio-tech or venture cap investments.

It is healthy to debate the reasons for Canada's lagging productivity, including stock market valuations if at all, and if somehow the government could create incentives for Canadian companies with mostly Canadian assets to go public in Canada, then this would prove to be a win-win for the country and its issuer community.? However, there are some other headwinds that we believe will hold back Canada's capital markets from reaping the benefits of these changes.? Namely, the power of the US market to attract new investments, given its increasing size and depth of investor eyeballs and capital, both passive (S&P 500) and active.? In the past ten years, the percentage of MSCI ACWI IMI represented by the US market increased from 48.5% to almost 61%, driven in large part by the Magnificent 7 large cap names which account for 15.5% of world market cap.? The strength of US markets led to valuation gaps between like for like companies located in in various geographies and led to pressure for companies with lower valuations to re-domicile to the US to seek out the higher valuations.? There is a laundry list of companies that have done just that and now IPOs from foreign jurisdictions (see ARM-UK) are bypassing local listings in favor of the US market.? Flow begets flow, and the US is winning, and this trend is hard to reverse.?

The UK (and, in turn, the LSE) is perhaps the country suffering the most from this recent trend to redomicile with CRH Industries, Smurfit (through acquisition), Ferguson to name a few all leaving the UK market (and in turn the FTSE UK benchmarks) for the US often with the backing of the largest shareholders but to the chagrin of the Sunak government.?? It is a five-alarm blaze in the UK and the government and stock exchange officials are working to come up with some solutions to keep UK issuers in the UK market. Not surprisingly, one of the solutions bandied about is for local pensions to own more local shares in the UK, although the background to the UK pension debate is very different from Canada.

While we do not believe that Canadian pensions should be forced to own a certain percentage of assets in Canadian equities, there is nothing wrong with stock exchange, brokerage executives, investors and government officials engaging in dialogue with local professional investors seeking out ways to work together to improve Canada's capital market.? These conversations will surely include some of the industry's concerns including permitting time for new mines, dearth of infrastructure assets for sale from governments, pressure from interest groups, lack of tax incentives for greenfield investments and finally the controversial topic of why private equity valuations are higher than public market peers (this includes the process for marking valuations of private holdings and lack of short term market volatility resulting in management distraction).? This dialogue is healthy, and two ways.? Meanwhile, it is important that pension executives be part of this discussion and not rest on the knowledge that its arms length structure creates distance from the local market debate.? There may be a role to play by having pensions focus a little more on the functioning of the domestic market, which could lead to opportunities for outperforming investments in Canada and, in turn, helping the Canadian stock market defend itself against the battle for international capital flows and issuers.?? This battle is only going to intensify, as is evidenced by efforts in the UK and surely other domestic markets to defend against the magnet called the US capital market.

Note: this article first appeared in TD Cowen's Weekly Index and Market Structure Research Report dated Monday, March 11, 2024.