The Bay Street Financial District with the Canadian flag in Toronto on Aug. 5, 2022.Nathan Denette/The Canadian Press
Keith Ambachtsheer is director emeritus of the International Centre for Pension Management (ICPM), senior fellow of the National Institute on Ageing, executive-in-residence at the Rotman School of Management and co-founder of CEM Benchmarking and KPA Advisory Services.
Sebastien Betermier is associate professor of finance at McGill University’s Desautels Faculty of Management and the executive director of ICPM. The views of the authors do not necessarily represent those of ICPM.
In a highly publicized open letter to the Canadian government, a group of business leaders have opined that Canadian pension funds are not investing enough in Canada and that this is hurting the Canadian economy.
Their opinion contradicts a well-established empirical fact in academic research showing Canadian pension funds and other investors allocate a disproportionately large portion of their portfolio to domestic assets, such that it has been termed as the “home bias.”
Even though Canada makes up approximately 3 per cent of the global stock market index, large Canadian pension funds invest about 20 per cent of their listed equity portfolio in domestic firms. That extra 17 per cent is the “home bias.” Therefore, Canada’s leaders must examine the issue carefully before taking any policy action, such as amending the rules governing pension funds to push them to invest even more in Canada, as the open letter proposes.
Finance academics, who have long studied the topic of domestic investments, have been scratching their heads over this “home bias” and why investors tilt their portfolio toward domestic assets. Such a disproportionate tilt is risky, especially when the local economy is comparatively small and concentrated in a few industries.
Consider that Canada’s GDP is comparable to that of Texas and heavily driven by the natural resource sector. To avoid the proverbial “all eggs in one basket” scenario of concentrated risk, our pension funds choose to invest in a highly diversified and global portfolio of companies to spread out the risk so that if one investment fails, the others will be there to buffer the loss. So, by investing globally, outside of Canada, the funds are able to decrease the risks in their portfolio and, in turn, provide greater retirement security for their millions of members and reduce the cost for the government in cases of severe losses requiring government financial intervention.
On the other hand, domestic assets do bring distinct benefits to investors which may be the reason we see this “home bias.” For one, domestic investments are relatively effective for hedging local interest rate and inflation risks. Additionally, pension funds have a home-court informational advantage which can result in high risk-adjusted returns for their domestic investments. Over the past 20 years, Canadian pension funds have not hesitated to go big on strategic domestic investments and make use of their superior information at home.
For example, in 2000 Ontario Teachers’ Pension Plan acquired Cadillac Fairview – a large owner, operator, investor and developer of best-in-class real estate primarily located in Canada. The $6-billion transaction represented close to 10 per cent of the fund’s $67-billion of assets under management at the time. The acquisition of Cadillac Fairview has allowed Ontario Teachers’ to create and capture significant value while retaining talent in Canada.
What is clear from this discussion is that 1) the risk-return trade-offs of domestic investments are complicated and need to be carefully assessed; 2) the 20-per-cent allocation to Canadian assets by our pension funds represents a considered strategic balancing of these trade-offs; and 3) we should not rush to conclusions about any policy measures proposed by the open letter.
If capital is not flowing into Canada, as the business leaders say, then the underlying issues could be structural and have to do with barriers to investing. Nothing discourages investment more than an uncertain policy environment which makes it difficult for long-term investors to commit large amounts of capital to Canadian ventures.
For example, let’s look at infrastructure. Assets such as toll roads have appealing properties for pension funds because they provide a steady and indexed stream of cash flows. But an uncertain policy environment makes such infrastructure investments high risk for the funds. The recent legislation introduced by the Ontario government to ban tolls illustrates the kind of policy risk pension funds are exposed to. If they had already invested in road infrastructure, they would lose their return on investment, which means a loss in retirees’ pensions.
The question we should ask ourselves is not whether Canadian pension funds invest enough in Canada, but instead how we can make Canadian assets more appealing to investors. Reducing the barriers to investing in Canada will unlock capital not only from our own pension funds but also from a much larger pool of international investors.