A Canadian pension plan sponsor with a 60% equity/40% bond portfolio was interested in options for diversifying its global large cap equity portfolio. Following a review of the merits of emerging market (EM) and global small cap equity, it looked at alternative asset mixes. The objective was to maintain the plan’s 40% long bond allocation and assess the merits of diversifying the 60% equity component.
The plan’s equity component was 45% global large cap equity and 15% Canadian equity. In each of the following three proposed scenarios, there was no change to the 15% Canadian equity allocation, the global large cap equity allocation was reduced to 35%, and the remaining 10% was invested as follows:
- Scenario 1: 10% EM equity
- Scenario 2: 10% global small cap equity
- Scenario 3: 5% EM and 5% global small cap equity
The table below shows the total portfolio risk and return analysis for the three scenarios for the five- and 10-year periods ending Dec. 31, 2010. The total portfolio returns are based on the relevant market index returns and asset class allocation for the different asset mixes. An allocation to EM, global small cap equity or a combination of the two resulted in a higher total portfolio return relative to the current portfolio mix, albeit with slightly higher volatility. The analysis did not take into account added value or lower volatility potential from active management.
For both the five- and 10-year periods, a 10% allocation to EM equities (and 35% global large cap equity allocation) was expected to deliver the highest return. However, when analyzing the quarterly relative returns over the 10-year period, the 5% allocation to both EM and global small cap (Scenario 3) offered the most consistent added value frequency in both up and down markets.
Many factors go into the asset mix decision. Recognizing the uncertainty associated with investing in equity markets, the proposed approach was to diversify the sources of return through exposure to both global small cap and EM equities.
Peter Muldowney is senior vice-president, institutional strategy, with Connor, Clark & Lunn Financial Group. pmuldowney@cclgroup.com
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