Countdown to Competition

Martino says Axa Rosenberg’s move into Canada is a response to a growing appetite for foreign equity among institutional investors. And he’s quick to state that it’s not a direct reaction to the Foreign Property Rule’s(FPR)demise, “although that certainly contributes to a general picture of robust demand for foreign equity products among Canadian pension plans.”

Axa Rosenberg’s decision to set up shop here is yet another entrance in a rapidly lengthening line. Recently, PIMCO—a large U.S. bond manager—and Bank of America have entered the Canadian money management scene. And according to some observers, Western Asset Management and Black- Rock Financial are two large players poised to follow suit.

Why is Canada suddenly hot? “Part of this is just active rates and the active market that have existed in Canada,” says Jim MacDonald, chief investment officer of Co-operators Investment Counselling in Guelph, Ont.(40th on this year’s Top 40 Money Managers list). “Foreign issuers have always been roaming around the world for relative spread—we just came on the map suddenly.”

Another reason is the Canadian money management industry is performing well, with BENEFITS CANADA’s Top 40 Money Managers Report revealing a 14.3% increase in pension assets to $568.8 billion from $497.5 billion as of June 30, 2005. The total number of pension assets under management for the industry as a whole is $651.8 billion.

Martino thinks the FPR’s removal might have also shifted perceptions. “I suspect the truth is that some players who may not have been considering the market before now have perhaps given it some thought.” But he thinks that managers entering the Canadian market are realistic: they are not banking on the FPR leading to any radical shifts in foreign weightings any time soon.

For those on the Top 40 list, the increase in foreign issuers is seemingly not a huge concern. Toronto-based Patrick Walsh, president of SEI investments(37th in the Top 40), says he’s not too worried about new players entering the market. “As a manager of managers, we hire all those guys,” he says.

“But if I was a traditional money manager and I’d been able to keep a client base happy by simply managing domestic assets for them, I might be quite concerned that all of a sudden for example, PIMCO, being a large bond manager, is going to come to Canada and start to sell their services. No longer do I feel protected that my fixed income is going to stay in Canada.”

But Nadi Naderi, vice-president of investment services for Guardian Capital in Toronto(22nd in the Top 40), is not sure the new players will be able to win over investors loyal to their Canadian mainstays. “[Foreign managers] don’t have the connection that Canadian managers have already established throughout the years,” she says.

Loyalty might have been a factor in this year’s Top 40 survey; two Canadian firms saw the highest percentage growth in assets among the Top 10 money managers. Montreal- based Addenda Capital had a 41.3% jump in assets to $15.9 billion, moving it into the top ten spot from 12th position last year. And Toronto-based Connor Clark and Lunn Financial Group also moved up with a 41% increase in assets to $16.2 billion, putting it in ninth spot. As well, Guelph, Ont.- based Co-operators Investment Counselling joined the list in 40th spot.

But there were also strong showings from global firms in the Top 40 this year: Mellon Capital Management had the highest percentage growth: 416% to $485 billion and U.S.-based SEI investments joined the list with $4.2 billion in assets under management(37th).

Naderi and others predict a more competitive environment in the coming years. “I think that over the long term, we are going to see increased competition.”

Already the market has seen an increase in merger and acquisition activity over the past year, a trend some say is led by smaller managers being pushed out of the market. The past year saw the acquisition of KBSH Capital Management by Rockwater Capital in November 2004 and the merger of Fiera Capital and Senecal Investment Counsel in June 2005. “The smallersized companies have struggled to make gains,” says MacDonald. He feels those companies could be looking to be acquired in the coming year.

Greg Malone, a partner with Eckler Partners in Toronto agrees. “We’re already seeing [domestic managers] forming alliances with foreign managers. Ultimately, we’re going to see acquisitions as well or they’ll evolve to operate in some kind of niche market. They’ll offer specialized Canadian equity management only or bond management only and try to serve that market rather than compete globally.”

For sponsors, more competition could be a boon. Some believe they could find themselves getting a lot of attention from players they would never have had access to previously. And with stiffer competition, fees could go down as players jostle for position. “The foreign managers in particular have been the ones who have tended to charge the higher fees,” says Malone. “If they want to enter this market, they may have to compete on a fee basis as well or be able to demonstrate the higher fees are justified, based on performance.”

But not everyone agrees. “There might be some sticker shock when [plan sponsors] see the fees,” says Bill Chinery, managing director for Barclay’s Global Investors in Toronto. “I think the fact that Canadian plan sponsors are paying lower fees to domestic Canadian equity managers—the foreign manager isn’t going to care.”

Most importantly, pension funds will now have a much larger realm in which to diversify their portfolios, now that Canada has gone global post FPR. The question is: will they heed the call?

POST FPR: SLOW MOVES

The FPR’s demise sent shock waves through the money management community in February when Federal Finance Minister Ralph Goodale made his surprise announcement in the federal budget. But the subsequent predictions that sponsors would move to increase their foreign holdings has amounted to a lot of talk and little action.

According to Chinery, the typical asset mix is as follows: 30% Canadian equity, 30% international equity, 40% domestic bonds. He foresees it becoming 25% Canadian equity, 30% international equity, 25% Canadian fixed income and 10% global fixed income. But that’s two to three years away.

Right now, there’s general sentiment that foreign fixed income is going to be hot in the next couple of years. “You’re going to see a significant increase in the fixed income component of non-Canadian assets,” says Chinery. Adds Mac- Donald: “We think that foreign bonds have a place in the portfolio now—I think clients are starting to look to that.”

What’s been keeping investors at bay have been such issues as the strong Canadian dollar and the resulting currency issues that accompany foreign allocation. For plan sponsors, the key question is just what impact currency will have in the short to long term. “Over the long term, maybe it’s a wash but over a two-year period, when you drop 35% in your U.S. equity portfolio on currency exchange alone, that can have a huge impact,” says Malone.

For that reason—and in the battle for competitive advantage—money managers had better bring their clients up to speed on currency issues, many advise. And that includes presenting them with various options for managing it. One option is to hedge it out. Another is to actively manage it via a money manager, generating an additional source of gain in the portfolio, explains Malone. He adds that pension fund committees are one group that requires education in this area.

LIABILITY DRIVEN INVESTING

Another area sponsors need assistance with are liability driven investments. “That’s probably the single biggest thing that’s confusing a few people right now,” says SEI’s Walsh. He says the chronic underfunded status of defined benefit pension plans coupled with low long-term interest rates has meant liabilities have grown. At the same time, pension assets have increased, due to a strong equity performance this year.

“Obviously, the returns on the assets have been fine, but the other half of the equation is what the liabilities are doing. And the longterm interest rate is the discount rate used to figure out the present value of the liabilities. So the lower the rate is—and it’s very low—the bigger the liabilities,” says Walsh. “It’s the classic: the assets have grown but the liabilities have grown faster.”

That concern has led sponsors to examine their policy mix, moving away from passive investment strategies to more active mandates such as income-oriented products. According to this year’s Top 40 survey, shifts from passive to active mandates occurred in Canadian equities, non-north American equities, global equities and—most of all—Canadian bonds. Naderi believes this is because sponsors want their managers to produce good absolute returns through alpha generation.

Alternative investments are being looked at more than ever, with real estate managers seeing a lot of demand. “Pension funds continue to have strong appetite for real estate,” says Malcolm Leitch, Bentall Capital’s chief operating officer in Vancouver. “You see it more in asset mix decisions now.”

Mortgages have also seen some activity, reports Judith Lowes, vicepresident, investment services with Co-operators. “They’re starting to realize the value [mortgages] can bring as a portion of their fixedincome portfolio”.

Income trusts have also been a hot topic among institutional investors, due to Goodale’s recent interest in the issue. Since his announcement that he would halt income trust conversions until the tax implications of these investment vehicles can be more closely studied (Ottawa stands to lose $300 million in corporate tax revenue next year, according to some estimates), the industry has been waiting on tenterhooks for a decision.

Naderi says that prior to Goodale’s announcement, income trusts were generating interest among sponsors. Many turned to the investment vehicle because 90% of the liability in a portfolio is eliminated, so the risk to the sponsor is very low.

But since the federal government’s examination of income trusts, investors have become skittish. “Plan sponsors, knowing what they know now, knowing that they could have adverse tax consequences to invest in them, are not generally going to allow their managers to invest in them anyway,” adds Chinery.

The good news is that most industry observers feel that Goodale will eventually back off his income trust stance and instead undertake tax reforms. “We think that trusts will still have an advantage when all is said and done,” says MacDonald. “It will be resolved.”

A FOREIGN FUTURE?

It’s been a good year for most domestic money managers, in large part due to high equity and bond returns and a home-country investing bias. Though there were a few significant drops in assets under management—Bentall Capital fell to 27th place after dropping 22.3% to $7 billion from $9 billion in 2004—most players increased their holdings.

But the future could be decidedly different. With industry sources predicting a move towards foreign fixed income on the part of sponsors, those firms moving into Canada that specialize in that sector could see a lot of activity. And that mean domestic players will need to adapt to stiffer competition.

At the moment, 25 of the Top 40 money managers are currently Canadian-based. And eight of the top ten managers are domestics. But will that hold as foreign players continue to enter the market? Many industry sources feel that ratio will gradually change.

For Malone, there’s no doubt the entrance of foreign players isn’t a blip on the radar screen. “I don’t think it’s an exploratory exercise,” says Malone. “I think they’re coming to Canada and they will be here for the long term.”

Axa-Rosenberg’s Martino would certainly seem to personify this new reality. Twenty minutes into our interview, he’s still talking—and still coatless—in his driveway.

Anna Sharratt is managing editor of BENEFITS CANADA.

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