Equities - Canada vs Global

I will be participating in an online debate on Canadian equities versus Global equities - what will provide superior returns and risk-adjusted returns over the next few years?
The debate is organized by the Canadian Investment Review and can be found here (I believe only members can access the debate)
Log-in, have a look and comment on the debate!

Japan - the new new QE

With the US embarking on QE2, it may be instructive to observe Japan's experience, whether or not one believes that the US faces similar macro issues to Japan.

Japan is an economy in deflation, a situation which has lasted the better part of 15 years. For many years Japan subsidized its exports by printing money to buy Treasuries and maintaining a relatively weak Yen but when 2008 hit and all hell broke loose, so did the Yen. And there is nothing worse than an economy in deflation with an appreciating currency. Bring on QE4.0 Japanese style: buy REITs.

What does this mean?
It lends support to real estate in Japan

So how does that help?
If real estate remains stable or actually appreciates then the consumer will feel richer potentially enticing them to spend today rather than wait for goods to get cheaper tomorrow due to deflation.

Will this work?
Unlikely - if we focus on demographics, Japan's population has been shrinking since 2007 (see Wikipedia listing under Demographics of Japan) with fewer births than deaths and no net immigration. This despite one of the longest average life expectancies in the world at 81.25. Think about it: will a more valuable piece of real estate entice older Japanese to spend more readily?

The US should take note, however, and observe how Japan plays out. If this succeeds it may be the trump card Ben Bernanke is looking for.

What is the risky decision?

We often evaluate decision-making risk relative to status quo as opposed to overall risk and I find this problematic. We assume that the status quo is our risk benchmark and that may be incorrect. And defined benefit plans are the perfect example.

Pension fund managers and trustees think of Liability-Driven Investing (LDI) as a risky decision: rates are low and equity markets are still 30% off their highs (at least in the US), and converting some equity holdings to fixed income would be a foolish decision, they claim. Although I personally think rates are lower than they should be, the context of the decision is where I have an issue. Those making the claim assume that the risky decision is to engage is risk mitigation, since historic wisdom suggested that a 60/40 equity to fixed ioncome ratio is appropriate. What they should be aware of, however, is that the current asset mix is an active bet that equities will outperform fixed income. And there is risk in maintaining that mix.

Risk-based Premia

After a few spectacular failures (Nortel, GM) the pension world is not the wonderland it used to be. Both employees and regulators should consider the safety of their pensions when valuing their personal balance sheet.

As an employee:
Consider the future of your company and the likelihood of its survival. It may encourage you to save more lest you end up getting 60-something cents on the dollar like the Nortel pensioners. Your biggest decision will be when you leave the company - do you take a commuted value and truncate your risk to the pension fund's potential demise or do you retain the pension inside the fund?

As a regulator:
Consider the survival of a company. Use default swaps as a guide. Examine the solvency ratio of the company's pension fund. Consider its asset mix relative to the exposure of its liabilities. What is its net risk exposure? Should a company with matched assets and liabilities and a 105% solvency ratio pay the same PBGF/PBGC (pension benefit guarantee fund/corp) premium as one with a significant mismatch and a 75% solvency ratio? Now that is an easier question to answer than the same one with the second fund also having a 105% solvency ratio....after all the greater mismatch has a wider array of potential solvency ratios one year hence.

Call it risk based charges on the regulator side and employees better managing their credit risk.

Pension Fund Leverage

Is it only me who cringes when pension funds issue debt or create "special purpose vehicles" (I know I date myself on that last one).
With respect to SPV's, the sense is that pension funds have tremendous internal investment expertise which they can share with the rest of the world. There are 2 issues:

1. Taking your eye away from your fiduciary duty to pensioners
2. The obligation to hold the equity piece

Yes, SPV's are a thing of the past, but pension funds issuing debt? And using derivatives to leverage their hedges? The bottom line is that leverage introduces risk and if one cannot justify leverage ex-ante or especially ex-post (after something blows up) then it may not be the right approach for a pension fund.

SEI Survey

A recent survey by SEI points to over 50% of pension funds moving to some form of Liability Driven Investing (LDI) mandate. Of course, defining that term is an imprecise science with plenty of debate. The range includes the hard-liners like Towers Perrin who advocate a 100% allocation to Fixed Income as part of its definition of LDI to softer versions with some allocation to equities.

To me, it is not about the actual asset allocation, but about education. It is about recognizing that risk emanates from the liability side of the balance sheet, not just the assets of a pension plan. It is about understanding that as a pension fund manager you are de facto short fixed income and likely inflation. These are not easy markets to navigate and the outlook is fairly bifurcated between doomsday prophets and cheerleaders of economic growth. And with respect to fixed income and inflation the picture is as murky as ever.

It is therefore imperative to understand, measure and interpret your risk based on an entire entity not single parts of that entity.

Bill Gross

Well, how do you like that - Bill Gross singing my tune