It's a riddle that mocks the Canadian mutual fund industry: More than 97 per cent of all the world's stocks are traded outside Canada -- and about half are U.S. equities. So why do Canadian equity funds make up 10 per cent of all mutual funds sold on the Canadian market, why do they outnumber U.S. equity funds, and why are there so few North American equity funds from which to choose?
If you asked that question two years ago someone would have pointed to the 30-per-cent foreign content limit on registered retirement savings plans and RRSP eligible mutual funds. At the time, Canadian equity funds were the meat and potatoes of any RRSP and foreign equities were the side salad. But the foreign content limit was dropped in 2005 and, even though the world has opened up, the industry and investors are like adults who won't move out of their parents' basements.
"Every country has a home bias, and Canada definitely has a home bias" says Morningstar Canada's senior fund analyst, Brian O'Neill. Reasons vary but the "past performance" theory seems to dominate. Canadian equities have grown by an average of 19 per cent annually for the past three years while U.S. equities have lagged far behind at 5.6 per cent annually. The strong performance from Canadian stocks can be attributed almost entirely to the financial services and resource sectors -- and the resulting strong Canadian dollar. "There's little incentive to look elsewhere," Mr. O'Neill says.
But it's that false sense of security that could bring doom to many retail portfolios. A slump in the banking and resource sectors could pull the rug out from the Canadian equity market and investors could find they were stretched too thin.
Mr. O'Neill says a few fund companies have been offering more foreign alternatives but demand for anything outside of Canada has been lacking. "As soon as investors start seeing returns, the sooner they demand a product and the sooner the industry provides it," he says.
Some of the more than 700 Canadian equity funds straining the limits of what some may consider a Canadian equity fund includes the Accumulus Talisman-A fund, which holds only 36 per cent of its total assets in Canadian stocks.
The most American Canadian equity fund on the market is Disciplined Leadership Canadian Equity-A. It has a Canadian equity weighting of 55 per cent and a U.S. equity weighting of 44.5 per cent. Fund manager and president of Barometer Capital Management, David Burrows says he can't get the diversification he wants without going south. "Any market that is very concentrated in certain industries has risk attached," he says.
More than a third of the Disciplined Leadership Canadian Equity Fund is invested in the information technology sector -- big U.S. stocks such as Hewlett-Packard Co. and Oracle Corp. Exposure to U.S. markets has taken its toll on returns. Up to Nov. 1 the fund grew only 4.2 per cent over a one-year period while the average Canadian equity fund advanced 17 per cent and the S&P/TSX grew 21.7 per cent.
"Most Canadian investors are too focused within Canada," Mr. Burrows says. He says his Canadian equity fund is currently "under review" and he plans to launch a family of North American funds in the next month. He's critical of the investment industry's reluctance to take the lead. "The investment management industry has a history of promoting what has been selling," he says.
Other Canadian equity fund managers have already taken the plunge into the North American equity pool. The Mackenzie Ivy Canadian fund -- once as Canadian as maple syrup -- is now categorized as a North American Equity fund. More than half of its $4.4-billion in assets are invested outside the country. Industry sources say the change is part of a push by portfolio manager Jerry Javasky to give the Ivy group of funds more international exposure.
Mr. Javasky was one of the first multibillion-dollar Canadian portfolio managers to get out of energy stocks and investors have paid the price. Up to Nov. 1, the Mackenzie Ivy Canadian fund had a one-year return of 7.2 per cent, compared with the Canadian benchmark of 21.7 per cent. The fund has even underperformed the North American equity benchmark -- the MSCI North American Index -- which returned 11 per cent.
One fund company that went straight to the North American model is Sprott Asset Management Inc. Last January Sprott launched the Sprott Growth Fund. "It's an unserved market," says portfolio manager Peter Hodson. "It's a trend that should have, and will happen."
The Sprott Growth Fund currently holds 44 per cent of it's assets in U.S. equities and Mr. Hodson says he expects to bring the U.S. weighting as high as 50 per cent. "If you go into small and mid caps in the U.S., you get bigger companies, more liquidity and better valuations," he says.
U.S. mid-cap health care stocks have been showing up on Mr. Hodson's radar screen lately. "I don't know why anyone would want to buy a Canadian drug company," he says.
It's too early to gauge long-term performance, but in October alone the Sprott Growth Fund returned 7.5 per cent while the MSCI North American Index advanced only 4 per cent.
There are currently 28 basic North American equity funds on the Canadian market. Six have been added to the roster this year.
Dale Jackson is a producer at Report on Business Television
© 2007 The Globe and Mail. All rights reserved.
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