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Canadian institutions prefer real estate and private equity to hedge funds, says report

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Freed from past regulatory constraints on foreign investments and driven by a desire for diversification and higher returns, Canadian pension schemes, endowments and foundations are buying

Freed from past regulatory constraints on foreign investments and driven by a desire for diversification and higher returns, Canadian pension schemes, endowments and foundations are buying international assets for their investment portfolios at a rapid rate, according to a new report by research provider Greenwich Associates.

But unlike their counterparts in the US, Canadian institutions are not making a big move into hedge funds. Instead they are drawn to real estate and private equity among alternative investments, says Greenwich Associates’ 2008 Canadian Investment Management Research Study.

As recently as 2003, when institutions were still limited by restrictions on foreign assets, international equity represented slightly less than half of institutional equity portfolios in Canada. According to the report, that share rose to 51 per cent in 2004, 56 per cent in 2006 and 58 per cent last year.

‘Since Canada represents roughly 3 per cent of the MSCI World Index, we contend that foreign exposure is still under-represented in Canadian equity portfolios, and we expect those percentages to continue to rise,’ says Greenwich Associates consultant Rodger Smith.

Overall, foreign securities represent about 30 per cent of institutional assets in Canada, with non-domestic equities making up more than 29 per cent, and international bonds accounting for slightly more than 0.5 per cent.

Those averages are skewed upward by the 42.3 per cent of total assets invested in foreign securities by the Canadian subsidiaries of US groups. Among Canadian corporate pension funds, foreign investments account for 32.8 per cent of total assets, while provincial government funds have invested slightly less than 28 per cent. Canadian endowments and foundations have just over 37 per cent of their assets in foreign investments.

As Canadian institutions expand their foreign holdings they are also taking on currency risk – a type of exposure of which many funds have only limited experience, and one that dealt a painful blow to many pension funds over the past 12 months as the Canadian dollar soared. However, 35 per cent of pension funds say they do not hedge their non-domestic investments.

‘Many funds opt not to hedge their foreign exposure on the belief that, over a long-term investment horizon, currency fluctuations will even out to the extent that hedging is not worth the cost,’ Smith says. ‘But we would encourage them to consult with their managers, consultants and currency overlay specialists in order to make an informed decision, weighing hedging costs against mounting currency risks.’

Allocations to real estate jumped to 8.4 per cent of Canadian institutional assets in 2007 from 5.5 per cent in 2006 and 5.3 per cent in 2004, while allocations to private equity surged to 5.0 per cent of assets from 2.6 per cent last year and 2.2 per cent in 2004.

However, allocations to hedge funds have been moving in the opposite direction, shrinking to 1.2 per cent of Canadian institutional assets in 2007 from 1.5 per cent in 2006 and 1.6 per cent in 2004.

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