Introduction

There is a well-known tendency among investors to favor domestic holdings over their foreign equivalents when it comes to capital allocation. Despite some differences, this tendency is evident across investor types, asset classes, and geographies, making it a global phenomenon. Commonly referred to as a “home bias,” it received increased level of attention in Canada this year, including the government’s announcement in April that a working group led by Stephen Poloz (former Governor of Bank of Canada) would be created to explore options to encourage Canadian pension plans to invest in their own backyard.

Concerns underlying these developments are understandable given the long-term trend of decreasing levels of domestic allocation in Canada among its own pension plans and other investors. For example:

• Allocation to Canadian stocks as a percentage of total portfolio investments decreased from nearly 28% in 2000 to around 4% in 2022¹ according to the Pension Investment Association of Canada. 
• Looking at equity investments across all investor types, Vanguard found that domestic allocation to Canadian stocks decreased from 67% in 2012 to 50% in 2023².
• A less dramatic, but notable reduction is also evident in fixed-income, where Canadian pension plans reduced their domestic holdings from 96% in 2013 to 88% ³ as a percentage of fixed-income investments only.

Regardless of the trend, what is interesting is that these levels remain well above what a pure market-based allocation approach would dictate. Based on research by the Global Risk Institute, Canadian pension plans were six times overweight in their equity allocations relative to “the global market portfolio that is set to maximize gains by diversifying globally” ⁱⁱⁱ. The question that comes to mind is whether this overweight is due to some inherent advantage that Canadian pension plans and other investors have when investing in their home country or whether this is just a residual from the past, when foreign investments faced numerous challenges, such as the foreign investment rules for Canadian pension plans that were abolished in 2005. In other words, is the data we are seeing a case of a home-field advantage or a home bias?

As with most portfolio allocation questions, the answer largely depends on the circumstances of each investor. However, it is an important question that Canadian pension plans should look to answer for themselves. To assist in the process, we have outlined commonly raised arguments for and against domestic allocations across a range of asset classes, especially as they relate to Canadian pension plans.

The case for home-field advantage

Liability hedging 

Arguably the most important reason to invest domestically for pension plans (and other institutional investors with market-valued liabilities) is the need to hedge the risk of an increase in the value of their domestically based liabilities due to market-driven changes, e.g., interest rates, inflation, and credit spreads. This is particularly true for investments in domestic bonds, whose value is directly tied to changes in local interest rates and credit spreads, as well as inflation for real return bonds. Domestic infrastructure and real estate investments are also frequently relied on to provide a proxy domestic hedge for long-term changes in inflation. While this rationale is much less relevant for equities, an argument can be made that the high amount of commodity companies in the Canadian stock market provides for a degree of exposure to inflation, either domestically or globally, as well.

Tax benefits

Canadian pension plans do not have to pay a tax on their domestic investment returns while returns on their investments abroad can be subject to material withholding taxes. The tax impact will vary by country and is subject to various bilateral tax treaties between Canada and the country in question. The implication is that two otherwise identical investments from a pure risk and return perspective can make the Canadian domestic investment more attractive than the one abroad once tax is factored in. 

Currency risk and transaction costs

Investments abroad are often made in currencies other than the Canadian dollar. As Canadian investors value their investments in Canadian dollars, it leaves their investments exposed to the risk of the foreign currency depreciating against the loonie. It is possible to hedge this risk to some extent, however:

• It is impossible to remove it entirely - this is especially true for investments with less certain return profiles, such as equities, as the value that would need to be converted in the future (i.e., hedged) is set prior to when the actual end value is known (i.e., once returns are generated or losses incurred). 
• It can increase an investment’s risk where returns on the underlying investment are negatively correlated with foreign exchange rates. 
• It comes at a cost, including fees and bid-ask spreads, which can be significant for less liquid and more volatile currency pairings.

Investors could always choose to leave their investment unhedged, which is not an unreasonable approach for long term investments with return expectations that are well above the likely downside of currency risk. However, foregoing currency hedging does not eliminate additional costs that come with foreign investments entirely, which can include higher brokerage fees and various administrative and compliance costs. These costs are especially high for investments in less-developed economies.

Informational advantage

A less definitive but frequently quoted advantage of investing domestically is the potential for informational advantage that investors have in their own country.  Knowledge of local trends, the ability to meet company management in person, language and cultural barriers, and even time zone differences can impact an investment over the long run. 

The case against home bias

Detailed arguments for reducing domestic allocations are numerous, but they largely boil down to one simple point – potential for better risk-adjusted returns.

Diversification benefit

By far the strongest argument for a higher allocation to foreign investments is the substantial increase in diversification of the underlying risk drivers. If diversification is the only “free lunch” in investments, then the international buffet is richer and its portions are even larger. This is especially true for countries where the economy is highly concentrated within industry sectors and companies. Clearly, Canada is such a country. For example, as of the end of April 2024, some of Canada’s S&P-TSX characteristics relative to the MSCI ACWI exhibit: 

• Financial and energy stocks being overweighted by 15.9% and 14.1%, respectively.⁴
• Canada’s top 10 names account for 37% of the S&P TSX’s market capitalization relative to 16%^iv within the MSCI ACWI.

There is a further, frequently forgotten Canadian risk that pension plans acutely need to consider – the source of their investment capital, i.e., their contributions. A material shock to the domestic economy will not only drive down the values of their risky assets but could also impact the sponsors’ and their employees’ ability to make contributions. This risk is particularly relevant for underfunded plans and those with a high proportion of active members or a weak sponsor covenant.

Higher return potential 

On the return side, a higher foreign allocation offers the potential for higher absolute returns. From a theoretical perspective, given its developed nature, the Canadian economy is unlikely to grow as fast as those in the developing world. At the same time, an overreliance on a select few sectors further limits sources of potential economic growth. The explosive growth in technology sector and its stocks outside of Canada over the past few years are a perfect example of this ongoing issue. 

What’s next?

The optimal allocation to Canada relative to other countries depends on the circumstances, views, and objectives of the individual investor. A way forward is to review the investor’s current portfolio and understand how the factors noted earlier apply. Where the portfolio maintains a high overweight to Canada, the key question that needs to be answered is – how comfortable would the investor be in making the same overweight allocation to another country?

1 Lord, C., & Atkin, D. (2024, March 16). Pension funds are Canada’s ‘crown jewels.’ Should they invest more at home? Retrieved from Global News: https://globalnews.ca/news/10357187/budget-2024-canada-pension-funds-domestic-investment/

2 Vanguard. (2024, June). Canadians reducing home bias, eh? Retrieved from Vanguard: https://www.vanguard.ca/content/dam/intl/americas/canada/en/documents/HOBI_052024_infographic_V5.pdf

3 Ambachtsheer, K., Betermier, S., & Flynn, C. (2024, June 9). Should Canada Require Its Pension Funds to Invest More Domestically? Retrieved from Global Risk Institute: https://globalriskinstitute.org/publication/should-canada-require-its-pension-funds-to-invest-more-domestically/

4 Dewan, A. (2024, June). Canadian Home Bias. Retrieved from Vanguard: https://www.vanguard.ca/content/dam/intl/americas/canada/en/documents/CHBP_062023_V8_secure.pdf

About TELUS Health

Over the past decades, our compensation, retirement and benefits solutions teams have contributed to the financial health of thousands of organizations and their employees. Through the unified strength of TELUS Health, our experienced teams strive to provide innovative, sustainable and flexible solutions that meet the compensation, retirement and benefits needs of customers across North America. https://go.telushealth.com/en-ca/personalized-consulting-services

Amir Musin, Senior Investment Consultant, TELUS Health

Amir has worked in the finance industry for the past 14 years, focusing on all aspects of institutional portfolio management. He started his career at KPMG’s Investment Advisory practice in London, UK, where he was the de facto portfolio manager for pension plans ranging from $50M and up to $3B in asses, as well as the Deputy Head of the research team that covered credit strategies globally. In that role, he originated several research pieces on tactical investment opportunities, ranging from Commercial Real Estate Debt to Investment Grade CLOs. Most recently, Amir joined the TELUS Health Consulting practice in Vancouver, BC as a Senior Investment Consultant to pension plans, foundations, First Nations trusts, and other institutional investors. Amir graduated with a Master of Science degree from the London School of Economics and Political Science in 2008 and has been a CFA charterholder since 2015.