Canadian Fund Managers Are Snowbirds in Investments Too

A major chunk of the foreign holdings in Canadian funds are allocated to the U.S.

Abdulai Mohamed, CFA 2 November, 2022 | 1:56AM
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 Canadian Geese

Most Canadian managers are allowed to invest a portion of their fund’s assets in foreign securities. While foreign could be taken to mean anywhere that is not Canada, a majority of these foreign allocations are to the United States.

In fact, most Canadian portfolio managers invest in foreign securities to the extent of their allowed threshold, and there’s every good reason to do so. Over the past decade, U.S. equity markets have outperformed Canadian equity markets. For example, the 10-year annualized return for the Morningstar US Market Gross Return outpaced the Morningstar Canada Gross Return by at least 5 percentage points, as of August 2022.

However, on the flip side, investors should keep in mind that although U.S. equities have historically outperformed Canadian equities, in times of market turmoil domestic equities have suffered less - partly because of our resilient (and concentrated) financial services sector.

Which Fund Categories Invest in the U.S.? Almost All.

Canadian mutual funds are grouped into categories as defined by the Canadian Investment Funds Standards Committee (CIFSC). There are over 60 categories, with the equity class dominating the space. Within equities, there are 5 categories that must invest primarily in Canadian securities but are allowed to hold a certain percentage of foreign stocks – Canadian Equity, Canadian Focused Equity, Canadian Focused Small/Mid Cap, Canadian Small/Mid Cap, and Canadian Dividend & Income Equity.

While Canadian Equity and Canadian Small/Mid Cap must invest at least 90% of their assets in Canadian securities, with only 10% in foreign stocks, we found that 57% and 42% of that foreign allocation was in the US, respectively. Similar observations were made within Canadian Focused Equity and Canadian Focused Small/Mid Cap, although these categories are less constrained, allowing up to 49% in foreign securities.

On the other hand, Canadian Dividend & Income Equity allows for 30% in foreign securities, but the category average only holds 20% - anchoring more to Canadian investments. Interestingly, 95% of the 20% foreign exposure is invested in US stocks.

What are Canadian Fund Managers Buying in the U.S.?

Canadian portfolio managers largely invest in foreign securities because of the highly concentrated Canadian market, which is dominated by a few heavyweight sectors such as energy, financials, and materials.

To find diversification, the only free lunch in investing, Canadian fund managers turn to the U.S. equity markets, which offer a much broader opportunity set – and translates into higher potential returns. For example, technology and healthcare are the key sectors driving the S&P 500; an index that is commonly regarded as being the most efficient market and challenging benchmark to beat.

Over the past 5 years, Managers invested more in the technology, healthcare, utilities, and financial services sectors than any other. The Canadian Focused Equity category invested a combined 45% in technology and healthcare stocks. The Canadian Equity and Canadian Dividend & Income Equity categories allocated 37% and 23% to utilities, respectively.

The Canadian Focused Small/Mid Cap Equity category is the most diversified, where industrials, financial services, technology, communication services, and consumer cyclical account for 73% of the country allocation.

Fund Managers Who Buy U.S. Securities: What is Their Investment Style?

Although Canadian mutual funds are put into categories based on their country and market cap exposure, the managers have the freedom to choose their style tilt – they can choose between value stocks, growth stocks, or a combination of the two (blend/core). The average style bias for Canadian mutual fund categories is a combination of value and growth, giving investors a balanced opportunity set.

Within its U.S. sector holdings, Canadian Focused Equity’s Technology and healthcare style bias was 83% growth and 56% blend, respectively. Other categories’ sectors predominantly displayed a blend style bias.

Why This Information Matters

It is useful to know the country and sector in which portfolio managers invest out money. Knowing that the Canadian equity investment landscape is concentrated in a few sectors, with this information, we can further diversify our investment portfolios by picking funds that have our desired country and sector mix.

While both the Canadian Equity and Canadian Dividend & Income Equity categories hold more domestic equities and are concentrated around the financial services and energy sectors, Canadian Focused Equity offers a broader country and sector exposure mix, allowing room for diversification.

Below is a list of medalist funds with the highest weight to U.S. securities. Investors that are anchored to Canadian equities and want some exposure to U.S. equities should look for medalist funds with at least 5% in Canadian Equity, 20% in Canadian Dividend & Income Equity, and 25% in Canadian Focused Equity category – an indication that the fund has a reasonable allocation to US securities given its category foreign restriction.

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About Author

Abdulai Mohamed, CFA  is a Manager Research Analyst for Morningstar.  

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