David Wilson, Chairman, The Investment Dealers Association and President and Deputy CEO, Scotia Capital Markets
BORDERLESS CAPITAL MARKETS: THE DECADE CANADIAN INVESTORS DISCOVERED THE WORLD
Chairman: Diana Chant, Treasurer, The Empire Club of Canada
Head Table Guests
Tony van Straubenzee, Partner, Insite Institute and a Past President, The Empire Club of Canada; Rev. Prue Chambers, Incumbent of St. Nicholas Anglican Church; Salina Khan, Grade 12 Student, Western Technical Commercial School; Dax Sukhraj, Chairman, Investment Funds Institute of Canada and President, Keybase Financial Group; Robert L. Brooks, Executive Vice-President, Investment Banking, Bank of Nova Scotia and a Past President, The Empire Club of Canada; Diana Chant, Treasurer, The Empire Club of Canada and Partner, Price Waterhouse; Barbara Stymiest, Senior Vice-President and CFO, Nesbitt Burns Inc. and Chair, The Toronto Stock Exchange; Arthur Labatt, President and CEO, Trimark Financial Corporation and CEO, Trimark Investment Management Inc.; and Duncan N.R. Jackman, Managing Director, Fulcrum Investments and a Director, The Empire Club of Canada.
Introduction by Diana Chant
Good afternoon ladies and gentlemen. Today, I've been asked to offer you some insights into the financial markets. During my 28 years in the investment business, I have observed many fascinating and dramatic changes in financial markets.
In the last decade, in particular, few could have imagined the explosive growth of the global capital market and the resulting exponential rate of change in the ways that people can invest their savings.
In 1987, total issuance of bonds around the world amounted to less than $200 billion from 2,000 deals. By 1996, the amount had more than tripled to almost $700 billion from 4,400 deals.
Global capital flows now know few, if any, boundaries. However, the degree to which Canadian investors have participated in this phenomenon has been surprisingly limited until quite recently. I'm not talking about Canadian governments and businesses, which have a long history of tapping foreign capital markets. I'm referring to purchases of global financial assets by individual Canadian investors, either directly or indirectly through professional pension fund or mutual fund money managers.
Although for many years we've heard talk about global markets, for most Canadian investors it has been just that--talk. But in the past few years there has been a sea change. The relationship between Canadian savers and international markets has been radically altered. We've acquired a ferocious appetite for global investments. Canadians have tossed aside the stereotypical image of the staid, cautious investor we cultivated in the past.
Why the dramatic and sudden shift? And what are the implications for policy makers and for self-regulatory bodies such as the Investment Dealers Association? I'd like to answer these questions for you today.
Canadians are accumulating foreign assets--foreign mutual funds, foreign currency, foreign assets of pension plans--at levels never witnessed before. In 1987, foreign assets in mutual funds and pension plans totalled about $14 billion. By 1996, the amount was almost $100 billion. In fact, Canadian purchases of foreign bonds and equities during the three years between 1994 and 1996 equalled the total for the previous nine years.
And Canadian investors are no longer just going south of the border to pick up their stocks. We've begun to widen our scope to encompass the global market. Ten years ago, Canadian purchases of foreign stocks and bonds were largely U.S. securities, almost 95 per cent. While the U.S. remains the undisputed foreign investment destination of choice for Canadians its share has now declined to around 80 per cent.
Why is Canadian capital suddenly going global? A little history is called for here.
For some time, Canadian investors were quite content to cocoon at home. Mountains of low-risk high-yielding debt was readily available here in Canada. As successive Canadian governments piled up deficits and debts in the 70s, 80s and early 90s, Canadian investors--along with a great many foreign investors--wisely grabbed what they could. Then, in the late 1980s, the Bank of Canada began pushing interest rates higher and higher to combat inflation.
In 1990, the risk-free yield on T-bills averaged almost 13 per cent. With very big, largely risk free returns like these, there was little incentive to look beyond our borders. Equity market risk and foreign currency risk were things that the average Canadian investor had had the luxury to avoid.
I think it was Peter C. Newman who once commented: "Too many Canadians believe that taking a financial plunge means buying Bell Telephone preferreds." Whether by our nature or not, we didn't have to take risks to get good returns.
But things changed by the mid-1990s. Inflation was beaten down like never before in recent memory. Governments found the religion of fiscal discipline. Not surprisingly, inflation and short-term yields plummeted with interest rates hitting 30-year lows. Low-risk, high-yield investments, so readily available before, suddenly became scarce. Short-term debt, the hardy potato of the average Canadian investment diet, became unappetising. Consider today's T-bill yield of a lowly 4 per cent. Investors, rewarded for their short-term, cautionary approach for so many years, were suddenly faced with a new world which involved greater risk for greater returns.
At the same time as Canadians were seeing their high fixed return, low-risk, home-grown domestic investment alternatives disappear, there was convergence of a number of powerful global trends, all having a dramatic impact on global capital flows.
Innovative computer and communications technology has caused an information explosion. The natural barriers of time and space that separate capital markets have been tumbling. Technology made it possible to go into markets anywhere in the world. And you don't have to be sitting in New York, Tokyo, London or Toronto. Warren Buffet--arguably the greatest investor of our generation (certainly one of the wealthiest)--lives and works in Omaha, Nebraska!
Then there's the Internet which allows average investors to explore the possibilities of the more than 50 new emerging markets that have opened up in recent years. The World-Wide Web has sites providing timely information on quotes, economic information and companies from around the globe. So technology will continue to power the globalisation train.
Technology has also allowed for instantaneous, extremely complex computations, which has led to the surge in derivative products. Without computers, derivatives would not exist. With derivatives, investors are able to invest outside their home market and to hedge their risks. They can hedge against fluctuations in exchange rates, interest rates, stock indices or commodity prices.
Access to global markets has also been enhanced by the ease of order execution. It used to be difficult to buy a share of a Tokyo public company like Sony. Now, electronic trades occur effortlessly. Trade settlements are simple due to the ease of electronic transfers of funds.
The demand for higher-return investments has surged--driven by the massive demographic bulge of the Baby Boomers, who are concerned about having sufficient funds with which to retire. There is a large demographic shift in the number of people who are now between the ages of 40 and 55. These Baby Boomers are looking for a profitable home for their substantial personal savings. By investing in professionally managed global pooled funds, they have realised that they can dramatically diversify their investments and therefore spread risk.
And finally, only recently have average Canadian investors been allowed to invest more in foreign markets within the shelter of an RRSP.
With the possible exception of low-risk, high-yield investments which could return, all these factors are permanent. Taken together, they indicate a significant trend: Traditionally cautious Canadians are investing in a very un-Canadian like way. We've gone global, not only attracted by the potential higher returns but also by the potential to diversify risk. And the vehicle of choice for accessing these markets has been mutual funds.
Foreign bond funds were the fastest-growing mutual fund category in the period from 1990 to 1995. And international equity funds were the second-fastest-growing during the same period. A recent Environics poll showed that about 57 per cent of affluent women, with an average age of 46 and a household income of $137,000, held international mutual funds. In fact, more affluent women held international mutual funds than GICs, blue chip stocks or Canada Savings Bonds.
So what are the implications of this permanent shift for policy makers and regulators?
For one thing, our discovery of global capital markets is a good thing. The timing couldn't be better. Canadians are coming to grips with the fact that the Canada Pension Plan may not be adequate to meet all of their income needs when they retire. In fact, about three-quarters of us hold that opinion. And for most of us to have the lifestyle we want when we retire we need the potential higher returns associated with diversification into foreign assets.
At the same time, we have to face facts. The Canadian market represents only about 3 per cent of the world's equity market. To limit an investment strategy so narrowly would be a foolish and risky position to take. Unfortunately government policies regarding foreign investing have put average Canadian investors precisely in that position. Current legislation continues to place a cap on foreign investments held in pension plans at 20 per cent.
A smart investment strategy includes a well-diversified portfolio. Diversification is the key to managing market risk and volatility. Yet Canadians are somewhat handcuffed when they attempt to build an adequate retirement safety net since current pension rules do not allow them to manage market risk in an optimal way through diversification into foreign investments.
Some would argue that many people don't take full advantage of the 20 per cent as it is. However, almost every pension fund and mutual fund manager in the country makes close to full use of the 20-per-cent limit. Why? To ensure that the portfolio is properly diversified.
Earlier this month, the Investment Funds Institute of Canada, an association of all of the big mutual fund managers and distributors in Canada tabled a very compelling research paper prepared by Ernst & Young. The study showed that between 1975 and 1995 an equity portfolio with 30-per-cent foreign content would outperform a similar portfolio capped at 20-per-cent foreign content by half of one percent per annum. In fact, under this 30-per-cent versus 20-per-cent scenario, $5,000 invested in an RRSP each year for 25 years would earn an additional retirement income of $32,000.
Government policy shouldn't put future Canadian retirees in an excessively constrained position. And it's the average person who is the most trapped inside the domestic capital market. Many sophisticated institutional investors routinely get around the 20-per-cent foreign content cap by using a variety of sophisticated techniques, including derivatives. For the individual investor operating on a small scale, it is virtually impossible to use these techniques on a small scale. In short, the cap should be raised to level the playing field and allow Canadians more flexibility in managing the risks of their retirement investments.
Finance Minister Paul Martin has argued that increasing the cap will undermine the strength of the Canadian dollar and that the Canadian economy needs an assured pool of domestic savings to invest in productive capacity in this country. However, when the limit was moved from 10 per cent to the current 20 per cent, there was little or no impact. The reason was simple; the change was made gradually. A target of 30 per cent could be achieved without any negative effects by increasing the ceiling by 2-per-cent increments each year.
Greater exposure to foreign markets obviously entails greater risks. The Asian stock market flu has been quite contagious. The Canadian and U.S. markets caught gentler forms of it. But that's short-term thinking. Investing for retirement is a long-term endeavour and short-term volatility shouldn't be the basis for policy. Whether investing domestically or internationally, one must focus on the long term.
As markets become more global and more complex, sound investment advice and counsel is absolutely crucial. And if the investment vehicles of choice for Canadians are mutual funds, that raises other issues.
In 1989, mutual funds assets in Canada amounted to $25 billion. Today, mutual fund assets equal about $280 billion. These billions of dollars have been collected from individual investors by approximately 500 investment dealers, banks and mutual fund distributors across Canada.
Members of the Investment Dealers Association distributed about 33 per cent of mutual funds over the past year. Banks sold about 50 per cent. The remainder of fund sales, amounting to billions of dollars, have been made by independent distributors--many of whom are relatively small companies.
These distributors typically are not members of the IDA or any other self-regulatory agency. They technically fall under the regulatory review of the various provincial securities commissions. However, because of the very large number of such distributors and the staffing limitations at the various commissions, these numerous smaller-scale mutual fund distributors don't receive any rigorous regulatory review. As a result, hundreds of small distributors are selling billions of dollars worth of mutual funds to individual investors--investors who have no assurance that they are being properly served or informed.
One of my favourite cautionary tales is about an old sailing ship captain. He was asked what you do when there's a typhoon blowing and a reef in front of you. His answer: "What you do is not get yourself in that position."
All of the Canadian securities commissions now see the reef ahead of them and now are seized with the reality of this regulatory gap. And there is a recognition that these distributors need to be supervised to ensure that their conduct is aligned with the best interests of their clients.
Close regulatory supervision would ensure compliance with a code of selling practices, including compliance with rules as to the suitability of risky equity funds for certain clients. Supervision would also ensure that all distributors maintain a sufficient level of net free capital and fund segregation practices to protect clients from the financial difficulties their distributor could experience.
The best way to close this existing regulatory gap is to mandate that every distributor of mutual funds to the investing public must be a member of a self-regulatory organisation (SRO). Only then will individual investors who purchase mutual funds receive the protection that an SRO provides to the investing clients of its member firms.
Ladies and gentlemen, let me close by making a couple of fearless forecasts.
I believe that Canadian investors will continue to be attracted to foreign capital markets particularly markets outside North America as they become more and more accessible and transparent.
I'm confident the Canadian government will--in the fullness of time--make the decision to increase the current cap on foreign holdings in pension plans to 30 per cent and eventually beyond 30 per cent.
And I'm also confident that a new self-regulatory organisation will be created in the next eight to 12 months that will be responsible for the regulation of all mutual fund distributors that are not already regulated by another SRO. The regulatory gap will soon be filled.
The Investment Dealers Association and its 187 members are prepared to dedicate the Association's considerable resources and expertise to work with the mutual fund distribution industry. A new SRO for this industry will allow its clients to benefit from the same high quality of self-regulation that has served the clients of the investment dealer industry so well for the past 70 years.
The appreciation of the meeting was expressed by Robert L. Brooks, Executive Vice-President, Investment Banking, Bank of Nova Scotia and a Past President, The Empire Club of Canada.