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portfolio strategy

It's not just individual investors like you who are fed up with the stock market's unpredictability.

Managers of pension fund investment portfolios are also trying to do something about volatile stock markets. They're looking more and more at alternative investments, they're increasingly diversifying away from a Canadian market that is dominated by just three sectors and in some cases they're taking a Warren Buffett-like approach of focusing on high-quality companies.

Pension funds are among the most careful of investors because they're stewards of money that current and future retirees are counting on for retirement income. Their mission: Seek consistent returns, minimize volatility and keep up with inflation. If that's what you're trying to do in your registered retirement savings plan, then you'll want to hear more about the latest trends in pension fund management.

According to David Service, director of investment consulting at global professional services firm Towers Watson, the average pension fund holds about 40 per cent of its assets in bonds and 60 per cent in stocks, real estate, infrastructure, private equity and other assets. But there's no longer the same unanimity in the industry that this is the ideal mix of assets.

"Within the pension fund space, there is clearly a lot wider variation now than we used to have," he said. "I have one client where it's 60-per-cent bonds at this point and 40-per-cent equities. We've been de-risking it now for close to 10 years. Others are saying they have an intent to move that way."

One of the trends in pension fund bond investing is to diversify by adding global content. The "more sophisticated" plans are moving some money out of Canadian corporate bonds and into their U.S. or international equivalents, Mr. Service said.

High-yield bonds have attracted a lot of money from retail investors in recent years, but Mr. Service said pension funds have added only a small amount. Typically, they're focusing on U.S. high-yield bonds because of the vastly larger selection when compared with Canada.

With stocks, Canadian pension funds have for the past five or so years been moving a significant amount of money out of Canada and into global markets. "The main issue people have is that if you look at the Canadian market profile, 77 or 78 per cent of it is in three sectors [financials, energy and materials]" Mr. Service said. "So it's a highly risky market."

An example of how a pension fund breaks down stock market investments in Canada and abroad can be found in the most recent annual report of the British Columbia Investment Management Corp., which runs public sector pension plans with total assets under management of $91-billion. Almost 17 per cent of the portfolio is in Canadian stocks, 20.7 per cent is in global stocks and 6.3 per cent is in emerging market stocks.

Mr. Service said there's a split among pension funds about whether to get their stock market exposure through low-cost index investing or active selection of stocks. "A number of pension funds are kind of taking the Buffett approach to investing," he said. "You want to buy great companies, and you don't want to overpay for them."

The rationale here is that quality companies will be less volatile than the stock market as a whole. That's how things played out in the Canadian market last year, with many blue chip dividend stocks delivering positive returns while the S&P/TSX composite index fell 11 per cent.

Retail investors have in many cases done poorly in global markets in the past 10 years, and a major reason has been a general rising trend for the Canadian dollar. Currency hedging can help screen out currency fluctuations so that investors get the returns of the stocks or funds they hold, but pension funds aren't big hedging enthusiasts. Mr. Service said that's partly a cost issue – only in the largest funds is it economical to run a hedging program.

Canada's largest pension funds have gradually been reducing their exposure to publicly traded stocks and replacing it with "alternative investments" such as shopping malls, office buildings, bridges, tunnels and pipelines. For example, the Canada Pension Plan Investment Board announced investments earlier this month in California shopping malls and a joint venture to develop a building complex in London.

The CPPIB had about 15 per cent of its assets in real estate and infrastructure as of Dec. 31, while the BCIMC had almost 20 per cent. Mr. Service said investment in these assets is driven in part by a comparatively small Canadian stock market. When you're a big pension fund, it's tough to trade in and out of stocks without affecting the price.

But infrastructure and real estate also offer the consistent returns that pension fund managers crave. "They recognize that they have long-term obligations and they're saying, I want something stable," Mr. Service said. "Give me 7- to 8-per-cent returns and I'm happy."

Large pension funds are investing directly in real estate and infrastructure, while small funds are buying into investment pools holding these assets. Retail investors have some options for getting exposure to these assets, but they're far from ideal.

The easiest way for investors to buy into commercial real estate is a real estate investment trust (REIT), or a fund holding a basket of these securities. "We've actually studied this," Mr. Service said. "If you look at REITs versus real estate investment, REITs behave half like an equity and half like real estate."

At least you're getting diluted exposure to real estate with REITs. According to Mr. Service, you're hardly getting even that when you buy the shares of companies active in infrastructure or in funds that hold this type of stock. "They're sort of a quasi-equity," he said. "It's not the same as investing [directly]in infrastructure."

Pension funds also hold some private equity, but Mr. Service said there's less of this than there was 10 years ago. He describes private equity as a "high octane" form of equity investment that contrasts with lower-risk infrastructure and real estate.

Individual investors can't follow all the moves being made by pension funds, but there are some broad concepts in portfolio design that they can absorb. Keep a significant weighting in bonds, don't ignore global markets and emphasize investments that provide consistent returns (like dividends, for example). That's how some of the smartest investing minds in the country are coping with today's unpredictable stock markets.

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