Issue 26 - April 2001
Flaherty Sends Regulators Back to the Drawing Board |
Borrowing for a Book of Business |
Thomas Gifford v. Her Majesty the Queen
| Nortel Networks
Nortel Networks 1998–2001
Lessons Learned from the Rise and Fall of an 800 Pound Gorilla
This article was written by Yannick Mennard of Watson Wyatt Canada and first appeared in the CCH Canadian Employment Benefits and Pension Guide.
It was not long ago that the mere whisper of Nortel made plan sponsors and portfolio managers tremble, overwhelmed by mixed emotions of fear and regret. Fear of owning too much of the stock, and regret of not owning enough of it. Today, with Nortel having lost most of its shine, some are dismissing its rise as an aberration, unlikely to reoccur. But it is now more important than ever to learn from these events, because, one day, a new market darling or a rejuvenated Nortel, might just reach similar highs. So let's go back in time.
Nortel's meteoric rise to a global technology leader had an impact never seen before on the Canadian equity markets. At its peak in the summer of 2000, the stock represented close to 35% of the TSE 300 index. To put things in perspective, at that time, Nortel by itself was worth more than three times the value of all Canadian banks combined.
Over the seven quarters between October 1998 and June 2000, Nortel's stock gained over 730%, and with its parent BCE, accounted for three-quarter of the TSE 300's spectacular 86% increase. Investment managers were scrambling to keep pace with the market, with less than one in six matching the index's performance. In fact, the median large cap Canadian equity manager underperformed the index by over 20% over this period.
For many investment managers, success or failure became directly related to their allocation to Nortel. Both plan sponsors and investment managers came under increased pressure to clearly enunciate their position on Nortel, trying to reconcile two seemingly opposite objectives. On one hand, owning too much Nortel endangered the diversification of their portfolio and increased the risk of large losses; but on the other hand, not owning enough of Nortel meant taking a big bet against the market.
Since reaching a peak of $124 in August 2000, Nortel's stock price has been mired in a steady decline, accentuated by the economic slowdown. By the end of March 2001, the stock was trading for $22, an 82% fall over seven months. This steep decline accounted for over three-quarter of the TSE 300 index's 32% loss over this period, a mirror image of the impact of Nortel's rise on the index's fortunes between October 1998 and August 2000. The impact of Nortel's collapse on the TSE 300 index's composition was equally dramatic, with Nortel's weight in the index falling from close to 35% last August to less than 10% at the end of March.
The decline also led to a resurgence in the performance of active managers, many of whom maintained significant underweightings to Nortel throughout the period. Between August 2000 and February 2001, the median Canadian large cap manager outperformed the TSE 300 index by more than 15%, with all but one manager in our universe outperforming the index. The median manager is now more than 10% ahead of the index since Nortel began its rise in October 1998.
A Global Perspective
While market concentration in Canada is a concern, we are not alone. A number of other countries face similar levels of concentration. In many of these countries, however, tax laws or cultural behaviour have generally mitigated this issue. In some, such as Germany and the Netherlands, pension plans allocate the majority of their assets to fixed income securities, while in others, pension plans allocate a large proportion of their assets to foreign equities and real estate.
We have compared below the concentration in the Canadian market with that of the U.S.A. and Japan, two of the most broadly diversified markets in the world, as well as four key European markets.
Weight of Largest
Country Largest Stock Stock 3 Stocks 5 Stocks
Canada Nortel Networks 10% 18% 25%
USA General Electric 4% 10% 15%
Japan NTT Docomo 7% 13% 17%
UK Vodafone Group 9% 24% 33%
Germany Deutsche Telekom 10% 28% 42%
Netherlands ING Groep 10% 31% 49%
Finland Nokia Oyj 65% 73% 79%
It is difficult to find a single solution that is best for all Canadian pension plans, since plans can have vastly different liability structures and risk management objectives. Ultimately, it will be up to each plan sponsor to decide what the best approach is under their specific circumstances. We believe, however, that a majority of plan sponsors can benefit greatly by establishing appropriate diversification guidelines and taking advantage of the recent increases in the foreign content limit.
All Canadian pension plan sponsors are required to establish and review annually a statement of investment policies for their plans. A key component of this statement is the investment guidelines governing the diversification, liquidity and security requirements of the plan. These guidelines are generally set as limits on individual securities within an asset class (e.g., Canadian equities), as well as on a total plan level, and as maximum limits on groups of securities (e.g., industry sector, country, size, quality).
All pension plans have such guidelines, but have all sponsors reviewed their statement to ensure that it appropriately addresses the high weighting of Nortel in the Canadian market? While there is some debate amongst plan sponsors regarding the best approach to follow, we have presented below the three most common.
- 10% limit for any stock—Many pension plans limit the allocation to any single issuer, including Nortel, to a maximum market value of 10% of Canadian equity assets. While this limitation ensures prudent diversification, if Nortel's weight rises again to 20% or 30% of the TSE 300 index, it would essentially force investment managers to be significantly underweighted in Nortel compared to the index. This issue is discussed below.
While it is difficult to generalize, we suspect that pension plans which followed this approach have lagged behind others during Nortel's rise, as they could not fully benefit from Nortel's impact on the market. However, these plans would have performed strongly relative to others during Nortel's recent collapse. Overall, we suspect that plans with tighter diversification guidelines have outperformed others over the rise and fall of Nortel, and that they have done so with much less volatility of returns.
- No limit for Nortel—Another approach is to remove the maximum limitation for Nortel. While this approach allows investment managers to allocate a larger percentage of their portfolio to Nortel, and fully benefit from its rise, it may also significantly increase the risks to the plan if Nortel rises again to 20% or 30% of the index. If this approach is followed, plan sponsors should consider taking full advantage of the foreign equity limit, so that the impact of Nortel on the total plan's risk level would be mitigated.
Note that pension legislation in most provinces limits the allocation to any corporate issuer to 10% of the book value of a pension fund. This limit, which is applied on the total assets of the fund, including fixed income and foreign equity assets, indirectly limits the maximum allocation to Nortel within Canadian equities.
- A higher limit for Nortel—Alternatively, a number of options between the above two extremes could be considered. One such option which merits consideration is to permit investment managers to increase the weight in Nortel to 15% of Canadian equity assets.
Note that when a pension plan is fully invested in pooled funds, the plan sponsor will have no control over the guidelines of these funds. The sponsor should nevertheless satisfy itself that the approach followed by its investment managers is appropriate for its plan.
As mentioned above, plan sponsors who have adopted a maximum limit on Nortel may also wish to review the benchmark that they use for Canadian equities. A key characteristic of a good benchmark is that it should be investable—investment managers should have the ability to underweight or overweight any stock relative to the index according to their outlook on the stock. To address this issue, a number of "capped indices" were introduced last spring, at a time when Nortel represented well over 20% of the TSE 300 index. These "capped indices" are similar to the TSE 300 index, except that the maximum weight of any stock is limited to 10% of the index, with 5% and 15% caps also sometimes used.
Foreign equity allocation
The median pension plan in our universe has only allocated 24% of its assets to foreign equities, and a number of other plans are well below that level. With the foreign content limit now at 30%, increasing the allocation to foreign equities can provide a number of advantages, especially given the Nortel concentration in the Canadian market.
- Global Opportunities—Canada represents less than 3% of the world's stock market capitalization, and the vast majority of leading global companies are located outside of our borders. The only way to access these companies is through foreign investments.
- Diversification—Not only do foreign markets offer access to a number of companies and industries not found in Canada, but foreign stocks also offer diversification because they are affected by different socio-economic factors. It is possible to actually reduce the overall risk of a portfolio by adding foreign equities, even though their volatility may be greater than that of Canadian equities.
- Potential for higher returns—Over the past twenty years, foreign equities have provided significantly higher returns than Canadian equities. While there is no guarantee that this trend will continue in the future, a majority of participants in our latest Survey of Economic Expectations expect that international equity markets will provide higher returns than North American markets over the next 15 years.
- Mitigate the impact of Nortel—The decision between holding Nortel or another global technology firm, such as Cisco Systems, should be based on the risk/return potential of the two stocks. But, because of a relative underweighting in foreign equities, many Canadian pension plans currently have up to ten times more of their assets invested in Nortel than in Cisco, even though Cisco is almost three times larger. This is both restrictive and risky.
Of course, there are also some drawbacks to investing in foreign equities. The first is that most pension plan liabilities are denominated in Canadian dollars, so that by investing abroad, the plan is assuming currency risks. In addition, plan liabilities are affected by local factors such as the levels of interest rates, inflation and salary increases. However, because of the globalization of world markets, we have found that a pension plan can safely make full use of the 30% foreign content limit without significantly increasing its asset-liability mismatch risk. The second drawback is that investing in foreign markets is more expensive than investing in Canada. This extra cost comes from a number of sources: higher investment management fees, higher custodial fees, and higher transaction costs.
Plan sponsors who decide to increase the foreign equity allocation of their fund should ensure that the resulting risk profile of the assets is still consistent with the liabilities of their plan and their risk management objectives. They should also carefully review the global research capabilities of their existing investment managers. Foreign equities is the area where we find the largest divergence of returns between top quartile managers and bottom quartile managers. The costs of staying with an underperforming foreign equity manager can therefore be significant.
In December 2000, we surveyed pension plan sponsors to determine how they approached the Nortel concentration issue. The key findings are summarized below:
- The increased concentration in the Canadian market is cause for concern, and has been recognized by most organizations in their investment guidelines through quantitative limits on individual holdings. Over half of participants impose such restrictions, with a maximum of 10% of Canadian equity assets being most common. When Nortel's weight in the index increased above this limit, only one-third of sponsors allowed their portfolio managers to overweight the stock relative to the index, another one in ten allowed their managers to match the index's weight, while one in five raised the limit for Nortel to 15%.
- Perhaps because many participants had already set limits for their managers, approximately half of plan sponsors did not take any action in response to Nortel's increased weight in the index. Only one-third introduced a TSE 300 capped benchmark for their plan, and another one in six modified the constraints on their managers. Overall, more than half of participants have maintained the TSE 300 index as their benchmark for Canadian equities, despite the fact that many of them prevented their managers from owning Nortel's stock to its full index weight.
- A popular approach to controlling Nortel's risk, followed by close to one-third of plan sponsors, was to increase the foreign equity allocation in their plan, with a corresponding decrease in the allocation to Canadian equities. We suspect that more sponsors will adopt this strategy over the coming months.
We may not have all the answers if a Nortel-type situation were to occur again, but establishing appropriate diversification guidelines and increasing the allocation to foreign equities will go a long way toward ensuring that plan sponsors benefit from this rise without adding unnecessary risk to their funds.