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Canada Increases Foreign Content Limits

The Canadian government's easing of foreign property restrictions in registered savings plans has created expanded opportunities for U.S. and other foreign money managers, and is prompting local firms to review their product strategies.

A two-stage increase that raises the foreign content quota to 25 percent this year and 30 percent in 2001 was announced Feb. 28 by Paul Martin, the federal finance minister. That is up from the 20 percent limit that had been in effect since January 1994.

The more generous limits affect registered retirement savings plans , pension plans and a number of other tax-deferred savings vehicles. Martin's announcement was applauded by the fund industry, and exceeded most expectations.

Tom Hockin, president of the Investment Funds Institute of Canada (IFIC), said the trade group welcomed the higher limits, and that the government had finally addressed the industry's concerns after years of lobbying. At the same time, Hockin questioned whether the foreign property rule was still justifiable, even in its watered- down state.

With products such as derivatives-based funds enabling investors to gain foreign exposure without exceeding the imposed limit, "we wonder if the government shouldn't have gone further and abolished the foreign property limit altogether," said Hockin.

The higher foreign thresholds are particularly beneficial to foreign-owned subsidiaries operating in Canada, which are best known for their international offerings. The largest of these firms are Fidelity Investments Canada, Templeton Management and AIM Funds Management, all of Toronto.

The industry will also be marginally more attractive to new foreign entrants, including Baltimore-based Legg Mason. On March 10, Legg Mason announced that it had agreed to acquire Perigee of Toronto, Canada's ninth largest institutional manager, with assets under management of $20.5 billion. (All figures in Canadian dollars.)

Perigee initiated the takeover to enable Canadian clients to gain access to Legg Mason's U.S. and international expertise, said Alex Wilson, CEO and managing principal of Perigee.

With Canada making up only two to three percent of the world's stock market capitalization, Canadians have always been attracted to foreign investments. Recently, that appetite has intensified. Funds investing in the U.S. and other foreign markets accounted for nearly 80 percent of net new sales of long-term funds in February, according to IFIC's latest sales figures.

A large proportion of the sales in foreign asset categories came in the form of fully-registered pension plan-eligible clone funds that hold futures contracts rather than actual foreign stocks. Through the use of customized forward contracts issued by banks, the clones are able to track closely the performance of actively-managed foreign funds, while still being considered domestic property.

The sole purpose of clones, which generally have management-expense ratios of about half a percentage point higher than the funds they track, is to get around the foreign property rules. The clones have proven to be a huge draw, attracting billions of dollars in sales.

For example, one of the pioneers of this new breed of funds - the Universal RSP Select Managers Fund of Mackenzie Financial of Toronto - has by itself grown to more than $3.5 billion since its launch in May 1999.

There are now well over 100 clone funds on the market. One firm alone, C.I. Mutual Funds of Toronto, has cloned 20 of its foreign and specialty funds.

However, at least some fund executives expect the revised foreign property rules to have an impact on the highly popular clones.

"This is going to take a bit of wind out of the clone fund sales," said Joe Canavan, president of Synergy Asset Management of Toronto.

But the consensus in the industry, and one shared by Canavan, is that even a 30 percent limit on foreign property will be too low for many investors.

"People will still want to boost their foreign content through the use of the clones," said Don Reed, president of Templeton's Canadian subsidiary and chairman of Templeton Investment Counsel in Fort Lauderdale, Fla.

The new rules will also leave fund managers with some hard decisions to make on the investment strategies of their Canadian equity and other domestic products. Funds in these categories are allowed to hold foreign securities up to the foreign property limit, while still retaining full eligibility for registered plans.

Templeton's Reed is among those who plan to bump up their foreign exposure in their domestic funds, to take advantage of the changes in foreign investments limits. But others, such as Richard Wernham, president of Global Strategy Financial of Toronto, are not so sure.

Wernham, who is also lead manager of a Canadian equity fund in his firm's $6.4 billion fund family, said it will come down to a competitive issue. Registered retirement plan-eligible funds that take full advantage of the foreign content quota have a performance advantage over those that do not, he said, so Global's decision will be based largely on what its competitors do.

Canadian mutual funds have broken out of an extended sales slump. The Investment Funds Institute of Canada reported net new sales of $6.5 billion (Canadian) in February, the strongest monthly inflow in nearly two years. Assets under management totaled $401.3 billion at the end of February, up from $382.7 billion in January and passing the $400 billion milestone for the first time.

By far the largest sales were the $3.9 billion in foreign equity funds, a group that includes broadly-diversified funds and overseas regional funds. Canadian equities were a distant runner-up, at $1.3 billion, followed by U.S. equities at $787 million. Next were money market funds, with $510 million in net sales.

Despite the overall rebound in February, several of the major categories tracked by IFIC had net redemptions. The highest outflows were from dividend and income funds, which had $179 million in redemptions, followed by mortgage funds at $112 million.