Many Canadian equ–ity fund managers are becoming distinctly less Canadian with their stock picks.

Two forces are at work: opportunities in the Canadian stock market are shrivelling at the same time as the shackles on fund managers have been lifted by the removal of foreign-content limits on RRSPs in 2005.

Several Canadian stock funds, including those from such prominent families as Dynamic Mutual Funds Ltd., CI Investments, AIM Funds Management Inc. and AGF Funds Inc. (all of Toronto), have changed their mandates to allow them to push their foreign content toward the 50% mark. And their portfolio managers are taking full advantage of the new leeway.

While this may be confusing for clients who naturally think their Canadian equity fund is investing in Canadian stocks, some managers say the broader mandate is necessary if they want to achieve a fully diversified portfolio with maximum growth potential.

“Increasing the foreign content broadens the scope of opportunities from which fund managers may choose,” says Philip Lee, an analyst at Morningstar Canada in Toronto. “Markets in Canada are extremely shallow. There’s little representation in consumer staples, consumer discretionary, health care or technology stocks.”

Eric Bushell, chief investment officer at CI and lead manager of Signature Select Canadian Fund, says the decision to increase foreign content has been “driven by necessity,” as more than 100 company names have disappeared from the S&P/TSX composite index during the past five years due to takeovers and consolidations. Foreign content in the Select Canadian fund was recently as high as 46%, but has since fallen to 38% due to some profit-taking as the fund became a bit more defensive.

“Anyone who is managing a pure Canada product would find getting a lobotomy less painful than trying to choose among the limited number of stocks in Canada,” Bushell says. “With the concentration in the Canadian market, sticking only to Canada does not compute from a risk-management standpoint.”

Clayton Zacharias, co-manager of AIM’s $1.8-million Trimark Canadian Endeavor Fund, says that even before the 2005 removal of the foreign-content restrictions in RRSPs, he was taking full advantage of the 30% allowance. Since the restriction was lifted, he has gone higher, and foreign content now stands at about 46%.

Zacharias points out that the S&P/TSX composite’s 75% weighting in resources and financial stocks creates “incredible concentration” and leaves only 25% for everything else. On top of that, the entire Toronto Stock Exchange accounts for less than 3% of world stock-market capitalization, and is virtually a mere hors d’oeuvre in the smorgasbord of global investment opportunities.

“In the global scheme of things, we’re in a small country with a small stock market,” Zacharias says. “On top of that, the market is extremely narrow. We’ve always believed that the flexibility to look beyond Canada is in the best interest of unitholders, and offers the potential for greater returns over the long term.”

While seeking exposure outside Canada may enhance the choice of investments in a fund, it clouds the waters for advisors and their clients who are making geographical asset-allocation decisions in a diversified portfolio of funds.

“A ‘Canadian’ fund may have 45% of assets in foreign content one moment, and the next moment it’s 10%,” says Lee. “That wreaks a bit of havoc on the do-it-yourself asset allocator.”

A few managers of Canadian equity funds, including funds sponsored by RBC Asset Management Inc., Guardian Group of Funds Ltd. and Franklin Templeton Investments Corp. (all of Toronto), are avoiding the confusion by steering away from foreign content and concentrating on style purity in their Canadian-branded product.

“We believe in truth in advertising,” says Don Chornous, chief investment officer at RBC. “If something is called a ‘Canadian equity fund,’ it should be full of Canadian equity.”

It’s no solution to fill the gaps in a Canadian fund with foreign stocks, Chornous says. Instead, investors should be able to decide how much they want to invest in Canada, and then use other funds with a global mandate to achieve their desired international diversification.

While Canadian equity means “only in Canada” at RBC, its balanced products generally have been increasing their foreign allocations. And some niche funds, such as RBC Global Energy and RBC Global Precious Metals, recently added “global” to their name to reflect an increased focus on international opportunities.

@page_break@“We’re not saying people should be excluding foreign content, but they should be getting it directly by investing in foreign funds,” Chornous says. “The labelling has to match what’s in the portfolio.”

New fund category definitions devised by the Canadian Investment Funds Standards Committee earlier this year give some clarity to the issue for advisors and clients who check Web sites such as www.morningstar.ca to see how their funds are classified.

The CIFSC says a “Canadian equity” fund is one with at least 90% of its assets in Canada. If a fund has at least 50% of assets in Canada, it is a “Canadian-focused equity” fund.

AGF has expanded to 49% the global component of several of its Canadian equity funds, including AGF Canadian Real Value and AGF Canadian Stock Fund, while maintaining the AGF Canada Class Fund as a pure Canadian equity offering.

“To capitalize on all the areas of growth and value, you need to go global,” says Martin Hubbes, chief investment officer at AGF. “After five years of strong markets, it’s hard to argue that Canadian markets are undervalued relative to the rest of the world.”

While global diversification may expand the opportunities available, it adds the element of exchange-rate risk. If the Canadian dollar strengthens, as it has rapidly during the past few years, that eats away at returns for Canadian investors holding foreign assets when they convert those assets back into C$. Some managers use hedging strategies to protect against currency risk, but hedging has its own cost and the decision to hedge varies from fund to fund. AGF doesn’t hedge, in the belief that in the long run, currency movements in various countries will balance each other out.

“Currencies can be a tremendous diversifier of risk,” says Hubbes. “They tend not to be correlated, while stock markets in different countries often move together.”

On the other hand, Bushell believes that hedging currencies is an important component of fund management. “Currency risk and international diversification are joined at the hip,” he says. “The rally in the Canadian currency during the past five years — which we think may be nearing an end — has been an enormous headwind for international funds to fight.”

Bushell says about half of CI Signature Select Canadian Fund’s foreign component is invested in U.S. stocks, with the rest in various countries. Foreign holdings include a handful of U.S.-based offshore oil services companies participating in drilling projects around the world, such as TransOcean Inc., Noble Corp. and Diamond Offshore Drilling Inc. In the consumer staples area, he likes U.S. drug retailer CVS Corp., French food company Groupe Danone and a couple of beverage companies.

Zacharias says his global value hunt has recently led him to stocks with good growth potential that have been temporarily beaten up by the U.S. housing slowdown. He particularly likes PoolCorp, which is involved in the building of swimming pools, as well as Zimmer Inc., a manufacturer of orthopedic products, and Austria-based Vienna Insurance Group.

Hubbes also holds Zimmer in AGF Canadian Stock Fund. He sees opportunities in health care and likes Express Scripts Inc., a U.S. company that helps group benefit plans manage pharmaceutical benefits. Other holdings include Germany’s BMW Corp. and English pub consolidator Whitbread PLC. IE