At first glance, the Canada Pension Plan looks like a model for a government-created retirement fund. The portfolio is growing, returns have looked strong and the plan is now among the 10 largest of its kind in the world.
But as it approaches $220-billion in assets, the CPP’s investment arm, the Canada Pension Plan Investment Board, is taking on more risk than ever. The CPPIB has moved into a host of far-flung private investments such as Chinese real estate, high-yield debt, speculative energy plays and even a deal with the organization that runs Formula One car racing. Sources say it has also faced an internal struggle over investment strategy that has contributed to the departure of several key executives.
As the fund moves farther away from safe holdings, like government bonds and blue-chip stocks, the ramifications could be significant for 18 million Canadians who depend on the CPP for retirement benefits. In the past four years, the CPPIB has rapidly expanded its private investment portfolio from $30-billion in 2010 to $88.5-billion today. And earning exceptional returns on these investments can be challenging.
“In my 15 years as a professional investor, this is by far the most difficult market” for private assets, CPPIB chief executive officer Mark Wiseman said in an interview.
In a sign the new strategy isn’t paying off just yet, the CPPIB has failed to beat its own internal benchmarks two years in a row, falling short by $350-million – and in four of the past six years, amounting to $1.9-billion worth of total underperformance.
Much like a mutual fund, CPPIB’s success cannot be judged on annual returns alone. The pension fund must also be assessed on its ability to beat the market. Almost any fund manager can earn 10 per cent when the market is up 15 per cent, but real value, or alpha, as it is known on Bay Street, comes from going above and beyond. Because the market is so hard to beat, surpassing it by even the smallest of margins is touted as a success.
Even if the underperformance seems small for such a large fund, failing to consistently beat the benchmark can have far-reaching implications. It would undermine the shift toward more high-risk assets and it could hold back overall returns. And considering that the CPP is expected to grow to $500-billion by 2030, any misstep on the investment strategy could be costly.
Such a scenario can be confusing. To the average person, the fund’s annual performance looks impressive. The CPPIB has roughly doubled the size of the fund in the past 10 years to $219-billion and its 16.5-per-cent return last year suggests the portfolio is humming. The fund has also become a major player on the world stage, opening offices in four countries and participating in several foreign transactions, and CPPIB executives are regularly invited to elite gatherings such as the World Economic Forum in Davos, Switzerland.
But the CPPIB has undergone a substantial transformation. A decade ago, executives lobbied hard to shift away from solely investing in passive investments, such as federal and provincial bonds that that pay low, safe returns. The goal: To take on riskier but potentially higher-paying strategies, such as investing in private companies and real estate. Ottawa ultimately gave CPPIB the green light, but required that the fund find ways to determine if the extra risk was worth it.
To help track its performance under the new strategy, the CPPIB created a “reference portfolio” – a low-cost, basic basket of global public market investments it could otherwise invest in. Each year, CPPIB’s returns are compared with this portfolio. When the returns fall short, it means Canadians would have been better off avoiding the riskier investments, the same way a retail investor might fare better by investing in an exchange-traded fund that tracks the simple S&P/TSX composite index instead of picking and choosing between companies.
The CPPIB must now prove that taking on the extra risk was worth it in the long run. And it has to do that just as the environment for these kinds of investments has become much more competitive as many other pension funds, private equity firms and sovereign wealth funds seek to do the same thing.
All this extra attention on private equity has put more pressure on the CPPIB’s far larger public investments arm, which buys and sells publicly-traded stocks and bonds as well commodities, currencies and interest rates. Returns here have to be good to compensate for any shortfall on the private side. The trouble is, this division, which comprises 60 per cent of the fund’s assets, hit a series of road bumps in recent years, such as infighting over investment strategy.
To start righting the ship, CPPIB launched a major strategic review last year, tackling everything from organizational structure to compensation. After some soul-searching, the pension fund is out to prove to Canadians that they will be adequately compensated for the extra risk added to their retirement funds.
Investment strategy strife
To truly appreciate the current conundrum, it helps to have a good grasp on the past.
The Canada Pension Plan has existed since the mid-1960s, but the program was revamped in 1997 when federal and provincial governments realized its demographic assumptions were outdated. To correct course, politicians forced Canadians to put more of their paycheques into the plan, sending the value of funds under management soaring. The government also created the CPPIB to start dabbling in investments beyond government bonds.
Almost a decade later, the CPP was overhauled again when management adopted a much more aggressive strategy to earn even higher returns. In the years since, CPPIB has invested in assets such as Sydney office towers and it has also completed a host of high-profile deals such as buying U.S. reinsurer Wilton Re for $1.8-billion (U.S.), forming a $250-million joint venture with China Vanke in Shanghai to invest in Chinese residential real estate and acquiring a portfolio of Saskatchewan farmland for $128-million (Canadian).
But it was deep in the board’s public markets division, which manages a $131-billion portfolio, where problems first surfaced a few years ago.
Because the public markets division is so large, it employs myriad investing strategies. Such diversity can sound like a good idea, but its practical implementation doesn’t always pan out. “The problem with the public markets group,” said a former employee, “is that they’re in so many different strategies that it’s very difficult for all the stars to align so that every group is making money.”
With so many strategies at play, it can be hard to pinpoint those that have worked and those that don’t. But in its simplest form: if one makes $3-million, another loses $4-million, and a third returns $1-million, the net effect is no gain.
There has also been a deep divide between the public markets group’s two dominant investing themes – quantitative versus fundamental analysis.
Many fund veterans, including recently departed chief investment strategist Don Raymond, were steadfast quantitative investors, which means they deployed money based on things like probability distributions and standard deviations. A quantitative portfolio manager may arrange an investment mix based on certain assets’ correlations to one another.
As CPPIB’s portfolio expanded, however, its fundamental investing team – which conducts research to forecast future cash flows and pores over corporate financial statements – grew bigger and very quickly housed a large group of people who had a different view of the market. These folks did not care much about what the statistics said.
In an interview, Mr. Wiseman acknowledged it was a marriage that could not work. “It’s like getting [people] who speak two different languages and asking them to go write a novel,” he said. “It just becomes really, really difficult.”
Other units within the public markets division also had to be overhauled after they each underperformed their benchmarks by hundreds of millions of dollars, according to two different sources familiar with the fund. CPPIB would not verify the amounts, saying it only reports results at a very high level.
Mr. Wiseman acknowledged problems in two particular units: the global corporate securities group, or GCS, which primarily played with long and short positions, and the global tactical asset allocation team, or GTAA, which invests based on macroeconomic themes, such as a euro zone recovery or an emerging-markets slump. The first group needed to fine tune its strategy, he said, while the second suffered from bad leadership.
Another problem was determining annual compensation for long-term investment strategies.
Because CPPIB has such a lengthy investment horizon – 75 years in some cases –both GCS and GTAA tried to use it to their advantage, sometimes placing trades that required them to hold securities for two to five years. (Most money managers in the private sector have a time horizon of less than two years.) At CPPIB, a portfolio manager might purchase Spanish securities in the middle of the European debt crisis, assuming the euro zone will eventually get its act together, even if it takes three or four years to reap the benefits.
The problem is that the securities’ values could fall farther in the meantime. If so, the annual mark on the investment would show a loss, and that affects group compensation for the given year, often leading to infighting. “A losing trade is an orphan,” one portfolio manager said. ‘No one wants it.”
Such a struggle isn’t unique to CPPIB, but it was something the pension fund had to learn the hard way. “All pension plans get into the habit of hiding in the long term,” said veteran pension consultant Malcolm Hamilton, now a fellow at the C.D. Howe Institute. “You can’t think like that. Unfortunately, you have to act in the short term, you have to pay in the short term.”
While all of this was playing out, CPPIB started losing some top talent. Mr. Wiseman said the fund’s total employee turnover ratio has held relatively steady near 9 or 10 per cent annually, but he acknowledged some venerable names have left, including Mr. Raymond; Sterling Gunn, a former vice-president of quantitative research; and Jean-François L’Her, the former head of investment research for the fund’s Total Portfolio Management team – a departure that led to crying on the trading floor, according to someone there that day.
Asked what his No. 1 concern was at the moment, Mr. Wiseman emphasized talent retention. “I’m worried: Are we going to be able to keep those people engaged and have them continue to be employed and working for us?” he said.
To help convince them to stay, CPPIB is considering restructuring compensation. CPPIB typically pays salaries based on four-year rolling windows, which differs from most funds and firms on Bay Street, and that means new hires got bonuses based on previous years’ results. Going forward, newer employees won’t have as much of their pay tied to the fund’s performance before they arrived.
The troubled units, GCS and GTAA, also have new leaders, and in some cases, have retooled their strategies – something Mr. Wiseman said showed CPPIB’s long-term dedication. “If we were a hedge fund, we would have fired the whole team,” he said. “We still believe in the fundamental tenets of those two strategies. We still believe we can get it right.”
Burying the bad news
As the public markets arm retools, the CPPIB’s private equity division is dealing with a different, but equally challenging, scenario.
Whenever the board’s managers are asked about the fund’s private equity capabilities, they are quick to tout its inherent advantages. As a publicly funded plan, the CPPIB has certainty of assets, meaning it does not have to worry about investors redeeming their money at the first sight of something going wrong. Canadians cannot get their savings out until they retire.
Like many funds, the CPPIB has a tendency to celebrate its private equity successes – such as the recent sale of Gates Corp., the automotive parts manufacturing division of Britain’s Tomkins PLC. The pension fund teamed up with Onex to buy Tomkins for $5-billion in 2010 and the partners have since sold eight of the conglomerate’s holdings for gross proceeds of $7.9-billion.
However, struggling investments are rarely highlighted. For example, the fund invested $250-million in oil sands player Laricina Energy Ltd. in 2010 at $30 per private share; in March, the CPPIB coughed up $150-million more for a debt financing that came with warrants -- which can serve as a proxy for Laricina’s private share price – that allow the CPPIB to buy new shares between $15 to $20 apiece.
“Whenever CPPIB has a success, they are quick to discuss it publicly. The same goes for new investments,” said Mark McQueen, who runs Wellington Financial, a private firm that specializes in venture capital. But when you ask about struggling investments, “CPPIB says they’re not material. They want to have it both ways, and the board is complicit in management’s tendency to bury the bad news.”
There is also the age-old issue of risk versus reward. Private assets can generate major returns, but they also come with drawbacks. “One of the big advantages of being in public markets is you have liquidity. You can exit when you want,” said Jim Keohane, CEO of the Healthcare of Ontario Pension Plan, which manages $52-billion. The same isn’t true of private assets.
Pressed about these realities, Mr. Wiseman acknowledged some missteps. “We’ve made bad investments; we’ve lost all our money,” he said, adding that it is just the nature of private equity. “If we’re not doing that, we’re not taking enough risk.”
He also acknowledged that private equity isn’t a sure bet – especially not in this competitive market when assets are sometimes purchased at big premiums. “It’s really hard to get right. It’s a tough, competitive business.” Jaw-dropping returns are getting harder to come by now that university endowment funds and sovereign wealth funds have all moved into this terrain. “This industry has matured. It’s always harder to get superior returns when there’s a lot of money chasing deals,” Mr. Wiseman said.
Private assets also pose a valuation problem – they are incredibly hard to value until they are sold. Because there are only so many power and water utilities up for sale at one time, it can take time to find comparable transactions. In financial circles, then, the valuation process is sometimes called “marking to myth,” and the problem is so widespread that Keith Ambachtsheer, a renowned pension expert who runs the Rotman International Centre for Pension Management at the University of Toronto, is devoting much of his research to analyzing the issue.
Back to the glory days
While it can seem like CPPIB’s task is daunting, the reality is far from it. The country’s largest pension fund is still pumping out positive returns, and it is complying with its most crucial guideline.
Every three years, Canada’s chief actuary calculates the returns CPPIB must generate to meet its long-term pension obligations. The last time the review was conducted, it showed the fund must generate a 4-per-cent real rate of return each year – or 4 per cent after adjusting for inflation. Over the past 10 years CPPIB’s annual real rate of return is 5.1 per cent.
As for the internal benchmark, CPPIB has proven it can beat it. Early on the fund generated a lot of alpha, and those gains have contributed to total positive “value-add” of $3-billion since CPPIB adopted its more aggressive approach and created the reference portfolio in 2006. Now management must prove that it can get back to the glory days.
Mr. Wiseman stressed there is no need to worry. Because 40 per cent of CPPIB’s portfolio is invested in private assets, he argued that the fund is at an inherent disadvantage when public stock and bond markets are hot, like they are right now, because private assets take much longer to reprice. “Just keeping up to the reference portfolio in a bull market is unbelievably good,” he said.
In the private asset portfolio, Mr. Wiseman said CPPIB has the luxury of being “steadfastly patient.” Because the fund doesn’t have to return money to investors every five to seven years, as private funds do, it can wait for good opportunities.
And overall CPPIB also has some wiggle room. The fund benefits from net inflows until 2023, meaning its members’ contributions amount to more than its annual payouts until then.
However, the net inflows can serve as a double-edged sword. Whereas Ontario Teachers’ Pension Plan can’t afford to make investment mistakes because it currently pays out more than it brings in every year, CPPIB can arguably hide behind its sizable contributions. The pension plan also has less stakeholder engagement than rival funds. OTPP, for instance, holds quarterly meetings with the Ontario Teachers’ Federation, according to Rhonda Kimberly-Young, the union’s secretary-treasurer.
“We really rely on the integrity of the people on the board and we rely on the competence and vigilance and transparency of the people who are on the staff to do a good job, [because] they don’t have a stakeholder looking over their shoulder,” said Mr. Hamilton of the C.D. Howe Institute.
Mr. Wiseman shrugs off such worries, arguing that the board is vigilant. Just because missteps happened does not mean management has had, or will have, a free ride. “Not making a mistake means you’re not building your business, you’re not taking enough risk,” he said.
But he also understands the severity of the situation, and pledged to prevent the same drama from unfolding again. “Making the same mistake twice? That’s unconscionable,” he said.
Even if CPP’s future is much smoother, there still is no guarantee that the active management strategy will pay off, something other massive pension funds are wrestling with. While Singapore’s GIC sovereign wealth fund has adopted a similar approach, Norway’s $850-billion wealth fund is debating whether it should move farther away from passive investments.
“It’s human nature for people not to invest passively,” Mr. Hamilton said. “They all want to try to do better [than the market].” The problem is that the time frame required to assess the merits of an active approach can take decades – time during which billions of dollars can be made or wasted. “At this point, it really is an experiment,” he said.