The person in charge of the strange and complicated science of changing the mix of invested assets is Don Raymond, 51. He is what you would expect of someone who has to think about this very question for a vocation. He is quiet, measuring his answers to even simple questions, a friendly and all-smiles nerd.
Raymond has been an RCAF pilot; service engineer in Mongolia for Schlumberger; bond manager at Goldman Sachs; and academic: He has a PhD in electrical engineering with a speciality in non-linear systems theory, which helps with the complicated calculations on non-linear pension payouts. Still, he was an unusual hire; it reflected the Board’s determination that its investment strategy would not be handcuffed by the fund’s eventual enormous size.
Before risk budgeting could be applied, restrictions on foreign investments by pension funds had to be lifted. By 2005, given some effective lobbying by CPPIB and others, the cap was removed. Other large funds, such as Ontario Teachers’ Pension Plan, had been cleverly complying with the letter of the foreign ownership rules for years by investing in Canadian derivative funds that mimicked the returns of foreign stock and bond indexes. But MacNaughton had shied away from that. “Using derivatives to bend the rules was not something I wanted to do,” he says. “I made a judgment call that we wouldn’t do a workaround.”
When Raymond arrived at CPPIB, he only had a little room to innovate. The Board had $11 billion invested with two external equity managers, TD Asset Management and Barclays Global Investors (now BlackRock), and it was required by law to invest the money passively. Shortly thereafter, however, these restrictions were removed, and Raymond moved quickly to establish internal passive management and hire external managers who could invest actively in equities and deploy currency hedging strategies for foreign holdings.
Raymond is widely credited with coming up with two radical ideas for investing. He believed that there was no point in hiring external asset managers if they didn’t beat the CPPIB’s benchmark equity portfolio, mostly consisting of index-fund-type investments based on the S&P/TSX 60, S&P 500 and others. He came up with a plan to allow managers to target portions of the portfolio and substitute other investments that they figured would perform better. The managers were only paid if they outperformed. Few took up the challenge, but a couple did so and have consistently beat their targets.
Raymond also recommended to his board that they should adopt the novel risk-budgeting approach. Simply put, all assets have risk, and each one behaves in a particular way. Raymond and his team’s strategy was to “budget” for the amount of risk each asset class had, and then focus on finding investments that would generate a higher return for taking the same amount of risk, regardless of whether the investments were in the same asset class or not.
This meant doing a massive amount of research into the behaviour of different assets. Real estate, for example, exhibits different return characteristics based on project age and size. A new apartment building has many of the same potential risks and rewards as the shares of a new company—it has big start-up costs, and the upside comes from the growth of revenue and profits as the buildings fill up. Old buildings or shopping malls are like bonds—start-up costs have been amortized, and they provide a steady stream of income.
Raymond’s idea could be tested. He asked external equity portfolio managers to target portions of the portfolio the CPPIB already had—which would be the benchmark—and propose alternatives. The essence of the strategy is telling money managers who claim that they can do better that they will only be paid if they tell the truth.
From the other side of the investing equation—sellers—CPPIB has a sticky sort of pitch. The size of its marketing literature speaks to this. The paper version of the CPPIB’s pitch deck—its spiel for potential partners—is 40% smaller than its competitors’. It’s the elevator pitch, which goes something like this: “We do our homework ahead of time, we move faster, we’ll stay far longer, and might buy everybody out at the end, and we’re nice.” Time will tell if they can keep all their promises.