Last week I attended a conference on pension fund investing in downtown Toronto. During the course of the day, an impressive roster of speakers stepped up to the podium. In total, they represented billions of dollars in pension assets and money management firms, so even if their forecasts prove to be in error, their buying power is enough to move markets.
So, what can the individual investor learn from a meeting where the chief investment officer of an $8-billion pension fund can describe his organization as “small enough to be flexible and respond quickly to proposals”?
First, these big investors are faced with the same low-interest-rate environment as the retiree on a fixed income so they too are moving up the risk spectrum. When risk-free government bonds yield 1 per cent to 3 per cent and the pension fund needs a return somewhere in the 4-per-cent to 5-per-cent range to maintain its funded status, then traditional fixed income is no longer a defensive component of the portfolio, but an exposure to price erosion in the event of higher interest rates in the future. As a result, many pension funds now target a bond exposure of 20 per cent to 30 per cent, down from the typical 40-per-cent weighting a few years ago. Individual investors should be making a similar directional adjustment in their own portfolios.
The antidote to a lower bond exposure is a shift toward higher risk investments such as junk bonds, private equity, hedge funds and infrastructure projects on the part of pension funds.
As individual investors, we are not going to be invited to participate in the privatization of Canada’s airports or toll roads, so this is not a source of portfolio incremental return for us. Actually, this may not be a competitive disadvantage: The simultaneous movement of billions of pension dollars out along the risk spectrum probably means that these megaprojects will not deliver particularly generous returns because of the competition for a limited supply.
This search for incremental risk-adjusted return, also known as alpha, prompted the chief information officer of one pension fund to make the offhand comment that he had asked all the managers in his stable to cut their fees by 10 per cent. Not all had agreed, but the net effect had been to reduce his management expense ratio by 13 basis points – a very effective alpha enhancement strategy! The individual investor doesn’t have this type of bargaining power, but shopping around for lower fees on passive investments or certain classes of mutual funds is clearly a strategy with a quick payback.
The comment from the CIO sent a frisson of fear through the money managers in the audience and holds a message for individual investors: In the past it has been smart to invest in the shares of money managers rather than the funds which they manage since managers enjoy a leveraged return on the growth of total assets even if the funds perform poorly. In an era when fees are under downward pressure, this is no longer good advice.
In my view, the best strategy for the individual investor came by chance from Nobel Prize-winning economist Robert Merton. He tackled the problem of extracting alpha from an almost efficient market when you have megadollars to invest. His examples made sense for international banks, insurance companies and hedge funds, which was his target audience after all, but in his warm-up comments he conceded that an investor can extract alpha from the market through informational inefficiencies. That is, knowing things about an investment that other market participants either don’t know or misinterpret.
If this happens to be inside information then clearly it is illegal to act on it, but many small cap companies have no sell-side research. They do, though, have to report promptly on SEDAR and many of them hold quarterly conference calls that are poorly attended. Professor Merton correctly dismissed this source of alpha as irrelevant to his audience because it is expensive and not scalable. In other words, you cannot buy enough shares to move the needle on an $8-billion pension fund.
As an individual investor, though, you don’t have to be a Nobel Prize-winner to be the most knowledgeable investor in these companies: Just read the financial reports as soon as they are released and listen to the conference calls. Plus, you only need a few hundred or maybe a thousand shares to have a major impact on your portfolio. Just because the big pension funds cannot buy a stock does not mean that it is a poor investment. In this sector of the market, the playing field is tilted in your favour.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.Report Typo/Error
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