Investing Surprises and Ideas from the CPP Investment Board

Have you ever wondered how that monthly Canada Pension Plan payment you will receive in retirement is generated? It doesn't come from government tax revenue, it comes partly from investments (and mostly from CPP inflows) made by the government-mandated but independently-operated (except for the influence arising from the fact that the federal government appoints the board members) CPP Investment Board.

The CPPIB has a conservative mandate: " ... to maximize returns without undue risk of loss." This sounds similar to my objectives, so I was curious to see what they do at CPPIB and whether there are any worthwhile investing ideas for the individual DIY investor. After all, the CPPIB is just a gigantic RRSP with no end date. It cannot afford to ever run out of money nor can I in my retirement. What does the CPPIB invest in and in what proportions? How much foreign content does it have and does it do any hedging to manage currency fluctuations? Does it just do passive index tracking or does it engage in active management?

What I found was very interesting and surprising.

Separation of Portfolio Structure from Cash Flows
The very existence of the CPPIB as a separate body whose only job is to generate investment return, not a retirement income cash flow, illustrates what I feel is a fundamental mistake in the way financial planners advise people to structure their portfolios in retirement. Planners often say to put lots of fixed income or high dividend stocks into the portfolio to directly generate cash to spend. But the CPPIB approach says the portfolio function is to generate returns, most of which is actually a capital gain of sorts, that can then be turned into cash as required by selling an investment and then shipping the net amount over to the CPP, the government body that mails the cheques to pensioners.

Right now, the CPP is still receiving massive net inflows ($6.5 billion in 2007-08) from the difference between CPP contributions and CPP payments - projected to last till 2019, another 11 years from today. That means it is in the pre-retirement phase, the equivalent of a person in his/her mid 50s. Will the CPPIB's portfolio shift dramatically to fixed income in 2019? There is nothing explicit I could find on the website that says what changes they will make at that point. I take hints from the use of words like sustainable in reference to their strategies, in other words not likely to change.

One caveat that applies to the individual but not the CPPIB and does justify somewhat a different investment allocation is taxes. The CPPIB doesn't pay any, at least in Canada (it does overseas) but you and I do. Therefore dividends, which have a much lower tax rate, do make sense for individuals in taxable accounts. But in a taxable account bonds, which are taxed at the highest rate, do not make sense, if the sole purpose is to generate cash. Investments that generate capital gains are also taxed at a lower rate than bonds.

Foreign Content and Lots of It
Surprise #1 - As of the end of March 2008, about half the portfolio (47%) of the CPPIB is invested outside Canada! Every penny of the returns goes to fund Canadian pensions in Canadian dollars yet the CPPIB invests abroad and intends to do that even more. Partly this is because the enormous amounts of money it has to invest mean that it must go elsewhere (already it owns 2% of all Canadian public equities). But it is also because of investment reasons, namely to further diversify risk and to achieve attractive returns in other sectors and countries (see CPPIB FAQ question 8). This is a good idea for the DIY investor too.

Currency is Not a Risk It's a Diversifier ... in the long term
Surprise #2 - The CPPIB does only partial hedging to remove the effects of currency fluctuations, which are negative when the CAD increases in value and the value of foreign holdings decrease as a result. One would have thought that huge foreign exposure ($57.7 billion in foreign assets and $47.6 billion in net currency exposure per page 69 of the annual report) would lead this organization with a conservative mandate and an obligation to pay out in CAD to remove all of the currency risk. It is not so - the CPPIB seems to hedge only about 20% of its foreign exposure.

The CPPIB hedges the amount arising from its investments in real estate and infrastructure. I cannot see why. Is it related to the fact that these investments are classed as inflation-fighters?

CPPIB's explanation of its hedging policy on page 17 of the 2008 Annual Report is worth reading, especially since it figures it could hedge at a cost of only 5 basis points or 0.05% (which raises the question why does it cost those hedged ETFs and mutual funds so much more?). Among the reasons cited for not hedging:

• when Canadian equities do worse than foreign equities, the CAD tends to fall, so the foreign equities go up even more in CAD terms - a performance boost
• a falling CAD results in higher inflation (which gets reflected in higher CPP payments) from imported foreign goods so the higher returns from foreign equities helps offset this source of inflation; they note it works both ways - as the CAD rises and foreign import inflation is reduced, as has been the case recently, the foreign holdings fall in value

An individual investor faces the same problem with inflation that the CPPIB does - the need for higher payments aka spending. Not hedging is thus a good idea from the inflation perspective.

The last reason cited by the CPPIB I do not believe applies to me as an individual:
"Investment theory, historical results and our research indicate that hedged and unhedged portfolios over the very long term have the same expected returns, except for the costs and fees of maintaining the hedge."
The key is the phrase "very long term". Is that 10, 20 or 40 years? I do not have an indefinite time horizon like the CPPIB. A 20 year upwards movement of the CAD that results in constantly lower or even negative returns from foreign holdings would not be good.

My own foreign holdings are only about 15% hedged. That's probably too little but hedging costs in the available hedged ETFs (like iShares S&P500: XSP and iShares Russell 2000: XSU) are much higher than for the CPPIB. Higher costs directly lower returns so the amount of hedging to do is a dilemma for me or any individual investor.

Equities are the Majority of the Portfolio
Surprise # 3 One would think they'd stick most of their money into "safe" fixed income, right? Nope, only 28% is in fixed income! The chart says only 25.6% but there is another 3% in inflation-linked bonds classified under inflation-sensitive assets. The rest is in equities. If the CPPIB is really adhering to its low-risk mandate, as it keeps repeating through the 90 pages of the annual report, then it must have mechanisms to control risk. While some means like the use of derivatives are difficult or impossible for the average investor to implement, the most important one - diversification - is available. Diversification for the CPPIB happens two ways:

• lots of investments - 2600 companies around the world, including 700 Canadian companies (the TSX only comprises 300 odd companies so the CPPIB has more than twice as many) - and
  
• investments whose risk-return characteristics fit together to reduce the overall portfolio risk.
  

Moral of the story for the DIY investor - diversify.

Inflation-protection is a Key Objective
Investing Idea: The CPPIB has a special category in its portfolio that it terms inflation sensitive assets to protect against inflation and help meet its obligation to fund CPP payments that are adjusted to rise with inflation. That objective is exactly what any individual investor would want to do as well. There is a hefty 11.7% of the portfolio devoted to such assets. There has been a significant increase in this type of asset since 2005.

What is interesting and worth looking at to do in any individual investor portfolio are the investments: real return bonds, real estate (commercial and office, not residential and most of it foreign) and infrastructure. There are ETFs and funds focused on those areas so it's quite possible for the individual investor to implement. There are attractive returns to be gained. In 2008, infrastructure was one big source of outperformance for the CPPIB. Infrastructure includes electricity transmission and distribution, gas transmission and distribution, water and sewage companies, toll roads, bridges, tunnels, airports and ports. CPPIB excludes hospitals and schools because the projects are too small - and it has big money to invest!

Costs are Low, VERY Low
Surprise #4: Considering that it is a government agency, the CPPIB's operating costs of 15 basis points, a measly 0.15%, are pretty darn good. Consider this statement in the annual report: "... every dollar saved in transaction costs is equivalent one dollar of additional income, or alpha, with no increase in risk." Low costs go straight to the bottom line and increase returns. Perhaps the CPPIB has the advantage of scale and doesn't have the marketing costs of mutual funds to pay for, but such low costs make one wonder again about the 2+% MERs charged by the average Canadian equity mutual fund.

Fixed Income contains Only Government Bonds and NO Cash
Maybe I missed the explanation but it was another surprise to find no corporate bonds in the CPPIB's portfolio. It is all federal and provincial debt (for some strange reason it has more PEI bonds than Quebec bonds). Global corporate bonds and private debt are on CPPIB's 2009 expansion list. I do not think the CPPIB's fixed income structure is one I or other DIY investors should emulate - corporate bonds have been shown to be an effective diversifier.

There seemed to be no, that is, zero cash on the books. That's right, the favourite ultimate "safe" asset isn't something the CPPIB holds at all in its investment portfolio. Obviously, the net CPP contribution inflow of $6.5 billion in 2008 didn't sit around long before it got invested. The only cash holdings of the CPPIB are a special fund (not considered part of the investment portfolio) it calls Cash for Benefits which it administers on behalf of the CPP to ensure cash is always available to meet CPP payment obligations. This is like an individual's current account cash for daily expenses.

The CPPIB doesn't explain anywhere why it holds no investments in cash. Cash is an asset un-correlated with other assets so can provide diversification to a portfolio. Probably, the reason is that the CPPIB is embarked upon the chase for higher returns. Which brings us to the next surprise.

The CPPIB is a Gung-ho Active Manager
Passive indexing as an investment strategy for pension funds is passé. The new best practice (or is it group-think?) is active management. That entails a whole raft of techniques and tactics, all of which the CPPIB is pursuing already or wants to expand: stock picking, hedge funds aka absolute return strategies, opportunistic buying (like ABCP last autumn), private equity and debt, tactical asset allocation aka market timing in stocks, bonds and currencies, country picking, buyouts and company management as principals. Holy moly, I'm having an attack of cognitive dissonance! This is cautious investing?

What leads the CPPIB to think it can do better than the market? Page 18 onwards of the annual report lays out the comparative structural and operational advantages that it feels will allow it to consistently outperform:

• a long investment horizon (they can be patient ... does that mean it believes other big investors like mutual funds suffer from short-termism?)
  
• a stable asset base and cash flows (CPP is predictable)
• scale (it can get deals, especially in private markets, and terms that others cannot)
• ability to acquire expertise (it says it will be smarter than the average)
• portfolio approach aka non-traditional view of asset classes where it is the risk-return characteristics they use to construct the portfolio (e.g. an infrastructure investment can behave like a bond)
• investment only mandate and transparent investment processes (government keeps its nose out so it has been able to avoid doing politically-correct screening out, or in, of poor investments)

Some of these qualities individuals can duplicate and should apply, like patience, unbiased choices, regular savings for investment and taking a portfolio approach. Other qualities are harder, like scale and outsmarting everyone. Perhaps the scale advantage can be turned around, for instance, the smaller companies that the CPPIB or other big investors have no interest in, can possibly be fertile investing ground.

The CPPIB has two strategies for pursuing outperformance relative to its benchmark:

1. "better beta" which consist of investing in new non-traditional asset classes whose risk-return characteristics lower overall portfolio risk and enhance return; it mentions specifically real estate, infrastructure and private equity, the first two of which we individuals can also invest in
2. "alpha" or above market returns obtained through skill and or smarts applied to temporary market mis-pricing
   

Aside: sometimes I wonder if the pursuit of alpha has something to do with the other meaning of alpha as signifying the dominant male in a pack of animals. Is part of the subliminal investment motivation to pursue alpha related to the macho alpha motivation to be top dog? Why don't those behavioural finance researchers who are so fond of revealing how individuals make stupid irrational decisions look at institutional behaviour?

In terms of risks of the active investing activities of the CPPIB, there are some interesting comments in a paper Upgrading the Investment Policy Framework of Public Pension Funds by Dimitri Vittas, Gregorio Impavido and Ronan O'Connor of the World Bank:
"Nevertheless, some aspects of the new approach should raise policy concerns. First is the risk (identified by Warren Buffett, the well-known investor) that ‘mark-to-model’ valuations may over time mutate to ‘mark-to-myth’ valuations. The recent experience with CDOs based on sub-prime mortgages lends support to this concern. Second, the more extreme forms of alternative investments, such as management of infrastructure projects, engaging in principal investing, and participation in hostile takeovers, expose public pension funds to risks for which they are unlikely to be well prepared and for which they are unlikely to have the requisite skills. It would be more consistent with the long-term objective of public pension funds to seek to maximize returns with a prudent level of risk if they limited their involvement in alternative asset classes to those that avoid ‘principal investor’ risks and rely on robust valuation models."

In its discussion of risks on page 44 of the annual report, the CPPIB does not address what I would describe as Fatal Flaw Wrong Assumption risk. With the intended increasing complexity of investments, will the board and top management really understand what the real under-lying risks are? That seems to have been a major cause of the sub-prime mess - institutions had no idea that the supposedly triple A mortgage CDOs were actually crap. Things can go fine for years, then the roof falls in. Oh well, we're in the same boat as Ireland, Norway and New Zealand since they have also gone modern and agressive. The actively managed part of the portfolio is still only a few percent so the total risk isn't that great ... yet.

One must admit that the results so far of the active management approach have been more than satisfactory. Compared to the passive Benchmark Portfolio, the CPPIB outperformed by about 2.4% last year, about the same as the year before. Hmm, is this proof that active management can work and the poor results of actively managed mutual funds merely shows that something is wrong with that model? This study posted on the U. of Toronto Rotman School International Centre for Pension Management shows US pension funds have also outperformed. The CPPIB's ongoing goal for outperformance is a modest 0.4%.

In 2007-08, about one quarter of the outperformance came from infrastructure and the rest from private equity, something not really available to the individual investor.

Maybe if they made executive compensation susceptible to actual losses instead of only rewarding upside performance, real "skin in the game", I'd be more convinced about active management.

I think I'll stick with going after "enhanced beta" in my portfolio for now.

The Reference Portfolio is a Good Guide
Investing Idea: the Reference Portfolio (see page 16 of the annual report) is the base against which the CPPIB measures itself. It is an investable portfolio composed of:

• 25% Canadian Equities
• 40% Foreign Equities
• 25% Fixed Income (all domestic government bonds)
• 10% Real Return (inflation-indexed) Bonds

That portfolio is designed to produce the 4.2% annual real (after-inflation) return that the Chief Actuary of Canada says is required to sustain the CPP for the next 75 years. In short, the Reference Portfolio offers a low-risk ultra-simple model portfolio that anyone can adopt and a target rate of return as well.

Where the CPPIB is Looking for Growth and Higher Returns
In case you might want to follow their lead:

• China, Hong Kong, South Korea, Taiwan, Mexico and some Eastern Europe
• infrastructure
• global corporate bonds
• real estate, especially Latin America

A "Modest Proposal" - investing in the CPP
>The thought crossed my mind that if the CPPIB were a mutual fund I might want to buy in; it would be one of the best with low cost, diversification, ability to participate in things I cannot do as an individual investor, outperformance of the market. Funny that the guru of pension management Keith Ambachtsheer, one of the drivers of the active management trend in pensions, was written up in a May 30 post on Jonathan Chevreau's blog Supplementary CPP for those without Workplace Pensions. He proposes that very idea plus a lot more, a beginning-to-end solution to the reason most people invest in the first place - to maintain a post-retirement standard of living.

Update June 25
When Net Inflows turn to Outflows
I was wondering what plans the CPPIB has for the moment about 12 years from today when net CPP contribution inflows turn to outflows, how that will affect investment policy and allocations among asset classes. Am still waiting for a response to my email enquiry but in the meantime I found a 2005 presentation given by the Chief Actuary of Canada, whose job it is to monitor the CPPIB and check that it will have enough to pay out CPP. Here is a copy of page 8 of the presentation, where it shows equities going down 10% and fixed income up by that much from 35% to 45% of the total. It's a classic retirement shift in allocation.

Update July 4th - When Net Inflows Turn to Outflows
The CPIB has now provided an answer to my questions!

Q - How will the composition of the portfolio and the investing policy change in 2019 when the CPP net inflow becomes an outflow?

CPPIB Answer - "This will be decided very much closer to 2019 and will be determined by the economic, demographic and investment environment at the time. Because the Canada Pension Plan (CPP) is primarily pay-as-you-go financed, only about one-third of its investment earnings will be needed to pay current benefits when the plan has “matured”. The 70% balance will be reinvested in the fund to provide a cushion against adverse future experience. By contrast, mature fully-funded pension plans use about 70% of their investment earnings to help pay benefits. As a point of interest, the most recent actuarial report assumes the CPP equity/debt asset mix will decline from the current 65/35 to 60/40 in 2010, to 55/45 in 2020 and 50/50 in 2025."


Q - Will you shift to a heavier proportion of investments that provide a stream of income, or those with a shorter expected payoff?

A - "Again, the composition of the portfolio will be determined by the circumstances at the time and the nature of the investment opportunities available. However, many of our most illiquid and longest horizon investments – private real estate and infrastructure – provide us with very large cash-flows. As well, dividends and interest payments are generated from all parts of the portfolio, and even private equity investments provide a steady stream of cash realizations."

It looks as though the CPPIB feels it will not need to shift its allocation to generate enough cash to pay for CPP benefits though it may move to more fixed income / debt investments if the actuary has his way. One can imagine a debate going on between a confident, aggressive CPPIB and the cautious, conservative actuary.

Update August 27 - Was browsing the Financial Webring and found some interesting comments on this thread page from a certain Bruce Cohen who says he has helped write the CPPIB annual report in recent years. He gives some additional info on how and why the CPPIB invests as it does - how much of the CPPIB money will be used for CPP, why no corporate bonds or cash and then unfortunately repeats the "management is too smart and professional to ever screw up" mantra.