Monday 30 June 2008

Some Views of Expected Future Returns

Ever wonder what to enter for the rate of return in those calculators that tell you what you will have accumulated after 40 years of saving and investing? It doesn't take a genius to understand that you can't just will a certain number to happen. Even extrapolating the past returns can be chancy - who says the future will be like the past and how many years of the past do you take?

Here are some forecasts whose credibility you can judge for yourself.

The US Social Security Administration's Chief Actuary Stephen Goss
Presented at the 2005 National Academy of Social Insurance Conference

Portfolio Solutions LLC (Richard Ferri) 30 Year Market Forecast

Canada Pension Plan Chief Actuary Jean Claude Menard
Presentation on Projecting Diversified Investments at the same Social Security Conference

I find it interesting that the forecasted returns on Canadian equity are lower than both US and other foreign countries. Is that Canadian reticence or a reflection of a country in the wrong economic sectors, like commodities, or just bad economic management? Whatever the reason, if accurate, it reinforces the need for Canadian investors to diversify internationally.

Friday 27 June 2008

Fundamental Indexing is Not Indexing at All ...

... It's an investment strategy that overweights value stocks.

As the short but incisive paper Fundamentally Flawed Indexing by Harvard Finance prof André Perold, demonstrates with a simple example and a mathematical model, the idea that cap-weighted passive indexing will systematically under-perform because it tends to hold more over-valued stocks doesn't hold water. Any outperformance of fundamental indexing compared to normal cap-weighted indexing can only be due to the higher-risk higher-return greater investment in value stocks (those with higher Price/Earnings ratios or other fundamental data).

Perold's conclusion: "... Holding a stock in proportion to its capitalization weight does not change the likelihood that the stock is overvalued or undervalued. The notion that capitalization weighting imposes an intrinsic drag on performance is, accordingly, false. Fundamental indexing is a strategy of active security selection through investing in value stocks."

Thursday 26 June 2008

Figuring Out How Risky to Make Your Portfolio - Ignorance is No Excuse

One of my pet peeves with those risk preference questionnaires from financial companies is the notion that a person's reaction to the possibility of a more or less large temporary dip in the value of a portfolio justifies a more or less heavy asset allocation to cash, bonds or equities. e.g. see the "Comfort Levels" portion of this typical questionnaire at Edmond Financial Group.

That's like your lawyer telling you to ignore laws because you dislike them.

It is true that if a dip makes you react and sell out at a market bottom then it is bad news. To continue the analogy, you went too fast in your car, had a crash, got a big fine, and now swear never to drive again. Does that makes sense? The problem is not the car or the law, but you and the poor behaviour.

In fact, it is too true that a majority of individual investors buy high and sell low, under-performing their mutual funds by a large margin. e.g. Cause of Low Returns for 401k Plan Participants on the IFA Canada website and The Sad Reality of Mutual Funds at InvestmentU.

Behavioural finance is the study of people making stupid money and investment decisions. It describes how people actually behave, not as they should do.

"... even if behavioral finance describes how investors actually do behave, it may not describe how they should behave. That is, investors may abandon their behavioral biases once they have the benefit of financial education and financial planning advice." John Y. Campbell and Luis M. Viceira in Strategic Asset Allocation Portfolio Choice for Long-Term Investors.

I'm all for that solution - investment knowledge and education. Once the risk-reward relationships of various types of investments are clear and especially the difference between short- and long-term investment returns of equities vs other asset classes, most people can modify their behaviour to match their real capability to bear risk, and their time horizon and investing goals (the other parts of those risk questionnaires). This is particularly important for long term goals like retirement, where the only hope of generating a large enough sum is to have a healthy dose of equities. Ignorance should not be an acceptable excuse.

Saturday 21 June 2008

Listen to World's Richest #1 and #2 Talk About Giving It Away

First you make a huge pile of money, then you give it away. A few years ago, Warren Buffett announced the largest donation to charity ever - most of his Berkshire Hathaway stock. Watch this video of an hour long TV interview with Buffett and Bill and Melinda Gates, to whose charitable foundation he gave the bulk of the donation. Maybe I'm fooled but there seems to be little ego in any of these folks' attitude to their charity.

It is apparently as challenging to give it away productively as it was to amass the wealth in the first place. Both Gates and Buffett expressed the interesting attitude that their children should not inherit such incredible wealth - that it would be bad for the kids themselves and that the money should go back to society from whence it came. Buffett's quip about how much to leave to kids: " enough so they can do anything but not nothing."

Two men and a woman using their money to better the world, good on them.

Book Review: You Can't Take It With You by Sandra E. Foster

... and You Can't Do What You Want With IT either. A key message of this popular book, now in its fifth edition revised in 2007, is that various people and governments have a claim on what you leave behind when you die. Estate planning in large measure consists of arrangements to maximize the chances that as much as possible of your property goes to whom you wish within the constraints of laws and taxes.

Everyone needs to know something about estate planning, that is unless, you:
a) die penniless with no assets to your name or
b) have never married, co-habited common law, or had children or
c) don't care about the hassle those you leave behind will go through to sort out your affairs

This book, subtitled Common-Sense Estate Planning for Canadians, covers the financial and legal aspects of incapacity and death:
  • estate - what is in or out
  • wills and dying intestate (without a will) - clauses explained, limits to your freedom to give away under Family Law
  • gifts - ways to give before death and after death
  • probate and ways to minimize this tax
  • powers of attorney for both financial and personal care
  • income tax returns due
  • family law, marriage and remarriage, divorce, separation
  • life insurance terms and uses
  • trusts - types and uses
  • executor choice and responsibility
  • funeral planning
  • business succession planning
The aim of this book is NOT to provide a DIY guide, as it says clearly on page xxiii of the introduction. It provides an introduction to what is a vast and highly technical topic. It explains informally, provides a lot of pros, cons and considerations and is very useful as a general checklist on each of the topic areas, enough to know whether in one's own case, it is worth looking into further.

An example of the level of depth in the book is the Q&A on page 202 in which it describes setting up a trust for children that you don't want to receive their inheritance till they are older, say 25 or 30. This is not the end of the story, apparently. Lawyer Lloyd Duhaime's website cites the 1832 case of Saunders v. Vautier whereby a beneficiary, having reached the age of majority, got a court to have assets in a trust handed over to himself despite a condition of the trust that he would receive the assets at age 25. Another example is the explanation of the prudent investor rule on page 197, which allows trustees some latitude to choose investments. The book cites the Ontario general conditions (in section 27 of the Trustee Act, though it does not reference that) but fails to mention the key implication in that it allows a trust to hold mutual funds (and presumably ETFs?), as lawyer Kenneth Pope points out in this article at Professional Referrals.

The book does not provide the further delving into, nor links and references as to where to obtain that information, a disappointment to me. There is the constant refrain to go consult a lawyer, an accountant or a specialized estate financial planner. Sometimes this reminds me of my teaching days when a student would ask a tricky question to which I could not explain the answer, so I would buy time by saying, "that's a very good question, we will be dealing with that tomorrow".

One topic the book should, but does not, cover is how to pick a good professional to deal with. Going to a lawyer to have a will drafted merely improves the chances that it will accomplish what you want. A bad lawyer can screw it up just as much as you doing it yourself. Note the necessity for a book giving guidance to lawyers on how to draft wills with the blurb "practitioners Mary-Alice Thompson and Robyn Solnik demonstrate the most common errors made by solicitors in drafting wills".

The book's attempt to cover rules all through Canada is very helpful but it makes apparent the variety of sometimes critical differences between provinces. Things are bad enough with one set of complex laws, why do we Canadians such a confusing multiplication? Should I need to revise my estate plan if I move provinces for a new job?

  • "Any particular strategy or technique, considered in isolation, may appear to make sense until it combined with other objectives or considerations." i.e. tax and probate minimization carried to an extreme may cause big problems among your heirs
  • "... you can't do whatever you want or write whoever you want out of your will." even having a signed contracting out of an inheritance may be over-turned!
  • "You don't go into surgery thinking, 'Boy, am I glad my paperwork is in order and that we've reduced the amount of tax that will be due...'." ... my wife isn't so sure about me ;-)
  • "Warren Buffett said that, '[the perfect inheritance] is enough money so that they feel they could do anything, but not so much that they could do nothing."
Every reader who is going to die will find something useful in this book. Even as someone who has been through a lot of it as the executor of a will and a trustee, there were a number of things I learned. Everyone will realize the importance of preparing a will.

My rating: 4 out of 5

Wednesday 11 June 2008

Bloggers Contravening Securities Laws?

Many financial bloggers, me included, like to write about specific companies, mutual funds, ETFs or other investments that we either like or dislike. Are we thereby in danger of running afoul of securities laws that require people who give investment advice to be registered with a government regulator charged with protecting the public from the baddies of the world?

In Ontario, for example, the Ontario Securities Commission defines a Securities Adviser as,
"Persons or companies that hold themselves out as engaging in the business of advising others either through direct advice or through publications or writings, as to the investing in or the buying or selling of specific securities, not purporting to be tailored to the needs of specific clients."
and an Investment Counsel as,
"Persons or companies that engage in or hold themselves out as engaging in the business of advising others as to the investing in or the buying and selling of specific securities..."
Both types have to be registered and obtaining registration is only possible with a bunch of complicated and stringent conditions, which I doubt most bloggers would be able to fulfill, let alone be hardy enough to withstand the psychological torture of trying to do so.

There are also certain people exempt from the requirement to register, most notably journalists under section 34 (d) of the Ontario Securities Act:
"a publisher of or any writer for any newspaper, news magazine or business or financial publication of general and regular paid circulation distributed only to subscribers thereto for value or to purchasers thereof, who gives advice as an adviser only through such publication and has no interest either directly or indirectly in any of the securities upon which the advice is given and receives no commission or other consideration for giving the advice, where the performance of the service as an adviser is solely incidental to their principal business or occupation,..."
Since most bloggers don't charge a subscription fee, it doesn't look like that exemption would be sufficient. If the blogger happens to be a lawyer, accountant, engineer or teacher then that might work since they also get exemption under section 34, but even then if it not done in the course of that occupation, maybe it wouldn't.

I wonder if the word "business" in the text above regarding Securities Advisers and Investment Counsel would provide the out for bloggers. Do Google or other ads on a blog make it a business? I sure don't get much from mine! I bet the tax people wouldn't be very impressed by me trying to pretend this blog is a business and trying to deduct my computer and Internet costs.

Now, one can take the chance that the "OSC is too busy frying other fish or has not clued in to bloggers and won't do anything". But occasionally they wake up and go after someone, as they did a few years ago when Brian Costello received a $300,000 fine from the OSC.

To be cautious, maybe it would help for bloggers to plaster "this is not investment advice, consult an adviser" notices on their blog site..... Oops, on the other hand, cancel that last statement, the Law Society might come after me for dispensing legal advice.

Caveat blogger and by the way, caveat investor now and forever.

Monday 9 June 2008

6 Reasons to Consider Using Testamentary Trusts

A trust is a legal entity created when a person transfers the ownership of property to one or more trustees, who manage the property for the benefit of a particular person or group of persons (called the 'beneficiaries'). A testamentary trust is usually set up in a will and takes effect upon the death of the settlor. A will can create any number of trusts for different beneficiaries. The will names the beneficiaries and the trustees, identifies the assets going into the trust, and states how and when the income and capital is to be distributed.

A key quality of trusts is that the Income Tax Act treats them as a separate individual taxpayer. A second key characteristic is that testamentary trusts benefit from the graduated personal income tax brackets, whereby lower income pays tax at a lower rate. A third important feature is that assets in a trust, while they are there, legally belong to the trustee and not the beneficiary.

What are the six reasons that people should consider using a testamentary trust?
  1. Tax Savings from Income Splitting for Children and/or Grandchildren - consider a grandparent who wants to leave money for minor children - instead of leaving everything to the parents who then must include the income it generates in their own income, which may be at a high rate already, the inheritance is put into a testamentary trust. Minor children are likely to have little or no other income, so the trust distributes income to the children who pay no tax. The inheritance can perhaps provide tax-free income for many years. If the parent is named as trustee, and the instructions in the will give the discretion, he/she can still control all the spending on behalf of the children. Each child can have a trust, further sub-dividing the income. For an adult child with a high income already, the trust may be in a lower tax bracket so it could retain the income to be taxed instead of distributing it to the child. A properly set up trust can have the ability to change from year to year whether it distributes any, some or all income, so that overall taxes are minimized.
  2. Tax Savings from Income Splitting for a Spouse - in a similar manner as for children, sending an inheritance into a trust that has discretion whether to pay out income or retain it in the trust and have it taxed there may reduce overall taxes and allow the spouse to keep income tested OAS payments. That does not prevent the withdrawal of capital from the trust for money to spend.
  3. Protection of Funds for Disabled or Spendthrift Beneficiaries - for people not capable of managing an inheritance, especially when it has to last and support someone who cannot go to work and earn a living, a trust can be very beneficial; in addition, since a trust is a separate legal entity, creditors cannot come after funds held in a trust for a bankrupt person
  4. Protection of Funds from a Spouse of a Beneficiary - this could be a child in a shaky marriage, or a widow(er) in a second marriage; since the trust owns the assets, the other spouse can be prevented from laying claim
  5. Avoidance of Probate a Second time and Capital Gains Deferral through Rollover to a Spousal Testamentary Trust - tax rules allow a spouse, and only a spouse, to receive inherited assets exempt from the usual rules whereby capital property is deemed to have been disposed of at death at fair market value and capital gains tax has to be paid. This can allow capital gains to be spread over time, reducing taxes and to be deferred, allowing greater growth. When the assets are eventually distributed by the trust, they do not pay probate a second time as they do not pass through the will of the spouse.
  6. Control of the Funds - the trust can be set up so that children receive the capital to spend as they wish only when they are older, and hopefully wiser, or only for specific purposes; meantime a trustee, perhaps a parent, can decide what the trust will disburse. The trust can also mandate that income is used to support a spouse till death, after which any remaining assets are given to someone else, perhaps grandchildren or a charity.
About the only negatives of testamentary trusts are:
  • administration cost / trustee fees if done by a company or third party professional; in my view, a professional trustee is not necessary for many if not most circumstances; it can be quite straightforward, I've done it
  • extra tax returns and record-keeping: the trust must file a return every year even if it is only to report that it is distributing all its income to the beneficiaries. Though a trust can pick any date for its year end, if you are going to manage it yourself and use a discount broker to hold the assets in an account, the broker will only send out forms based on the calendar year, so you have to do a lot of manual work adding up the revenues
  • limited choice of discount brokers for investments in a testamentary trust: when I decided to manage the investments myself and approached various brokers, some said they did not handle trusts and others did not even know what a testamentary trust is. There was a presumption that you should deal with the full service broker side of their business.
The testamentary trust is embodied in clauses in the will. Despite my ardent DIY philosophy, I would never try setting one up using a will kit. I think it wise to use a lawyer to get it right since the wrong words may invalidate the trust.

More detailed reading:
Richard White, Advantages of establishing a testamentary trust at the Ontario Medical Association - child income splitting example
Thompson Dorfman Sweatman, The Tax Planned Will - Creating Savings for Your Spouse and the Next Generation - OAS example
Richard S. Niedermayer, Testamentary Trusts, at
Kenneth C. Pope, Trusts - give examples of set up and professional management fees
Glenn C. Davis, Spousal trusts Protect Assets, Income and Heirs at SunLife Financial
Green Financial Group, Tax Planning with Testamentary Trusts - good income splitting for spouse tax saving example

Sunday 8 June 2008

So You Think You Work Hard and Long?

Whenever you might be tempted to moan about how hard you work or pat yourself on the back about not ever being off the job sick, consider these examples.

A couple Jimmy and Linda have just shut down their independent filling station and corner shop business here in our small town. They operated for 18 years, 7 days a week, more or less 365 days a year, 16 hours a day, starting around 5:00am and closing at 9pm. No weekends, statutory holidays, sick days, "mental health" days, or vacations for them! That amounts to 105,120 hours. Just for fun and comparison, in the government environment where I used to work 37.5 hours a week and three weeks vacation is the minimum, deducting statutory and other days off, the number of working days per year is 233. Per the barometer of government employees, in the space of 18 years Jimmy and Linda worked the equivalent of 60 years together or 30 years each.

Ottawa optometrist Dr Grenville Goodwin once casually mentioned to me as he peered into my eyes that he had just logged 50 years without missing one day due to sickness. Most people don't come close to working that many years.

Hats off to them. These folks have my utter admiration, lazy sod that I am in comparison. Thank goodness for people like them to keep our world turning reliably.

Thursday 5 June 2008

Yikes! One US University = 18% of Canada

Did you know that the Yale University Endowment Fund in 2007 had net assets of $22 billion (see this article from the NY Times), which is about 18% of the $122 billion that the Canada Pension Plan Investment Board manages on behalf of 17 million Canadians? And Yale's total was the result of posting a 28% return in the year ending June 30, 2007. Meanwhile the CPPIB had a small net loss at the end of its financial year in March 2008. Yale is catching up!

There aren't 18% x 17 million = 3.1 million students at Yale needing to benefit from the endowment fund so the wealth distribution is slightly unbalanced wouldn't you say?

The ongoing long term success of Yale no doubt was a role model in convincing the CPPIB to adopt its very active investing strategy getting into all sorts of things like hedge funds, private equity, private debt and real estate. Take a look at Yale's asset allocation in this article at SeekingAlpha. Not very familiar looking is it? The CPPIB is still evolving its strategy, getting more aggressive and active. Is the Yale model where it is going?

Tuesday 3 June 2008

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.

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