Monday, July 21, 2008

FY 2008 Results: Comparing CPPIB To PSPIB

Given that CPP Investment Board (CPPIB) and the Public Sector Pension Investment Board (PSPIB) both have fiscal years that end on March 31st (same time as other federal Crown Corporations and government organizations), it is instructive to compare their FY 2008 results.

In my last entry, I covered PSPIB's results in detail, critically examining where the PSP Fund lost and made money. In this post, I will begin by scrutinizing the CPP Fund's FY 2008 results to see where they made and lost money. I will then compare the two funds, highlighting some important differences in their performance results.

As stated in the press release, the CPP Fund sustained investment losses of 0.3% in FY 2008, representing negative $303 million. In percentage terms, this is exactly what PSPIB lost over the same period.

In explaining the Fund's performance, David Denison, President and CEO of CPPIB, had the following comments:

“The CPP Fund was certainly not immune from the sometimes extreme volatility of the equity markets during our fiscal 2008 year. Given that global developed equity markets were down 12.8 per cent over that period, our almost 52 per cent weighting of public equity holdings was certainly caught in that downdraft.”

Importantly, the press release added the following statement:

However the CPP Fund avoided the credit-related problems that affected many financial institutions and investors during the year. At the time the credit crisis began to materialize in August 2007, the Fund had no exposure to sub-prime mortgages or other investments subject to credit-related repricing.

Moreover, the press release cites foreign exchange exposure as another factor that impacted the Fund's total performance:

Another factor impacting performance was the Canadian dollar’s rise against the U.S. dollar, and to a lesser extent other major currencies, which reduced returns on the Fund’s foreign holdings when expressed in Canadian dollars. We maintain a long-term strategic unhedged exposure to foreign currencies amounting to 40 per cent of the assets in the portfolio and only hedge exposures beyond that level. Overall, currency factors reduced returns on the Fund’s foreign holdings by approximately $1.4 billion or 1.1 per cent when expressed in Canadian dollars for the year.

Drilling down we see that Public Markets overall produced a return of negative 2.4 per cent or negative $2.4 billion, compared to a gain of 11.0 per cent or $10 billion in fiscal 2007 (approximately $1 billion of that negative return was attributable to foreign exchange):

Public equities returned negative 6.8 per cent or negative $4.5 billion in net investment income, versus positive 13.1 per cent or $8.1 billion in fiscal 2007. In contrast, fixed income assets managed by the department performed well; bonds and money market securities earned a solid return of 6.9 per cent or $2.0 billion, up from 5.9 per cent in 2007.

So where did CPPIB make money? Where else? The bulk of the value added came from Private Investments (real estate, private equity and infrastructure) which generated returns of 225 basis points at the total fund level, or approximately $2.7 billion of additional investment income for the CPP Fund relative to its benchmark. In more detail:

In terms of overall return, the department earned $1.7 billion before taking foreign exchange into account and netted $1.5 billion or 10.8 per cent when expressed in Canadian dollars. The department’s infrastructure investments earned 23.6 per cent or $524 million in net investment income in fiscal 2008, up from 18.4 per cent or $235 million in 2007. Private equities, comprised of Funds & Secondaries and Principal Investing, earned a return of 8.2 per cent and contributed $1.0 billion in net investment income, comprised of both distributions from our funds and valuation gains; this compares with 35.3 per cent or $1.9 billion in fiscal 2007.

So the big gains came from infrastructure investments in FY 2008 as well as from private equities. Moreover, total Real Estate Investments (private and public) produced a value-added return of 10 basis points at the total fund level, representing approximately $105 million of investment income relative to its benchmarks. This mainly due to the fact that public real estate investments lost 24.2% in FY 2008 after generating 38.1% last year.

It is worth noting, however, that private real estate investments fared much better:

The private real estate portfolio generated a return of 8.2 per cent, amounting to $0.5 billion in net investment income, reflecting particularly strong performance in Canada, partially offset by a slowdown in the U.S. and U.K. markets. That compares to 27.0 per cent or $0.9 billion in fiscal 2007.

In his remarks, Mr. Denison notes the following:

“Over the last two fiscal years the CPP Investment Board has generated approximately $5.3 billion in additional investment returns over and above our market-based benchmark to help sustain future pensions for 17 million Canadians.”

As stated above, in FY 2008 these additional returns were generated primarily through active strategies in private equity along with real estate and infrastructure programs.

We end off this post by comparing these results to those of PSP Fund. The first thing that strikes you is that CPP Fund did not invest in ABCP or CDOs which contributed to massive investment losses at PSP Fund. In an interview with Bruce Johnstone of Canwest News Service, Mr Denison was quick to point this out. I quote the following from the article:

"We actually had no exposure in the portfolio to either of those asset classes (subprime mortgages and ABCP). In fact, we had no write-downs coming out of the credit market dislocations. . . . We looked at ABCP opportunities in Canada and decided not invest in those at the time."

Instead, Denison said CPPIB used the credit crunch as a buying opportunity to purchase bank-sponsored asset-backed commercial paper containing "non-leveraged, over- collateralized" loans that were selling at a discount.

"The returns we could get because they were affected by the market seizure of the non-bank ABCP were very good. We stepped in and by December we had invested $6 billion into that (bank-sponsored ABCP)."

But Mr. Denison talked up the Fund's relative performance:

"A negative return is never encouraging," said Denison in a recent interview with Canwest News Service. "But, in relative terms, we outperformed our benchmarks by 241 basis points, or 2.4 per cent, which we are very, very pleased with."

This statement does not mean much to me. I will repeat what I have stated many times before: stakeholders need independent performance audits that scrutinize investment benchmarks to make sure they accurately reflect the investment activity's beta and risk exposures.

Without a detailed, independent performance audit, you risk over-compensating pension fund managers for what is essentially beta of the investments or for taking on undue risks to beat their benchmark.

Another key difference was the glaring underperformance in Public Markets at PSPIB. On page 8 of PSP's 2008 annual report, we read the following statement:

Our exposure to public markets represents 76% of our assets under management. Underperformance in our Public Markets portfolio can be explained in part by our investment philosophy of partnering with value oriented external managers. The easy credit environment of the past two years has not been favourable to value investors. We are confident, however, that value buys can lead to significant outperformance over the long term.

The performance of this portfolio has a significant impact on our overall performance. We remain committed to strengthening our own internal capabilities and are in the final stages of recruiting a new leader for our public market activities.

I hope that PSP is right that their "value buys can lead to significant outperformance over the long run" but as John Maynard Keynes once remarked, "In the long-run we are all dead".

This brings me to my final point. We cannot compare infrastructure or private equity investments at CPPIB or PSPIB because they are is still in ramp-up mode for the latter fund. But look at the wide discrepancy in the performance of Real Estate (click table above).

The CPP Fund posted private real estate returns of 8.2% in FY 2008 whereas the PSP Fund posted real estate returns of 21.9% over the same period (note: I only compare private real estate performance because PSPIB does not report public real estate performance). That is almost three times as much and most likely indicates strong differences in the risk profile of the underlying real estate investments - something which is not reflected in the benchmarks that governs Real Estate at PSPIB.

Importantly, no matter how you slice it, these type of performance discrepancies among similar investments can't all be attributed to better active management. Someone is obviously taken on more risk to generate higher returns. Moreover, these risks are not reflected in the investment benchmarks that determine compensation. It is also worth noting that private real estate returns are primarily based on valuations so they are not actual realized returns. This valuation "smoothing" exists for all private investments, including private equity and infrastructure investments.

My point is that there is an endemic problem that permeates many large public pension funds. There are glaring inconsistencies in investments portfolios of asset classes among similar pension funds as well as in the benchmarks that govern these investments. All too often, this leads to pension fund managers that get inappropriate compensation for beta or taking on more risk instead of generating true active returns.

The time has come to expose these benchmark problems and to put an end to compensating pension fund managers for generating returns in private markets over bogus benchmarks that do not reflect the beta or risks of these investments. These are public pension funds and they need to be more transparent to their stakeholders about the benchmarks that govern all investment activities, including internal and external active management.

If stakeholders are going to compensate their pension fund managers properly, they need to know who is responsible for each investment activity and they should make sure that they are paying them for generating true "alpha", not disguised beta or for taking on disguised risks!

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