Friday, July 18, 2008

PSP Investments Loses 0.3% in FY2008

Someone told me that another large Canadian pension fund quietly posted its FY2008 results on-line this past week (no press release here). PSP Investments finally posted its 2008 results and you can read the annual report by clicking here. The total portfolio returned -0.3% compared to Policy Benchmark of 1.2%. It is worth noting that CPP Investment Board also lost 0.3% in FY2008 but it outperformed its Policy Benchmark by 2.4% (its fiscal year ends March 31st too but CPPIB is more timely in posting performance results, including quarterly performance results that are posted on their website).

In his President's report, on page 6, Gordon Fyfe wrote the following statement:

In the context of a significant deterioration in global financial markets throughout our fiscal year ended March 31, 2008, the total return of PSP Investments for the year was -0.3%. This was the first time in the last five years, and since I became President, that we generated a one-year total return below that of our Policy Benchmark. However, it is important to keep in mind that in a period of severe stress and volatility, preservation of capital and minimization of investment losses are our overarching priorities.

Digging deeper into the report, on page 16, we see where PSP Investments lost and made money:

Our holdings in ABCP and CDOs were significant contributors to underperformance in fiscal year 2008 versus the Policy Benchmark return. As at March 31, 2008, PSP Investments held $1,972 million of ABCP with a fair value of $1,522 million. The difference reflects a write-down of approximately $450 million, decreasing the overall rate of return by approximately 1.2%. Our investment in CDOs, through a notional exposure of $1.4 billion, reflects a write-down of approximately $470 million, decreasing the overall rate of return by approximately 1.2%. The investment losses related to ABCP and the CDOs are unrealized as at March 31, 2008, and generally reflect deteriorated credit market conditions and related mark downs.

Importantly, the report adds:

There are very little, if any, credit losses in both ABCP and CDOs and the
possibility of recovering the nominal investment value in a subsequent period is probable if general credit conditions improve. The losses were not allocated to any particular asset class but are included in PSP Investments’ total return.

Lo and behold, the bulk of the "alpha" was generated in private markets, especially Real Estate:

A significant source of value-added in fiscal year 2008 came from the Real Estate and Private Equity asset classes. Real Estate (included in real return assets) generated a rate of return of 21.9%, surpassing the Policy Benchmark rate of return of 7.6% by 14.3% and was the primary driver of value-added in the Real Return asset class. Private Equity (included in Equities) generated a rate of return of 10.1%, surpassing the Policy Benchmark rate of return of 3.7% by 6.4%. As a result of the PE team’s careful fund and asset selection, the Private Equity Portfolio has not experienced the negative performance (J curve effect) typically experienced during the early years of such a portfolio.

Public Markets did not fare well, especially U.S. large caps (-21.3% vs its benchmark return of -15.6%) and small caps developed world (-23% vs its benchmark return of -20.5%):

Equities underperformed the benchmark return primarily due to the underperformance of related public market asset classes in fiscal year 2008, partially offset by the aforementioned private equity outperformance. Over a four-year period, equities generated a rate of return of 10.7%, surpassing the Policy Benchmark rate of return of 10.6% by 0.1%, primarily due to the Private Equity and Canadian Equity asset classes outperforming their respective benchmarks.

A few comments need to be made here. First, how many other large plans in Canada have these types of "notional exposures" to CDOs? Second, even if the investment losses on CDOs and ABCP are not realized, what happens if credit conditions worsen in 2009? Third, and most importantly, who assumes the responsibility for all these investments? By not allocating these losses to any particular asset class but including them into PSP Investments' annual returns, stakeholders do not know who is accountable for these investment decisions.

Fourth, on page 15 of the annual report, we note the following:

PSP Investments has an active management strategy designed to add value to the Policy Portfolio, in accordance with a risk budget, approved by the Board, which management allocates to active strategies. Within this framework, management works to optimize its “roster” of active strategies, in order to meet the value-added objectives set out above, under the “Investment Objectives” heading.

Active management involves both internal and external managers and is not limited to the asset classes of the Policy Portfolio. It includes mandates in other spheres such as currency management and tactical asset-allocation across countries and asset classes. Indeed, PSP Investments believes that the best way to achieve its active management target is through the diversification of its return sources. That process continued in fiscal year 2008: we added four new active mandates, using internal and external managers.

Who are these active managers and who is responsible for them? How are they evaluated and what are the benchmarks used to evaluate the pension fund managers who oversee them? What is the risk budget governing external and internal active management?

Looking at the compensation doled out for FY2008 (pages 30-37), we note the following:

In fiscal year 2008, the total fund investment performance of PSP Investments ended below the incentive threshold and, therefore, no awards were earned for that component of the Deferred Incentive Plan. For the participants with target deferred incentive based on the investment performance of a particular asset class, awards were earned depending on the performance of said asset class.

On page 37, we see that the total compensation for PSP Investments' President & CEO as well as two senior real estate professionals was over $1 million for FY2008. As shown in the table above, the bulk of the "alpha" came from Real Estate, returning 21.9% in 2008 relative to its benchmark performance of 7.6%. In 2007, Real Estate returned 36.5% relative to its benchmark returns of 6.7%.

Obviously the Special Examination cited in the report did not cover a thorough performance audit. If it did, someone might question why the real estate portfolio significantly outperformed its benchmark for three years in a row.

Moreover, an independent performance audit for each and every investment activity (internal and external) would also shed some light into the "notional exposure" of CDOs and the investment losses related to ABCP and determine who was responsible for these investment decisions. Finally, a detailed independent performance audit would shed some light on the losses in public markets and whether or not they were attributable to external active managers or internal active managers.

Stakeholders deserve a lot more transparency and information on accountability than what is provided in this annual report.

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