Wednesday, November 12, 2008

Canada Pension Plan Fund Gets Nuked in Q2

The Canada Pension Plan Investment Board (CPPIB), Canada's second-biggest public pension manager, reported an investment loss of 8.5% in the fiscal second quarter as world stock markets declined. Canada Pension Plan covers every Canadian province except Quebec.

In a news release, CPPIB states the following:
The CPP Fund ended the second quarter of fiscal 2009 on September 30, 2008 with assets of $117.4 billion, reflecting investment returns of negative 7.5 per cent for the first six months of the fiscal year and negative 8.5 per cent for the second quarter.

The Fund declined $5.3 billion in value for the fiscal year to date and $10.3 billion since the previous quarter.

The Fund’s four-year annualized investment rate of return through September 30 was 6.6 per cent, which has resulted in $22.0 billion of investment income for the Fund over the four-year period. The CPP Investment Board reflects its long investment horizon by regularly reporting rolling four-year performance.

“The CPP Fund is invested for the long term, has a broadly diversified portfolio and steady cash inflows, and is structured to withstand stock market cycles in order to help secure CPP pensions for decades and generations,” said David Denison, President and CEO, CPP Investment Board.

“While the Fund was adversely impacted by broad declines in public equity markets, it had virtually no losses due to credit or counterparty exposures in this period.”

“Although the turmoil in financial markets has been unsettling for everyone, unlike many short-term investors who have had to sell assets at distressed prices, the CPP Investment Board is very well-positioned to acquire attractive assets at advantageous prices that will generate significant long-term value for the Fund,” said Mr. Denison.

“While market conditions have worsened since the end of the quarter, we remain confident in our ability to generate superior long-term risk-adjusted returns to help sustain the CPP for the benefit of 17 million Canadians. Given our mandate, the CPP Investment Board invests not for the quarter, but for the quarter century and beyond.”

Fiscal year-to-date, the Fund’s decline of $5.3 billion was primarily due to a negative investment return of 7.5 per cent, representing negative $9.5 billion, partially offset by a net inflow of $4.3 billion in CPP contributions not needed to pay current pension benefits. For the second quarter ended September 30, 2008, the Fund’s decline was the result of a negative investment return of 8.5 per cent, or negative $10.8 billion, and a net inflow of $0.5 billion in CPP contributions.

“Given our significant strategic weighting in equities, the 19.3 per cent decline in Canadian public equity markets and the broad decline in global markets, for instance the 12.9 per cent drop in the FTSE 100 and the 9.0 per cent drop in the S&P 500, during our latest quarter were the primary factors affecting our results,” said Mr. Denison.

“Our equities strategy is consistent with our very long investment horizon and our view that equities will deliver higher risk-adjusted returns over longer time periods.”

Consistent with our long-term strategic portfolio design, at September 30, 2008, equities represented 59.9 per cent of the investment portfolio or $70.4 billion. That amount consisted of 46.8 per cent public equities valued at $55.0 billion and 13.1 per cent private equities valued at $15.4 billion.

Fixed income, including bonds, money market securities, and other debt represented 26.8 per cent of the portfolio or $31.5 billion. Inflation-sensitive assets represented 13.3 per cent or $15.6 billion. Of those assets, 6.2 per cent consisted of real estate valued at $7.3 billion, 4.0 per cent was inflation-linked bonds valued at $4.7 billion, and 3.1 per cent was infrastructure valued at $3.6 billion.

These results shouldn't surprise anyone. According to Royal Bank's RBC Dexia unit, pension funds in Canada fell an average of 8.6% in the quarter as Canada's benchmark Standard & Poor's/TSX Composite Index dropped 19% in the quarter ended Sept. 30, the most in 10 years. Indexes across the world are getting pummeled this year and waves of deleveraging are hitting all asset classes hard.

Mr. Denison, however, is no doubt extrapolating from the past equity risk premium when he states that "equities will deliver higher risk-adjusted returns over the longer time periods."

In a recent blog entry, What's Happened to the Equity Risk Premium?, Felix Salmon notes the following:
...stocks do seem to be a better long-term bet today than they were three months or a year ago. I asked Brad DeLong, who's something of an expert on the equity risk premium, whether it goes up when stocks go down, and he replied:

Yes--it does. We're reviisng a paper for the Journal of Economic Perspectives now. it's supposed to come out in the winter, and all the numbers are changing...
Start with the Gordon equation for the market as a whole: P = D/(r-g), and turn it around
r = D/P + g.
D/P has just gone up, and the long-run g of dividends hasn't gone down by very much--so the expected rate of return r must have risen by a lot.

This doesn't mean that stocks are cheap, of course, or that they won't fall quite a long way from current levels. But if you're investing for the long term, you can probably sleep better investing now than if you invested back when they were obviously much more overvalued.

However, I would caution people that we are entering an era of tight credit, deleveraging and massive regulation to correct for the excesses of the past era of easy credit and massive deregulation which allowed hedge funds and private equity funds to take huge leveraged bets.

While I concur that the 2008 stock market crash has created tremendous long-term buying opportunities, we should be careful when discussing future equity risk premiums.

Furthermore, if a global consumer recession brings about mass unemployment all over the world, we will enter an era of debt deflation that will wreak havoc on equities for a very, very long time.

How long? Who knows, but if you look at a twenty year chart of the Nikkei (click chart above), you can see that the Japanese equity markets have still not recovered from their lost decades.

Moreover, I agree with JP Morgan's CEO, Jamie Dimon, that this recession could be worse than the financial crisis:

"We think (the recession) could be deep; we don't know how deep," Dimon said. "We think the economy could be worse than the capital markets crisis."

He said the government's actions to pump cash into the financial system have been "powerful medicine" to help fix the dislocated financial markets. But even an eventual normalization in the markets "may not stop us from having a deep recession," Dimon said.

Many people still can't get financing, he said. And the troubles are so widespread that companies all over the world are stuck with bad investments on their hands and running for cover. Referring to billionaire investor Warren Buffett's adage about finding out who's been swimming naked when the tide goes out, Dimon said: "There are people swimming naked everywhere."

Financial institutions around the world have been slammed by both deteriorating consumer credit and turbulent financial markets.

I found the following note in the backgrounder accompanying CPPIB's Q2 results particularly interesting:

The current market environment offers a fund with our size, steady cash inflows, secure asset base and very long investment horizon opportunities to buy quality assets at attractive valuations across all asset classes.

As we review these opportunities, we subject them to diligent and comprehensive risk management, market and credit analysis, which can be characterized by:

  • A high degree of discipline in the analysis and monitoring of investment opportunities before we commit and as we manage them.
  • Rigorous risk management: if we can’t understand, model and quantify the risks of an investment, we simply won’t make it.
  • A willingness to be opportunistic when our discipline and process uncover opportunities that fit in the context of our long-term investment mandate.

As a result, we have had virtually no losses due to credit or counterparty risk associated with failed U.S. financial institutions. We have no investments in non bank-sponsored ABCP, CDOs or other opaque structured products where we cannot quantify the risk.

[Read between the lines: we did not make the same foolish mistakes as PSP Investment Board, the Caisse and Ontario Teachers!]

Although we were approached to participate in the recapitalization of U.S. and other global financial institutions in the last year, we chose not to invest in them because we believed it was impossible for us to correctly value the underlying assets on their balance sheet in the time available. The Fund also currently has only a relatively small exposure to the U.S. real estate market because of our concerns about valuations in that market in recent years.

[Thank God almighty they did not "recapitalize" FIs and have limited exposure to U.S. commercial real estate. Unfortunately, global commercial real estate will not fare much better.]

But the truth is that CPPIB did have exposure to Bear Stearns, Lehman Brothers, AIG, and a ton of other companies with toxic debt on their books through their passive indexing of equity markets.

Importantly, their "rigorous risk management" did not help them with equity volatility as they were highly exposed to the carnage in financials.

Moreover, as reported in their frequently asked questions, CPPIB invests in hedge funds or absolute return strategies:

Absolute return strategies, commonly known as hedge funds, represented $1.6 billion or 1.3 per cent of the portfolio in Fiscal 2008. We do not have an explicit portfolio allocation for hedge funds; rather, on a case-by-case basis, we evaluate them on the same risk/return investment criteria as other externally managed active strategies.

This now brings me to my pet peeve with CPPIB. While I commend CPPIB for its regular reporting of its results and its transparency - CPPIB is leagues ahead of its peers in communication and transparency - there are still far too many unanswered questions in the reporting of the results that are simply unacceptable.

I went over the financial statements that accompanied the Q2 results and I got a headache trying to figure out a few simple things (all those bloody notes!!!).

For example, there is an (unaudited) consolidated statement of investment portfolio on page 3 that shows the fair values for public and private equities as well as other investment classes.

We see that the fair values for public equities and bonds went down while those of private equities, private real estate, infrastructure and absolute return strategies went up. These fair values obviously include fresh contributions for the quarter.

But at the bottom of the table, it states: "The accompanying notes are an integral part of these Consolidated Financial Statements":

(ii) Fair value for fund investments is based on the net asset value as reported by the external managers of the funds using accepted industry valuation methods.

(iii) Private equity and infrastructure investments are either held directly or through ownership in limited partnership arrangements. The fair value for investments held directly is determined using accepted industry valuation methods. These methods include considerations such as earnings multiples of comparable publicly-traded companies, discounted cash flows and third party transactions, or other events which would suggest a change in the value of the investment. In the case of investments held through a limited partnership, fair value is generally determined based on relevant information reported by the General Partner using accepted industry valuation methods.

So the fair values in private funds are generally reported by their General partners (GPs). How are we to know that these "fair values" are indeed fair and accurately representing the value of these investments if they were to be liquidated today? (This is why in private markets, all I care about is cash on cash returns - the rest is bogus!)

Then I moved on to page 8 to see the board approved active risk. I wish all pension funds reported their risks budgets in the exact same fashion so we can compare apples with apples.

Finally, I went to page 14 to see the net investment income (loss) which is is reported net of transaction costs and investment management fees.

I can't understand why they have to bundle up private equities and public equities. Moreover, we see significant net losses in fixed income (507) and inflation sensitive assets (285) and losses in absolute return strategies (75) with no explanation of the results.

Why can't CPPIB just show net investment income for each and every investment activity? Keep it clean and granular so we can see exactly where the losses were concentrated.

Importantly, show us your benchmarks for each and every investment activity, including private equity and hedge funds, so we can gauge whether they accurately reflect the beta and risks of the underlying investments.

All in all, I am glad CPPIB reported their results on time and I was not surprised by their poor results. The only thing that I wonder is if beta is cheap, why are they paying so much in "alpha" fees if it hardly adds any incremental value to their overall results?

In fact, if they are going to be so highly exposed to equities, any talk of "risk-adjusted" returns or "rigorous risk management" is just plain silly.

Like all large funds, anything they do on the alpha side will be swamped by the vagaries of equity markets, undermining their ability to secure future pension obligations despite their "long investment horizon" which can easily change if the CPP becomes a fully funded plan.

I realize that CPPIB is a partially funded plan that can take on more risk than mature, fully funded pension plans, but why not introduce more bonds in the portfolio to buffer the volatility of the overall Fund?

Sticking to the old "stocks for the long-run" mantra might prove to be a very costly mistake, especially if we head into a protracted period of debt deflation.

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