Saturday, February 14, 2009

CPPIB Outperforms in Brutal Market?


The CPP Fund ended the third quarter of fiscal 2009 on December 31, 2008 with assets of $108.9 billion, compared to $117.4 billion at the end of the second quarter of fiscal 2009.

The Fund’s decline for the quarter reflects an investment return of negative 6.7 per cent or negative $7.9 billion:
For the nine-month period ended December 31, 2008, the CPP Fund declined by $13.8 billion after operating expenses. The decline consisted primarily of an investment return of negative 13.7 per cent or negative $17.4 billion, offset by CPP contributions of $3.7 billion.

The CPP Investment Board reflects its long investment horizon by regularly reporting rolling four-year performance. For the four-year period ended December 31, 2008, the CPP Fund has generated an annualized investment rate of return of 3.5 per cent which has resulted in $10.2 billion of investment income for the Fund over the four years.

For the same period the total value of the Fund (including CPP contributions) has increased by $31.7 billion. Since inception the Fund has delivered $30.1 billion in investment income net of operating expenses, for a 5.1 per cent annualized investment rate of return since April 1, 1999.

“Sharp declines in global equity markets, especially in October and November, negatively impacted our results for the quarter,” said David Denison, President and CEO, CPP Investment Board.

“However, looking beyond these short-term results, we continue to believe that our long investment horizon, steady cash inflows and broadly diversified portfolio will generate the longer-term results necessary to deliver on our multi-generational mandate. The funding structure of the CPP means that it is able to weather an extended market downturn and the assets we are managing today are not required to help pay pensions for another 11 years.”

“While current market conditions are creating near-term portfolio declines, they are also providing us with long-term investment opportunities,” said Mr. Denison. “Since we are not forced to sell assets in these market conditions to pay current benefits, we instead are well-positioned to acquire assets at attractive prices. As we assess potential new investments in this market, we are continuing to make decisions based upon our disciplined risk/return analytical framework.”

Performance and Asset Mix
The Fund’s investment return of negative 6.7 per cent, or negative $7.9 billion, for the third quarter accounted for most of the Fund’s $8.5 billion decline over the period. The quarter also saw an outflow of $0.6 billion as part of the CPP Investment Board’s cash management role for the CPP. The CPP Fund routinely receives inflows of CPP contributions well in excess of benefits during the first part of the calendar year, and then returns a portion of those funds for benefit payments during the latter part of the calendar year.

The primary factor affecting performance in the quarter was the sharp decline in public equity markets. In Canada the S&P/TSX dropped 23.5 per cent, while globally the S&P 500 declined 22.5 per cent, the FTSE was down 9.6 per cent and the DAX and Nikkei dropped 17.5 per cent and 21.3 per cent respectively.

“While we have adjusted our short-term tactics in light of cyclical changes in the markets, we believe our investment strategy and our weighting to key asset classes continue to be appropriate for a fund with as long a time horizon as the CPP Fund,” said Mr. Denison. “Over the long term this investment approach will deliver the returns required to help sustain the CPP.”

Consistent with the CPP Fund’s long-term strategic portfolio design, at December 31, 2008, equities represented 57.5 per cent of the investment portfolio or $62.7 billion.
This consisted of 42.2 per cent public equities valued at $46.0 billion, and 15.3 per cent private equities valued at $16.7 billion.

Fixed income, including bonds, money market securities, and other debt represented 27.8 per cent of the portfolio or $30.3 billion. Inflation-sensitive assets represented 14.7 per cent or $15.9 billion. Of those assets, 7.1 per cent consisted of real estate valued at $7.7 billion, 4.2 per cent was inflation-linked bonds valued at $4.6 billion, and 3.4 per cent was infrastructure valued at $3.6 billion.

At December 31, 48.7 per cent of the fund or $53.1 billion was invested in Canada, while 51.3 per cent or $55.8 billion was invested globally.

Long-term Sustainability

Following the successful CPP reforms of 10 years ago, the CPP Fund was created to help partially pre-fund future pensions. According to the Chief Actuary of Canada’s 2007 report, CPP contributions are expected to exceed annual benefits paid through to the end of 2019, providing an 11-year period before a portion of the investment income is needed to help pay CPP benefits.

The report indicates that because of these steady net inflows and because investment income is not required to help pay pensions until 2020, the CPP Fund is expected to grow without drawdowns between now and then. Beyond 2020, the report indicates that the Fund will continue to grow, but at a somewhat slower rate. The Chief Actuary’s 2007 report projects that the CPP, as constituted, is sustainable throughout the 75-year period of the report.
I also read the accompanying backgrounder to the Q3 Fiscal 2009 results and noted the following:
  • Canadians should not be concerned about their CPP pensions and should put these results in context.
o The funding structure of the CPP means that it is able to weather an extended market downturn.
o The assets that the CPP Investment Board is managing today are not required to help pay pensions for another 11 years.
o According to Canada’s Chief Actuary’s 2007 report, the CPP is sustainable as currently constituted throughout the 75-year period covered by the report.
In order to understand the "funding structure" of CPPIB, you should go through an excellent presentation given by Jean-Claude Ménard, the Chief Actuary of Canada. I quote the following from the accompanying speech:
(Slide 22) One major distinction between the partially funded CPP and fully-funded pension plans is its sources of income. The CPP follows the 70:30 rule in that in the long-term, 70% of CPP income is attributable to contributions while 30% is attributable to investment earnings. When the CPP A/E ratio reaches about 5.5, 30% of revenue will come from investment earnings.

Fully funded pension plans are funded in the opposite way: 30% of income is attributable to contributions, with 70% coming from investment earnings.

Currently, 100% of CPP benefits are paid by contributions since contributions exceed benefits and are expected to continue to until 2019. However, beginning in 2020, a portion of investment income will be required to pay benefits. When the Asset/ Expenditure ratio reaches about 5.5, 90% of the money required to pay benefits will some from contributions, with the remaining 10% coming from investment earnings. Under the 9.9% contribution scenario, each $100 of benefits paid in 2030 will be funded by $90 of contributions and $10 of investment earnings. This $10 needed to pay benefits represents 27% of expected investment earnings.
Now let me give you my take on these results. I generally agree that CPPIB outperforms in brutal market:

Canada Pension Plan Investment Board executives have taken to prefacing any comments they make to pretty much anybody with "You'll be fine. The CPP is fine."

And judging by the results the big money manager turned in, they're right. Overall investment returns were negative 6.7 per cent in the final three months of 2008, a time when equity markets around the world plunged by three or four times that amount. On top of that, CPPIB has built in demographic protection, saying it has 11 years before any of its current assets will be needed to pay benefits.

Unlike Ontario Teachers Pension Plan and some other funds that need money soon, the CPP fund is the pension version of a person still eyeing a distant retirement and looking at a smorgasbord of cheaper assets in the meantime. This may well be a very good thing for Canadian pensioners.

But that doesn't mean there won't be a significant amount of noise in the short term about declining fund values. Even if equity markets stabilize in 2009, which they show few signs of doing, there are parts of the CPPIB portfolio that face further challenges.

The 7-per-cent weighting in real estate is likely in for a drop in value as commercial real estate brokers say that Canada is on the cusp of a big drop in values for the kinds of malls and office towers that CPPIB invests in as soon as the market vacuum ends and properties actually start to change hands. Similarly, the private-equity portfolio that accounts for about 15 per cent of the overall fund may face drops in the book values for some investments, especially those tied to oilfield equipment, retail, media and real estate.

The nice part for CPPIB is that many of those investments, especially those in retail, may decline in value but the rent and dividend checks should continue to roll in, along with contributions from Canadians' paychecks, giving the fund a chance to reinvest at depressed prices.

Another article from Lori McLeod of the Globe and Mail, CPP loses but still outperforms markets, echoed the same sentiment:

Boring is proving to be beautiful for the Canada Pension Plan.

A measured investment approach and rock-solid structure are helping the fund weather the most challenging financial times since its complete overhaul a decade ago.

The value of its holdings fell $8.5-billion in the last three months of 2008, the fund's third quarter, a staggering amount due to its vast asset base, which includes $46-billion in public equities.

Its second, consecutive quarterly loss means the fund ended 2008 with $108.9-billion in assets, compared with $127.7-billion at the end of June.

But in one of the bleakest periods in market history, its investment return of negative 6.7 per cent doesn't look half bad. It means the Canada Pension Plan Investment Board, which manages the fund's assets, significantly outperformed many other institutional investors and stock markets around the world.

In the last three months of the year, the S&P/TSX composite index, for example, dropped 23.5 per cent. The S&P 500 fell 22.5 per cent, and many other exchanges tumbled by similar amounts.

In addition to equities, the fund holds diverse assets including real estate, infrastructure and bonds.

But it managed to avoid last year's more exotic investment death traps. It has no exposure to the troubled portion of the asset-backed commercial paper (ABCP) market, a costly move for many, including giant pension fund manager the Caisse de dépôt et placement du Québec.

"I think our [third quarter] really did reflect our asset weightings, and the fact that we haven't had any significant, material impairments. The fact that our results were down broadly reflects the sharp decline in global equity markets, particularly in October and November," said David Denison, president and chief executive officer of the CPPIB.

It snubbed other ill-fated acronyms as well, including SIVs (structured investment vehicles), CLOs (collateralized loan obligations), and CDOs (collateralized debt obligations). And it turned down numerous invitations to participate in the recapitalization of investment banks in the United States.

Instead, the CPPIB has been meticulously building up its stable of low-risk, cash-flow-generating assets. A recent example is its stake in the $5-billion purchase of Washington-based electric and natural gas utility Puget Energy by a consortium.

Carefully scooping up deals created by the market downturn, the CPPIB is now paying attention to trophy real estate assets in the U.S. and Britain it thought would never end up on the market, he said.

All investments are screened through a "total portfolio approach," which rigorously evaluates everything from a multibillion-dollar private equity deal to a small commitment in an investment fund.

The CPP is also protected by a steady inflow of contributions and the fact it has no investor redemptions, Mr. Denison said.

For the 2008 calendar year, the CPP fund posted an investment return of negative 14.4 per cent, or a loss of $18.3-billion, he said. That was partly offset by contributions, meaning the fund's overall value declined by $10.5-billion for the year, he added.

One more tidbit of information that caught my eye last week is that regulatory filings show that CPPIB increased its stake in Agnico-Eagle Mines Ltd. almost fivefold in December:

Canada Pension owned a 6.3 percent stake, or 10.1 million shares, in the Toronto-based gold producer at the end of 2008, according to a filing with the U.S. Securities and Exchange Commission. That compares with about 2.1 million shares at the end of the third-quarter.

Canada Pension, which manages about C$120 billion ($98 billion), is now the second-biggest shareholder of Agnico after Fidelity Investments.

Some investors, including Greenlight Capital Inc. and Federated Investors Inc., are buying gold and equity in the companies that produce it to protect against market turmoil and the threat of inflation. Joel Kranc, a spokesman for Toronto- based Canada Pension, declined to comment.

At C$686 million, the investment in Agnico is Canada Pension’s second-largest after its holding in Toronto-based Barrick Gold Corp., worth C$1 billion. Agnico plans to double gold output to 1.2 million ounces next year as it develops new mines in Mexico, Finland and Canada.

Agnico fell C$3.60, or 5.3 percent, to C$64.50 at 4:10 p.m. in Toronto Stock Exchange trading. The stock has gained 2.8 percent this year for a market value of C$10 billion.

Canada Pension makes monthly payments to retired contributors, supplementing the country’s Old Age Security pension, in every province outside Quebec.

So, CPPIB is beefing up its positions in gold to guard against market turmoil and their partially funded status allows them to take on more risk than more mature fully funded plans.

While the fiscal Q3 results were better than the disastrous Q2 results, I would like CPPIB to start publishing the benchmarks that govern all internal and external investment activities.

Importantly, while CPPIB is way ahead of all its Canadian peers in terms of overall transparency, it is completely unacceptable that the Fund does not provide a granular breakdown of benchmarks governing all investment activities, including hedge funds, private equity and real estate.

Unless each benchmark is properly disclosed, there is no way for stakeholders to gauge whether the benchmarks accurately reflect the risks and beta of the underlying investments and whether CPPIB's pension fund managers are being appropriately compensated to take those risks.

[Additional note: I would also like them to publicly disclose their Board minutes just like some of the U.S. public pension funds do, most notably, Alaska Permanent Fund.]

Also, picking up assets 'on the cheap' is tricky because cheap can get a whole lot cheaper over the next two to three years (the so-called 'value trap').

Finally, given CPPIB's high equities exposure, the Fund is highly vulnerable to a prolonged period of debt deflation. The long-run can end up being a very long time if deflation develops.

Stating that we invest for the "long run" and "our funding structure allows us to weather an extended market downturn" can only buy you some time, but the results better come through soon.

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