Monday, April 18, 2011

OTPP's Neil Petroff on Active Management

On Monday, after S&P issued an unprecedented warning to the United States government, I was lucky enough to find Neil Petroff, Executive Vice-President, Investments and CIO at Ontario Teachers' Pension Plan (OTPP). Mr. Petroff only had a few minutes but was kind enough to discuss some issues which I will get to below.

First, Paula Vasan of aiCIO reports, Ontario Teachers' Petroff: 'Active Management Outperforms':

The Ontario Teachers' Pension Plan (Teachers') chief investment officer Neil Petroff, riding a 14% annual return in 2010, claims the fund's active strategy has added more than C$23 billion to the bottom line since its inception in 1990.

In a wide-ranging interview with Petroff, the CIO of Canada’s third-biggest retirement-fund manager claims: "If we were a passive fund, we'd be C$23.2 billion lower in value, with liabilities at the same level. That really speaks to the value of active management - you add value when you pay for active management."

This seeming evidence of the effectiveness of active management also supports the fund's mix of external vs. internal structures that come at a time of stellar growth for the fund. Regarding the value of internal vs. external management, Petroff replies that all departments of the fund outperformed last year due to their embrace of both processes of active management. "As long as the internal team earns appropriate risk-adjusted returns given the cost, I'm indifferent to which approach is utilized," Petroff tells aiCIO.

Furthermore, Teachers' benefitted from a range of transactions and investments in 2010, such as the fund's purchase of UK's national lottery operator, Camelot, a UK high-speed rail, and interest in a Brazilian investment bank. "All those investment from 2010 have great potential to help pay our pensions going forward."

"This was the best year in the past 20 years in terms of dollar-value added," Petroff states, noting that large increases in real estate and private capital fueled the superior returns. According to a statement released by the fund today, Teachers' achieved its double-digit return in 2010 thanks to rising stock prices and gains in real estate. Net investment income totaled C$13.3 billion ($13.8 billion) last year, up from C$10.9 billion in 2009. The fund managed C$107.5 billion in assets as of December 31, compared with C$96.4 billion a year earlier.

Teachers' revealed that real assets such as infrastructure and timberland returned 13.9% for the year, followed by stock and private-equity investments (10.4%), fixed-income (9.9%), and commodities (3.2%). At the end of 2010, Ontario Teachers’ equity portfolio holdings were C$47.5 billion, up from C$41.2 billion a year earlier. Fixed-income assets were C$45.9 billion, up from C$35.3 billion. Meanwhile, the fund’s allocation to commodities rose to 5% last year from 2% in 2009, and was valued at C$5.2 billion at year end, up from C$1.9 billion.

Still, Petroff knows such high returns can't last forever. "This kind of return is something that's tough to repeat," he says. Despite the optimistic returns, the plan said it continues to face funding challenges due to factors such as member longevity, retirement periods that exceed working years, and low real interest rates, with an estimated funding shortfall that increased to C$17.2 billion from C$17.1 billion a year earlier.

Nevertheless, Petroff will try to repeat 2010's strong results. In terms of asset allocation, Petroff asserts that emerging markets will continue to be an area of intense interest for the fund. "I'd say that from a global perspective, emerging markets will do better than North American markets, and North America will do better than Europe," he claims, emphasizing his confidence in the long-term value of the sector. "We took most of our exposure in 2005 and 2006. Emerging markets are overheating now from an inflation perspective, but long-term, with their young populations and growing middle classes, the asset class is growing rapidly."

When questioned about the embrace of alternatives, which have enjoyed heightened popularity among institutional investors, Petroff voices his belief that the sector serves not as an asset class but more as an investment strategy. "We started our research in alternatives in 1995, and entered our first hedge fund in 1996. It's been an area that adds diversification to the total fund and it will always have a place in our portfolio."

It's interesting that Mr. Petroff mentioned the focus on emerging markets because I was reading an excellent white paper by AIMCo's Brian Gibson, a former colleague of Mr. Petroff, on how investing in emerging markets "is not what it used to be". Mr. Gibson concludes that "emerging markets are certainly not what they used to be, but they still represent a fertile area for generating attractive amounts of value added."

As far as hedge funds, it's no secret that Teachers' is one of the best institutional investors in the world (along with others like ABP). Claude Lamoureux and Neil Petroff hired Ron Mock in 2001 and he has done an outstanding job allocating billions to external hedge funds. Ron is now Senior Vice-President, Fixed Income and Alternative Investments, and one of the best pension fund managers I ever had the pleasure of meeting.

Back to Neil Petroff. We didn't have much time to chat but I did listen carefully to his comments. First, we talked about liabilities. He told me that every pension fund is different and has different liabilities. The duration of a plan's liabilities should determine the asset allocation and the benchmarks they use for their investment portfolios.

Teachers' has one client and manages both assets and liabilities. The profile of their liabilities has changed since now the ratio of working-to-retired members is 1.5 to 1 (was 4 to 1 when he first started working there). And those retired teachers are living much longer, placing additional pressure on the plan. Great news for teachers but you still have to pay out pensions longer. But the biggest problem with liabilities has been the decline in real rates (read my comment on Teachers' 2010 results for details).

He explained to me how benchmarks are set in accordance with liabilities and are routinely reviewed by senior staff and the board. I mentioned the case about T-bills in money markets and how prior to 2008, some Canadian pension fund managers were investing in illiquid non-bank asset backed commercial paper (ABCP) to easily beat their benchmark. He told me that Teachers' uses a spread over the OIS rate instead and manages liquidity risk extremely well, especially after 2008.

I let him know that I've been tough on Teachers' in regards to private market benchmarks. We talked a lot about benchmarks. He explained that Teachers' Private Capital does use a spread over public markets. As for real estate, infrastructure and timberland, they're long-term cash flow providers and the benchmark (CPI+575 bps) "isn't easy to beat over the long-term". True but I've seen some funny things in real estate where pension fund managers took big risks to easily beat their CPI+ benchmark. Mr. Petroff explained that Cadillac Fairview still has an operating benchmark of IPD and their operations focus on stable cash flows, just like infrastructure and timberland.

On this last point on benchmarks, one senior pension fund manager shared these thoughts with me:

Leo, I now you are very involved in comparing benchmarks. The more important difference is leverage implied by gross versus net assets.

OTPP made a lot of money on being able to run a leveraged balance sheet (150 B gross versus 100 net assets). They effectively borrowed 50 billion at an average cost of around 2% and made a decent 10% on that capital in 2010 and 2009, not so well in 2008.

If one is restricted from non-real estate borrowing, as some provincial rules require, that road for return/risk is closed. OTPP unlevered returns work out to about 10%, which is what I got to, with a lot of historical j-curve baggage.

One can argue whether it should be or how big it should be but those are the facts. Not sure where CDP (Caisse) fits on that scale, but my guess is that between recovering 2008 write-offs and leverage, you have a big part of the differential.

Finally, and most importantly, I liked what Neil Petroff told me about being "non-conventional and opportunistic". I mentioned that I wrote about the time Teachers' took a big position in Transocean Ltd. and publicly commended them for having the guts to take that position. "We did our homework and found that Transocean had virtually no liabilities". That position alone earned Teachers' nearly 80%.

Here is where the discussion got interesting. I told Mr. Petroff that I like asset managers who take concentrated positions. Teachers' did their homework, saw an opportunity and bought Transocean shares as they tanked. Did they also consult their external hedge fund partners? Maybe, but the point is they took a big position in a company that most institutional investors were steering clear from at that time. "We won't always be right but if we're right 60% of the time, making more on average than we lose, then we come out ahead."

Mr. Petroff added that unlike mutual funds "who churn their portfolio every 18 months" pension fund managers have a long horizon - ten years - and should be compensated that way. "The reason we can take concentrated positions is that we're not looking at quarterly returns like most mutual funds that are closet indexers." He also noted that a four or six years horizon is too short to evaluate a pension fund's performance.

I then proceeded to discuss how I see ideological warfare going on against traditional defined-benefit plans. He mentioned that the Economist did a special report on pensions falling short, and agreed with me that defined-contribution plans aren't the solution to the retirement crisis. "The value added we generated over the years would not have been available to teachers doing their own investing."

As we ended our discussion, I thanked him and asked him why Teachers' isn't a lot more transparent on their operations. "We can't share all our secrets because the minute we do, everyone is trying to mimic us." I agree, they can't share all their secrets, but pension funds can learn a lot from Teachers' and for me the most important lesson is to invest opportunistically with a long-term view and not be afraid of taking concentrated positions after doing your homework. If you're right most of the time, you come out ahead. That explains a big part of Teachers' success and why more and more plans are trying to emulate their active management style.

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