CPPIB's Struggle With Bold Investment Bets?
At first glance, the Canada Pension Plan looks like a model for a government-created retirement fund. The portfolio is growing, returns have looked strong and the plan is now among the 10 largest of its kind in the world.
But as it approaches $220-billion in assets, the CPP’s investment arm, the Canada Pension Plan Investment Board, is taking on more risk than ever. The CPPIB has moved into a host of far-flung private investments such as Chinese real estate, high-yield debt, speculative energy plays and even a deal with the organization that runs Formula One car racing. Sources say it has also faced an internal struggle over investment strategy that has contributed to the departure of several key executives.
As the fund moves farther away from safe holdings, like government bonds and blue-chip stocks, the ramifications could be significant for 18 million Canadians who depend on the CPP for retirement benefits. In the past four years, the CPPIB has rapidly expanded its private investment portfolio from $30-billion in 2010 to $88.5-billion today. And earning exceptional returns on these investments can be challenging.
“In my 15 years as a professional investor, this is by far the most difficult market” for private assets, CPPIB chief executive officer Mark Wiseman said in an interview.
In a sign the new strategy isn’t paying off just yet, the CPPIB has failed to beat its own internal benchmarks two years in a row, falling short by $350-million – and in four of the past six years, amounting to $1.9-billion worth of total underperformance.
Much like a mutual fund, CPPIB’s success cannot be judged on annual returns alone. The pension fund must also be assessed on its ability to beat the market. Almost any fund manager can earn 10 per cent when the market is up 15 per cent, but real value, or alpha, as it is known on Bay Street, comes from going above and beyond. Because the market is so hard to beat, surpassing it by even the smallest of margins is touted as a success.
Even if the underperformance seems small for such a large fund, failing to consistently beat the benchmark can have far-reaching implications. It would undermine the shift toward more high-risk assets and it could hold back overall returns. And considering that the CPP is expected to grow to $500-billion by 2030, any misstep on the investment strategy could be costly.
Such a scenario can be confusing. To the average person, the fund’s annual performance looks impressive. The CPPIB has roughly doubled the size of the fund in the past 10 years to $219-billion and its 16.5-per-cent return last year suggests the portfolio is humming. The fund has also become a major player on the world stage, opening offices in four countries and participating in several foreign transactions, and CPPIB executives are regularly invited to elite gatherings such as the World Economic Forum in Davos, Switzerland (click on image below).
There is a lot to cover here so let me begin by referring you to some comments I made when I went over CPPIB's fiscal year 2014 results (click on image below):
But the CPPIB has undergone a substantial transformation. A decade ago, executives lobbied hard to shift away from solely investing in passive investments, such as federal and provincial bonds that that pay low, safe returns. The goal: To take on riskier but potentially higher-paying strategies, such as investing in private companies and real estate. Ottawa ultimately gave CPPIB the green light, but required that the fund find ways to determine if the extra risk was worth it.
To help track its performance under the new strategy, the CPPIB created a “reference portfolio” – a low-cost, basic basket of global public market investments it could otherwise invest in. Each year, CPPIB’s returns are compared with this portfolio. When the returns fall short, it means Canadians would have been better off avoiding the riskier investments, the same way a retail investor might fare better by investing in an exchange-traded fund that tracks the simple S&P/TSX composite index instead of picking and choosing between companies.
The CPPIB must now prove that taking on the extra risk was worth it in the long run. And it has to do that just as the environment for these kinds of investments has become much more competitive as many other pension funds, private equity firms and sovereign wealth funds seek to do the same thing.
All this extra attention on private equity has put more pressure on the CPPIB’s far larger public investments arm, which buys and sells publicly-traded stocks and bonds as well commodities, currencies and interest rates. Returns here have to be good to compensate for any shortfall on the private side. The trouble is, this division, which comprises 60 per cent of the fund’s assets, hit a series of road bumps in recent years, such as infighting over investment strategy.
To start righting the ship, CPPIB launched a major strategic review last year, tackling everything from organizational structure to compensation. After some soul-searching, the pension fund is out to prove to Canadians that they will be adequately compensated for the extra risk added to their retirement funds.
Investment strategy strife
To truly appreciate the current conundrum, it helps to have a good grasp on the past.
The Canada Pension Plan has existed since the mid-1960s, but the program was revamped in 1997 when federal and provincial governments realized its demographic assumptions were outdated. To correct course, politicians forced Canadians to put more of their paycheques into the plan, sending the value of funds under management soaring. The government also created the CPPIB to start dabbling in investments beyond government bonds.
Almost a decade later, the CPP was overhauled again when management adopted a much more aggressive strategy to earn even higher returns. In the years since, CPPIB has invested in assets such as Sydney office towers and it has also completed a host of high-profile deals such as buying U.S. reinsurer Wilton Re for $1.8-billion (U.S.), forming a $250-million joint venture with China Vanke in Shanghai to invest in Chinese residential real estate and acquiring a portfolio of Saskatchewan farmland for $128-million (Canadian).
But it was deep in the board’s public markets division, which manages a $131-billion portfolio, where problems first surfaced a few years ago.
Because the public markets division is so large, it employs myriad investing strategies. Such diversity can sound like a good idea, but its practical implementation doesn’t always pan out. “The problem with the public markets group,” said a former employee, “is that they’re in so many different strategies that it’s very difficult for all the stars to align so that every group is making money.”
With so many strategies at play, it can be hard to pinpoint those that have worked and those that don’t. But in its simplest form: if one makes $3-million, another loses $4-million, and a third returns $1-million, the net effect is no gain.
There has also been a deep divide between the public markets group’s two dominant investing themes – quantitative versus fundamental analysis.
Many fund veterans, including recently departed chief investment strategist Don Raymond, were steadfast quantitative investors, which means they deployed money based on things like probability distributions and standard deviations. A quantitative portfolio manager may arrange an investment mix based on certain assets’ correlations to one another.
As CPPIB’s portfolio expanded, however, its fundamental investing team – which conducts research to forecast future cash flows and pores over corporate financial statements – grew bigger and very quickly housed a large group of people who had a different view of the market. These folks did not care much about what the statistics said.
In an interview, Mr. Wiseman acknowledged it was a marriage that could not work. “It’s like getting [people] who speak two different languages and asking them to go write a novel,” he said. “It just becomes really, really difficult.”
Other units within the public markets division also had to be overhauled after they each underperformed their benchmarks by hundreds of millions of dollars, according to two different sources familiar with the fund. CPPIB would not verify the amounts, saying it only reports results at a very high level.
Mr. Wiseman acknowledged problems in two particular units: the global corporate securities group, or GCS, which primarily played with long and short positions, and the global tactical asset allocation team, or GTAA, which invests based on macroeconomic themes, such as a euro zone recovery or an emerging-markets slump. The first group needed to fine tune its strategy, he said, while the second suffered from bad leadership.
Another problem was determining annual compensation for long-term investment strategies.
Because CPPIB has such a lengthy investment horizon – 75 years in some cases –both GCS and GTAA tried to use it to their advantage, sometimes placing trades that required them to hold securities for two to five years. (Most money managers in the private sector have a time horizon of less than two years.) At CPPIB, a portfolio manager might purchase Spanish securities in the middle of the European debt crisis, assuming the euro zone will eventually get its act together, even if it takes three or four years to reap the benefits.
The problem is that the securities’ values could fall farther in the meantime. If so, the annual mark on the investment would show a loss, and that affects group compensation for the given year, often leading to infighting. “A losing trade is an orphan,” one portfolio manager said. ‘No one wants it.”
Such a struggle isn’t unique to CPPIB, but it was something the pension fund had to learn the hard way. “All pension plans get into the habit of hiding in the long term,” said veteran pension consultant Malcolm Hamilton, now a fellow at the C.D. Howe Institute. “You can’t think like that. Unfortunately, you have to act in the short term, you have to pay in the short term.”
While all of this was playing out, CPPIB started losing some top talent. Mr. Wiseman said the fund’s total employee turnover ratio has held relatively steady near 9 or 10 per cent annually, but he acknowledged some venerable names have left, including Mr. Raymond; Sterling Gunn, a former vice-president of quantitative research; and Jean-François L’Her, the former head of investment research for the fund’s Total Portfolio Management team – a departure that led to crying on the trading floor, according to someone there that day.
Asked what his No. 1 concern was at the moment, Mr. Wiseman emphasized talent retention. “I’m worried: Are we going to be able to keep those people engaged and have them continue to be employed and working for us?” he said.
To help convince them to stay, CPPIB is considering restructuring compensation. CPPIB typically pays salaries based on four-year rolling windows, which differs from most funds and firms on Bay Street, and that means new hires got bonuses based on previous years’ results. Going forward, newer employees won’t have as much of their pay tied to the fund’s performance before they arrived.
The troubled units, GCS and GTAA, also have new leaders, and in some cases, have retooled their strategies – something Mr. Wiseman said showed CPPIB’s long-term dedication. “If we were a hedge fund, we would have fired the whole team,” he said. “We still believe in the fundamental tenets of those two strategies. We still believe we can get it right.”
Burying the bad news
As the public markets arm retools, the CPPIB’s private equity division is dealing with a different, but equally challenging, scenario.
Whenever the board’s managers are asked about the fund’s private equity capabilities, they are quick to tout its inherent advantages. As a publicly funded plan, the CPPIB has certainty of assets, meaning it does not have to worry about investors redeeming their money at the first sight of something going wrong. Canadians cannot get their savings out until they retire.
Like many funds, the CPPIB has a tendency to celebrate its private equity successes – such as the recent sale of Gates Corp., the automotive parts manufacturing division of Britain’s Tomkins PLC. The pension fund teamed up with Onex to buy Tomkins for $5-billion in 2010 and the partners have since sold eight of the conglomerate’s holdings for gross proceeds of $7.9-billion.
However, struggling investments are rarely highlighted. For example, the fund invested $250-million in oil sands player Laricina Energy Ltd. in 2010 at $30 per private share; in March, the CPPIB coughed up $150-million more for a debt financing that came with warrants -- which can serve as a proxy for Laricina’s private share price – that allow the CPPIB to buy new shares between $15 to $20 apiece.
“Whenever CPPIB has a success, they are quick to discuss it publicly. The same goes for new investments,” said Mark McQueen, who runs Wellington Financial, a private firm that specializes in venture capital. But when you ask about struggling investments, “CPPIB says they’re not material. They want to have it both ways, and the board is complicit in management’s tendency to bury the bad news.”
There is also the age-old issue of risk versus reward. Private assets can generate major returns, but they also come with drawbacks. “One of the big advantages of being in public markets is you have liquidity. You can exit when you want,” said Jim Keohane, CEO of the Healthcare of Ontario Pension Plan, which manages $52-billion. The same isn’t true of private assets.
Pressed about these realities, Mr. Wiseman acknowledged some missteps. “We’ve made bad investments; we’ve lost all our money,” he said, adding that it is just the nature of private equity. “If we’re not doing that, we’re not taking enough risk.”
He also acknowledged that private equity isn’t a sure bet – especially not in this competitive market when assets are sometimes purchased at big premiums. “It’s really hard to get right. It’s a tough, competitive business.” Jaw-dropping returns are getting harder to come by now that university endowment funds and sovereign wealth funds have all moved into this terrain. “This industry has matured. It’s always harder to get superior returns when there’s a lot of money chasing deals,” Mr. Wiseman said.
Private assets also pose a valuation problem – they are incredibly hard to value until they are sold. Because there are only so many power and water utilities up for sale at one time, it can take time to find comparable transactions. In financial circles, then, the valuation process is sometimes called “marking to myth,” and the problem is so widespread that Keith Ambachtsheer, a renowned pension expert who runs the Rotman International Centre for Pension Management at the University of Toronto, is devoting much of his research to analyzing the issue.
Back to the glory days
While it can seem like CPPIB’s task is daunting, the reality is far from it. The country’s largest pension fund is still pumping out positive returns, and it is complying with its most crucial guideline.
Every three years, Canada’s chief actuary calculates the returns CPPIB must generate to meet its long-term pension obligations. The last time the review was conducted, it showed the fund must generate a 4-per-cent real rate of return each year – or 4 per cent after adjusting for inflation. Over the past 10 years CPPIB’s annual real rate of return is 5.1 per cent.
As for the internal benchmark, CPPIB has proven it can beat it. Early on the fund generated a lot of alpha, and those gains have contributed to total positive “value-add” of $3-billion since CPPIB adopted its more aggressive approach and created the reference portfolio in 2006. Now management must prove that it can get back to the glory days.
Mr. Wiseman stressed there is no need to worry. Because 40 per cent of CPPIB’s portfolio is invested in private assets, he argued that the fund is at an inherent disadvantage when public stock and bond markets are hot, like they are right now, because private assets take much longer to reprice. “Just keeping up to the reference portfolio in a bull market is unbelievably good,” he said.
In the private asset portfolio, Mr. Wiseman said CPPIB has the luxury of being “steadfastly patient.” Because the fund doesn’t have to return money to investors every five to seven years, as private funds do, it can wait for good opportunities.
And overall CPPIB also has some wiggle room. The fund benefits from net inflows until 2023, meaning its members’ contributions amount to more than its annual payouts until then.
However, the net inflows can serve as a double-edged sword. Whereas Ontario Teachers’ Pension Plan can’t afford to make investment mistakes because it currently pays out more than it brings in every year, CPPIB can arguably hide behind its sizable contributions. The pension plan also has less stakeholder engagement than rival funds. OTPP, for instance, holds quarterly meetings with the Ontario Teachers’ Federation, according to Rhonda Kimberly-Young, the union’s secretary-treasurer.
“We really rely on the integrity of the people on the board and we rely on the competence and vigilance and transparency of the people who are on the staff to do a good job, [because] they don’t have a stakeholder looking over their shoulder,” said Mr. Hamilton of the C.D. Howe Institute.
Mr. Wiseman shrugs off such worries, arguing that the board is vigilant. Just because missteps happened does not mean management has had, or will have, a free ride. “Not making a mistake means you’re not building your business, you’re not taking enough risk,” he said.
But he also understands the severity of the situation, and pledged to prevent the same drama from unfolding again. “Making the same mistake twice? That’s unconscionable,” he said.
Even if CPP’s future is much smoother, there still is no guarantee that the active management strategy will pay off, something other massive pension funds are wrestling with. While Singapore’s GIC sovereign wealth fund has adopted a similar approach, Norway’s $850-billion wealth fund is debating whether it should move farther away from passive investments.
“It’s human nature for people not to invest passively,” Mr. Hamilton said. “They all want to try to do better [than the market].” The problem is that the time frame required to assess the merits of an active approach can take decades – time during which billions of dollars can be made or wasted. “At this point, it really is an experiment,” he said.
- Except for bonds, these results are very strong across the board. If you look at the table above, you will see exceptional returns in both public and private markets except for bonds which were basically flat in fiscal 2014.
- Almost $10 billion of the gain came from foreign exchange as the Canadian dollar slid in FY 2014 (I warned all of you to short Canada back in December). And it could have been better if CPPIB didn't hedge F/X. Footnote #4 in the table above explicitly states that the total fund return in fiscal 2014 includes a loss of $543 million from currency hedging activities and a $1 billion gain from absolute return strategies which are not attributed to any asset class.
- CPPIB should follow AIMCo and others and report net returns in their headlines. Their press release, however, does state the following: "In fiscal 2014, the CPP Fund’s strong total portfolio return of 16.5% closely corresponded to the CPP Reference Portfolio with $514 million in gross dollar value-added (DVA) above the CPP Reference Portfolio’s return. Despite the strong CPP Reference Portfolio return, we outperformed the benchmark due to strong income and valuation gains from our privately-held assets. Net of all operating costs, the investment portfolio essentially matched the CPP Reference Portfolio’s return, producing negative $62 million in dollar value-added."
- The press release, however, emphasizes long-term results: "Given our long-term view and risk/return accountability framework, we track cumulative value-added returns since the April 1, 2006 inception of the CPP Reference Portfolio. Cumulative gross value-added over the past eight years considerably outperformed the benchmark totalling $5.5 billion. Over this period cumulative costs to operate CPPIB were $2.5 billion, resulting in net dollar value-added of $3.0 billion. "
- I realize CPPIB is running a mammoth operation and is being "built for scale" but operating costs matter and they include fees being doled out to external public and private managers. This is why I'm a stickler for transparency on all costs, fees and foreign exchange fees. At the end of the day, whether you are running a pension fund, hedge fund, mutual fund, or private equity fund, what matters is the internal rate of return (IRR) net of all fees and costs, including foreign exchange transactions.
- Mark Wiseman is a very smart and nice guy. I've spoken to him on several occasions and he knows his stuff. He's absolutely right, in markets where public equities roar, CPPIB will typically under-perform its Reference Portfolio but in a bear market for stocks, it will typically outperform its Reference Portfolio. Why? Because private market investments are not marked-to-market, so the valuation lag will boost CPPIB's return in markets where public equities decline. Over the long-run, the shift in private markets should offer considerable added value over the Reference Portfolio which is made up of stocks and bonds.
- But while I understand the diversification benefits of shifting a considerable chunk of CPPIB's assets into private markets, this shift presents a whole host of operational and investment risks which need to taken into account. My biggest fear is that too many pensions and sovereign wealth funds are chasing big deals around the world, enriching private equity and real estate gurus, and bidding up the price of assets. Lest we all forget the wise words of Tom Barrack, the king of real estate who cashed out right before the financial crisis in 2005, stating back then: "There's too much money chasing too few good deals, with too much debt and too few brains."
- Shifting more and more assets into private markets has become the new religion at Canadian public pension funds. It goes back to the days of Claude Lamoureux, Ontario Teachers' former CEO, who started this trend, made the requisite governance changes and started hiring and compensating people properly to attract and retain talented individuals who know what they're doing in private markets. But I agree with Jim Keohane, CEO of HOOPP, a lot of pensions are taking on too much illiquidity risk, and they will get crushed when the next crisis hits.
- Of course, CPPIB and PSP investments have a huge liquidity advantage over their counterparts in that their cash flow is positive for many more years, which means they can take on a lot of liquidity risk, especially when markets tank.
- But right now, the environment isn't conducive to making a lot of deals in private markets which is why Mark Wiseman and André Bourbonnais, CPPIB's senior vice-president of private investments, are going to sit tight and be very selective with the deals they enter. CPPIB's size is more of a hindrance in this environment because they need to get into bigger and bigger deals which are full of risks when other players are bidding up prices to extreme valuations.
- As far as India, China and other BRICs, there are tremendous opportunities but huge risks in these countries. Hot money flows wreak havoc in their public markets and if you don't pick your partners carefully, good luck making money investing in their private markets.
- In terms of compensation, I note that both Mark Wiseman and Mr. Bourbonnais both made almost the same amount in fiscal 2014 ($3.6 million and $3.5 million). I contrast this to PSP's hefty payouts for fiscal 2013 where Gordon Fyfe, PSP's CEO, made considerably more than other senior executives (all part of PSP's tricky balancing act). This shows me that CPPIB's compensation, while generous, is a lot fairer than that of PSP which has the same fiscal year. PSP is outperforming CPPIB over a four-year period but still, the difference in comp is ridiculous considering the outperformance (value added over a four year period) isn't that much better and the fact is that PSP is based in Montreal which is way cheaper than Toronto in terms of cost of living (I have to give credit to Gordon, however, he sure knows how to ensure he and his senior managers get paid extremely well. He's a master at charming his board of directors).
- Finally, one area where CPPIB is killing PSP Investments is in plain old communication (you can even follow CPPIB on Twitter now). I embedded four articles from Canadian and U.S. sources in this comment (there are more). The pathetic coverage of PSP's results isn't just because its results come out in July when Parliament approves the annual report, it's because PSP's public relations and website stink when it comes to communication. Again, that's all Gordon's doing, he doesn't like being discussed in the media, keeps everything hush, and basically thinks the annual report suffices.
In CPPIB's case, because of its size, it invests huge sums in private equity and real estate funds, which means they dole out huge fees to these general partners (they do use their size and clout to negotiate them down and co-invest where they pay no fees). In infrastructure, they invest directly, meaning they don't pay out any fees to external managers.
As far as organizational issues, I can tell you from my experience working at the Caisse and PSP Investments, big funds mean big egos. There are plenty of arrogant jerks working at these funds, foolishly believing they're "kings" because they hold a chair. Trust me, once you lose your chair, nobody gives a damn about you.
Now, I don't know Don Raymond and don't think he has a huge ego (even if he is an ex Goldman alumnus, he's not a "big, swinging dick"). But his bias on quantitative investing was ridiculous to the point where you still can't apply to CPPIB's Public Markets unless you program C++ and are a derivatives and econometrics expert with a MSc in Finance and a CFA (a bunch of credentials that look good but mean nothing when it comes to making money in these markets).
I have an MA in Economics from McGill. During my undergrad years, I did my minor in mathematics at that same university. I also took honors history of economic thought and honors econometrics courses with Robin Rowley who taught us how to critically examine a lot of the quantitative nonsense being published in respected economic journals. Rowley graduated from the London School of Economics (LSE) at the same time as David Hendry, one of the best and most respected econometricians in the world who is equally skeptical on a lot of nonsense being published out there.
At McGill, I was also fortunate to take courses in comparative economic systems with Alan Fenichel and underground economics with Tom Naylor, the combative economist who taught us what is really going on in the world and to ignore the neoclassical garbage our other professors were teaching us. I also took and audited courses in political philosophy with Charles Taylor, a world-renowned philosopher (and the only professor who gave me intellectual orgasms in each and every class).
All this to say, I'm against the tyranny of quants and think a lot of Canada's large public pension funds are too busy hiring quants programming a lot of malakies (Greek word for wankers) and not enough thinkers from diverse backgrounds who can fundamentally and critically analyze what is going on out in the global economy.
In the summer of 2006, right before I was let go by PSP Investments, I did some research on the U.S. housing bubble and looked at the issuance of CDOs (collateralized debt obligations), including CDOs-squared and CDOs-cubed. I showed my findings to PSP's senior management and in particular, I showed them one chart on CDO issuance that scared the hell out of me (click on image below):
But the 'quant experts' shrugged it off and kept doing what they were doing, like using PSP's AAA balance sheet to sell credit default swaps (CDS) and buy as much asset backed commercial paper (ABCP) as the National Bank and Deutsche Bank were selling them. That didn't end well for PSP and exacerbated their huge losses in fiscal year 2009. It was even worse for the Caisse but that ABCP scandal is being covered up by Quebec's media.
Now, getting back to CPPIB, I have a bone to pick with their talent management team. In fact, I have a bone to pick with all of Canada's large public pension funds who seem to be content reverting back to mediocrity and lack true diversification at all levels of their organization.
Let me blunt here, get your heads out of your asses, stop giving your HR departments so much power and start hiring good people with good attitudes who actually know what the hell they're talking about.
In terms of competition, I read yesterday that Japan is preparing to free its huge pension fund:
Japan's government is readying to unfetter its huge public pension fund, freeing managers to dump low-yield sovereign bonds and go in search of higher, but riskier returns, in a move that could see cash flood global markets.I guess Soros' message is resonating at the upper levels of Japan's government and I read somewhere else that the GPIF is modeling its governance after that of CPPIB, which is a smart move.
The nation's pension programme, into which almost all citizens pay, is supported by the world's largest investment fund, worth a staggering US$1.26 trillion - equivalent to one-quarter of the country's entire economy.
It towers over its nearest competitor - the US$700 billion belonging to Norway - and is multiples of the US$173 billion holdings of Temasek, a Singapore investment company.
But, unlike some other more adventurous vehicles, the Government Pension Investment Fund (GPIF) keeps by far the majority of its cash in super-safe - and super low return - Japanese government bonds.
Lastly, one thing I can share with you is CPPIB's first direct investment in China is poised to yield huge rewards with the initial public offering of Alibaba Group Holding Ltd. Goldman didn't fare as well and will miss out on this IPO.
Boyd Erman and Tim Kiladze of the Globe and Mail appeared on BNN to discuss whether the CPPIB's aggressive investing strategy is paying off. You can click here to watch that interview.
Below, I share something special someone sent me last week. Everyone knows farming requires hard physical labor but this incredibly courageous individual isn't letting his physical limitations stop him from doing what he loves most. I encourage all of Canada's public pension funds, especially CPPIB which leads by example, to do a lot more to diversify their workplace and hire people with disabilities.