Wednesday, February 28, 2018

Canadian Pensions Cranking Up The Leverage?

Kate Allen of the Financail Times reports, Canadian pension fund issues €1bn, 15-year bond:
Some of the world’s largest pension funds have begun to issue bonds, with the Canada Pension Plan Investment Board today raising €1bn in 15-year debt in the latest example of the growing trend.

CPPIB’s deal — priced at a 1.5 per cent fixed annual coupon — is its second euro-denominated debt-raising, after a €2bn deal last June. The order book topped €4.6bn.

Globally pension funds have issued $28bn of syndicated bonds since 2014 according to figures from data provider Dealogic. The largest proportion of that total — $11.1bn — has been denominated in US dollars, with Canadian dollars close behind at $8bn.

CPPIB has been by far the most active pension fund in the capital markets to date, having raised nearly $12bn in debt before today, according to Dealogic data.

Canada’s Public Sector Pension Investment Board, the Ontario Pension Board and the Ontario Teachers’ Pension Plan have all also tapped the bond markets in the past four years.

Pension funds are required by regulators to hold large volumes of highly rated, ultra-safe debt. This has proved challenging for their returns targets in recent years as yields on these investments have lurked around historic lows, thanks to the era of ultra-expansionary monetary policy.

As a result infrastructure and private equity have become popular investment areas for funds which are lured by the relatively high yields these areas can offer.

Now, funds are adding leverage to the mix, too.

In a 2017 presentation to investors CPPIB said, that debt issuance “allows CPPIB to benefit from our standalone AAA/AAA ratings”, gives the fund a “better tailoring of risk profile via selective leverage” and “prudent liquidity management provides CPPIB with the flexibility to invest in dislocated/distressed markets”.

CPPIB’s underlying fund has net assets of $337bn; its board has approved plans to raise up to CA$25bn of bonds in total.

The same presentation tells bondholders that, in the event of any cash flow issues, they will take precedence over pensions savers.

“CPPIB cannot be required to transfer amounts to fund CPP benefits if, after any such transfer, CPPIB would not be in a position to meet all of its obligations including under the Notes [ie. bonds],” it says.

The largest holders of CPPIB’s outstanding bonds are central banks and other official institutions, which hold more than a third of each of its issues according to figures included within the presentation.

Bank of America Merrill Lynch, BNP Paribas, Deutsche Bank and JPMorgan acted as bookrunners for CPPIB.
You can read CPPIB's presentation on debt issuance here.

I've already discussed why Canada's pensions are piling on the leverage here and followed up with another comment on Canada's highly leveraged pensions here.

There are many misconceptions about Canada's large pensions and their use of leverage and to what extent they're leveraging up their portfolio to address the real challenge of a low rate, low return world.

Let me try to address some myths and stick to the facts on the use of leverage at Canada's large pensions.

First, it's definitely true that Canada's large pensions leverage up their portfolio and some do it  a lot more than others. It's not just about issuing debt, some pensions (like HOOPP and OTPP) use extensive bond repos to leverage up their fixed income portfolio or swapping into fixed income indexes to invest in hedge funds (portable alpha strategy).

But whatever the case, it's critically important to understand two things:
  1. Canada's large pensions have the governance to hire very talented individuals who understand derivatives and how to engage in very sophisticated trades that may seem risky to an outsider but in reality is an efficient and conservative use of capital
  2. Canada's large pensions have a successful long-term track record, they're fully-funded which allows them to get a AAA credit rating from the rating agencies to go out and issue debt to invest across public and private markets all over the world. Again, this is an efficient use of capital, much like a corporation that issues debt to invest in new plant equipment. 
I think it's critically important to keep these two points in mind when it comes to Canada's pensions leveraging up their portfolio. They're doing so because a) they have the balance sheet and long-term track record to do so and b) they know what they're doing and investing wisely and c) their interests are perfectly aligned with those of their members.

It's also worth noting that when structured carefully and inteligently, increasing leverage can reduce the overal risk of the portfolio (think about risk parity strategy done internally).

The only criticism I have when it comes to using leverage is that Canada's pension overlords get compensated extremely well which is fine given their long-term success and expertise, but at one point leverage has to be factored into the equation when it comes to benchmarks and compensation.

To make my point, let’s say I have a choice to invest in two hedge funds, similar strategies, but one is employing twice the leverage of the other. Even though they have better returns, I have to adjust my expectations and take into account the leverage they're using because if markets tank, the one using more leverage will suffer bigger losses.

Again, it's not as simple for Canada's large pensions because they're not always using directional leverage but leverage is leverage and we need to keep in mind some of Canada's large pensions use leverage more liberally than others.

The problem is they're not all transparent about it. If it were up to me, I'd change legislation to force them to have a dedicated section in their annual report explaining in detail their use of leverage. No exceptions, spell it out clearly a bit like CPPIB did in that presentation which by the way they need to do by law to issue debt. They all do but what I want is something much more clear and part of the annual report.

Below, Warren Buffett, quoting partner Charlie Munger, says there are three ways to go broke: 'liquor, ladies and leverage'. He's right for individuals taking out home equity loans or any loan to buy stocks but he's not right when it comes to major institutions like Canada's large pensions which know how to intelligently leverage up their portfolio to make efficient use of their capital, seizing opportunities as they arise. I think Buffett would agree with me on that point.

Tuesday, February 27, 2018

Should Pensions Divest From Tobacco?

Back in June, Del Irani of ABC News Breakfast in Australia published an article, Meet the doctor hitting big tobacco where it hurts:
"Are you telling me I'm currently investing in tobacco?!"

Radiation oncologist Dr Bronwyn King made a horrifying discovery in March 2010.

At a coffee meeting with her super fund representative, she discovered — by accident — that her money was being invested in big tobacco.

"I was just so taken aback because I'd been a doctor then for 10 years and had superannuation for 10 years," she told News Breakfast.

"So for 10 years, I owned Philip Morris, British American Tobacco — I owned these companies. Because when you invest in these companies, you own these companies."

A turning point for the good doctor

Dr King's voice trembles when she reflects on the horror she felt at that moment.

Up until that point she had never really paid any attention to her super.

However, at that moment in the cafeteria, everything changed. She simply couldn't let it go unchecked.

Since then, Dr King has worked tirelessly to champion tobacco-free investment, bringing the issue to boardrooms of super funds across Australia and the world.

She is the chief executive officer and founder of Tobacco Free Portfolios and has helped redirect $6 billion of investment from the tobacco industry to other industries globally over the past five years.

It is estimated 15,000 Australians die every day because of tobacco, and according to the World Health Organisation the world is on track for one billion tobacco deaths this century.

Dr King believes that by engaging the finance sector we can change that trajectory at least a little bit, and she feels obliged to act.

"Most of my patients are either not here any more or are very sick, but I've got their stories," she said.

"I need to make sure that those stories are told and that we use those stories to change things."

'I was naive in the beginning'

When it comes to saving lives, Dr King admits her journey has been unexpected and she had a lot to learn when it came to taking on the finance industry.

"I was very green when I came to this," she said.

"I didn't understand any of the language, regulatory environment, the rules or the systems.

One of the roadblocks she faced was justifying her stance.

She was frequently asked: "If we do exclude tobacco, are you going to come back next week and make us exclude 10 other industries. How can you justify excluding just tobacco?"

In response, Dr King developed a framework that suggested investors ask three questions of any company in which they may invest:
  1. Can the product made by the company be used safely?
  2. Is the problem caused by the company so significant on a global scale that it's subject to a UN treaty?
  3. Are there are any other effective strategies to deal with the problem? For example, can you engage with a company to encourage them to behave better?
The trouble is, it's tricky to find out if your money is being invested in tobacco or not.

Crowdfunding campaign to create change

To tackle this, Tobacco Free Portfolios launched a crowdfunding campaign, seeking donations to help roll out their new initiative called "Verified Tobacco-Free".

The concept is a bit like the Heart Foundation tick.

Tobacco-free funds that agree to being audited (to confirm they are indeed tobacco-free) will be able to purchase and adopt the Verified Tobacco-Free logo.

They can then display the logo on their websites and letters to members to proudly declare their tobacco-free status.

Tobacco Free Portfolios hopes the increased awareness of the issue will encourage other funds to follow suit.

"The goal is to raise awareness of this not just in super funds but in sovereign wealth funds, insurers, banks, reinsurers, fund managers," Dr King said.

Tobacco Free Portfolios are engaged with more than 100 of those organisations globally and their goal is to make Australia the first country in the world with a completely tobacco-free superannuation system.
Dr. Bronwyn King is in Montreal today and Toronto this week where she will meet with executives from pensions and other institutional investment funds to discuss her campaign to divest from tobacco.

You'll recall back in Novermber, I explained why OPTrust is following AIMCo, CalPERS and others and butting out for good. Hugh O'Reilly, OPTrust's CEO, called Dr. Bronwyn King, Radiation Oncologist and CEO of Tobacco Free Portfolios, a "real hero" for the work she is doing all over the world. He said he had lively discussions with her but in the end, he too was convinced divesting from tobacco was the right course of action.

Clare Payne, the Chief of Global Strategy who works with Dr. King at Tobacco Free Portfolios, was kind enough to send me her thoughts on how tobacco made its way into the boardroom across the global finance sector:
The boardroom agendas of businesses across the globe are strikingly similar despite each crafting their own distinct market proposition. Like much else, agendas are subject to fads, the influence of others and external forces, sometimes unexpected and sometimes entirely predictable. Attempts to influence the agenda range from the overt (protestors with placards), to the public (a tonne of coal delivered to the front door of a bank for example) to the illegal (hacking internal email systems to deliver blunt messages to staff). Others take a less confrontational route: they write letters, speak to their local member or advocate patiently for change. On occasion, change happens. Some issues are dealt with swiftly, once and for all. Others are not so easy, they’re grappled with, Boards might choose to wait and see – or lead.

One issue that has made a surprising entry as a priority on boardroom agendas is that of tobacco. Even public health officials, with a lifetime of tobacco control experience, have marvelled at the attention the issue of tobacco, and more specifically financial investment in tobacco, is receiving across the finance sector globally.

Tobacco has long been considered a health problem. We’ve been well aware for some time of the health issues related to tobacco, it’s now over 50 years since the US Surgeon General announced the unequivocal link between poor health outcomes and tobacco use - and even then it was considered late. We know that tobacco use results in devastating health impacts from lung cancer, to heart disease, the lose of limbs, eye sight, even respiratory problems in our children. Despite this knowledge the facts might still startle: 2 out of 3 smokers will die early as a result of their tobacco use. 7 million people will die this year and 1 billion people this century – because of tobacco. One hundred thousand children start smoking tobacco each and every day. This, despite the persistent and gallant efforts of doctors, public health experts and governments across the globe. The fight against tobacco companies has been relentless, the wins both big and small – but mostly just costly.

An ally that has long been missing in global tobacco control is that of the business community, namely finance. Tobacco after all is a business and the health implications an outcome of a business model that has allowed tobacco companies to privatise their profits whilst outsourcing the costs of their products to governments and communities. These companies have thrived through continued financial investment allowing expansion and influence.

Unwittingly, for many, they’ve found themselves as ‘owners’ of tobacco companies through having tobacco company stocks in their pension fund portfolio or other financial products. A ‘best of sector’ methodology has meant that even ‘sustainable’ and ‘responsible’ investment options routinely include tobacco companies. We’ve certainly created complex financial systems and untangling not just the average worker but also the biggest financial institutions from tobacco takes consideration and time, but it can be done.

Momentum around tobacco-free investment has grown steadily. The announcement in January this year by ABP, the world’s 5th largest pension fund, of a new policy excluding investment in tobacco could be considered a signal of the year to come, and indicates what will almost certainly be on the agenda for others in the global finance sector.

Tobacco now stands as the most commonly requested exclusion at BlackRock, and to date global finance leaders such as AXA, BNP Paribas, CalPERS, CalSTRS, PFZW, AMP Capital, Bank of New Zealand, Aviva, Natixis, OP Trust and PME have implemented completely tobacco-free investment mandates. Government run financial funds and pension funds including the Norwegian Oil Fund, the New Zealand Superannuation Fund, the Australian Future Fund, T Corp, the Irish Sovereign Investment Fund, Fonds De Reserve Pour Les Retraites, AP4 and the Alberta Investment Management Corporation are also tobacco-free. Currently, approximately 60% of the Australian pension sector (excluding self-managed funds), with total assets approaching AU$1 Trillion, is tobacco-free. In turn, tobacco-free products are coming to market to meet the demand.

Tobacco Free Portfolios has worked closely with many of the finance leaders on the tobacco-free list. Taking a strong position on tobacco can be justified for the following reasons:
  1. There is no safe level of consumption of tobacco: When used as intended, tobacco will have contributed to the early death of two out of three smokers.
  2. There is a UN Treaty: In recognition of the global ‘tobacco epidemic’ the United Nations’ Tobacco Treaty was established in 2005, called the World Health Organisation Framework Convention on Tobacco Control. It is the world’s first global legally binding public health treaty and is signed by 181 countries, representing 89.6% of the world’s population, making it one of the most widely embraced treaties in the United Nations’ history.
  3. Engagement cannot be effective: According to Dr Vera Costa, Head of the Secretariat of the World Health Organisation Framework Convention on Tobacco Control, “Engagement (with tobacco companies) is contrary to UN systems, objectives, fundamental principles and values”, 2017. Dr Margaret Chan, the former Director General of the World Health Organisation has declared, “The tobacco industry is not and cannot be a partner in effective tobacco control.” Positive influence of the industry through professional engagement is considered futile, as the only acceptable outcome is for tobacco companies to cease their primary business.
As environmental, social and governance practices become a criterion for which investment might be received or withheld, leaders across the finance sector are using their power to do what they can to address some of the most pressing issues of our time – and tobacco is undoubtedly one of them. The words of educator and writer, Anna Lappe, remind us that, “Every time you spend money, you’re casting a vote for the world you want.”

In finance, tobacco control has a new ally and its force is set to grow - that, it would seem, you can bank on.
Now, I had a chat with a friend of mine yesterday who told me he's all for giving pensioners a choice to divest from tobacco, big oil, guns, or whatever but when it comes to defined-benefit plans, he has real issues divesting from anything which is legal.

"DB pensions aren't there to make moral choices on behalf of their members, they are there to maximize returns without taking undue risks to fulfill their pension promise. If tobacco was illegal, fine, divest from it, but it isn't and I can see many pensioners worried about the state of their pension plan having real issues divesting from tobacco if it helps them bolster their plan over the long run."

He added: "Dr. King is right to feel the way she does but it was easy for her to check off a box in her Australian DC plan, much harder to do when you're part of a large DB plan which has a clear mission and return objective."

He ended on a sobering note: "Governments should make tobacco illegal but they refuse to because it's an easy way to collect revenues from the masses. If it was illegal, we wouldn’t have these debates on whether or not to divest from tobacco. People shouldn't blame their pension for doing its job, they should be campaigning governments to make certain things illegal if they feel so strongly against an industry."

I actually agree with him because even if all pensions divested from tobacco, there will be other funds like hedge funds, private equity funds or mutual funds that refuse to divest, stating they have a fiduciary duty first and foremost to their investors, not to some social or health cause no matter how worthy it is.

But if you listen to Dr. King's TED talk below, you can't help but wonder why pensions and other institutional investors still invest in big tobacco, it's like investing in death and despair.

Lastly, as someone who was diagnosed with MS over 20 years ago, I can't understand why anyone would smoke. My neurologist asked me a long time ago if I smoke and I said "no". He told me: "Good, smoking makes MS a lot worse."

Smoking makes everything a lot worse but it's so addictive that people can't seem to stop even when they want to. There is a moral problem investing in addiction and disastrous health outcomes, no matter how good it is for your pension.

Update: I managed to attend Dr. King’s lecture at the Centre Mont-Royal late this afternoon and also got to meet her. The presentation was meant for a broad audience and it was excellent. She showed us why cigarettes are so addictive and how the global tobacco crisis is here. In terms of her organization’s work, I was impressed with one slide where she showed all the Australian pensions, banks, insurance companies and sovereign wealth funds that collectively manage close to $1 trillion and divested from tobacco investments. Her organization has managed to convince many other major global financial institutions to divest from tobacco.

Interestingly, I told her governments are the problem because they collect major revenues from the sale of cigarettes. She told me the costs to the healthcare systems across the world due to tobacco-related illnesses dwarfs the revenues they get. She agreed with me the problem is governments spend the bulk of that revenue on other projects, not on healthcare costs due to tobacco-related illnesses.

She ended her serious lecture with a funny scene from the movie The King's Speech (see below).

Update #2: Jordy Gold, Director at Shift, sent me an email asking me this:
Your colleague said that DB pensions "are there to maximize returns without taking undue risks to fulfill their pension promise." I was speaking with a lawyer last month who works with some large Canadian pension funds. I said exactly what your colleague said about maximizing returns and asked how any fund could justify full divestment from tobacco or any other type of company for that matter. The lawyer corrected me. While there are some pension funds that have the explicit mandate to maximize profits, not all of them do. In general, he said that some/many funds have a mandate to simply meet their short and long-term obligations. As such, so long as they meet those obligations, funds with this type of mandate can justify divestment from tobacco. Do you agree or disagree with this interpretation?

It sounds like you enjoyed Dr. King's talk. After hearing her speak and your colleague's thoughts on DB fund responsibilities, would you say that OPTrust is breaching its fiduciary duty by divesting from tobacco?

I'm curious to hear your thoughts.
To which I replied:
I wouldn’t say OPTrust isn’t fulfilling its fiduciary duty, it most certainly is since it’s fully funded, but what if it wasn’t and divested from tobacco? Some members don’t take too kindly to their pension divesting from any investment when the plan is underfunded because it makes the plan more expensive which means they need to raise the contribution rate or cut benefits when it's underfunded. You’re right, I should elaborate, maximize returns without taking undue risks AND meet the plan’s actuarial target rate of return.

Also, CalPERS, CalSTRS and other big pensions that divested from tobacco did so despite being underfunded, which they did for ESG reasons but it still pissed off some of their members because it meant they need to pay more into their plan.
I thank Jordy for asking me his questions and hope this clarifies a few things on divestments. Importantly, pensions that divest aren't breaching their fiduciary duty, especially if they consulted their members beforehand, but there are costs associated with such decisions, especially if the plan is underfunded.


Monday, February 26, 2018

OMERS Gains 11.5% in 2017

Ryan Murphy of Benefits Canada reports, Boosted by public equities, OMERS posts 11.5% return for 2017:
The Ontario Municipal Employees Retirement System saw its net investment return rise to 11.5 per cent at the end of 2017, compared to 10.3 per cent at the end of 2016 and a benchmark of 7.3 per cent.

Its investments generated almost $10 billion in net investment income during the year, with net assets increasing to $95 billion at Dec. 31, 2017, up from $85.2 billion at the end 2016. Also, OMERS’ funded status improved slightly, rising to 94 per cent from 93.4 per cent in 2016.

During a press conference in Toronto on Friday, Jonathan Simmons, the pension fund’s chief financial officer, said the double-digit returns have allowed OMERS to reduce its discount rate by a further 20 basis points in 2017. Though it will cost $2.7 billion, Simmons added it’s the right thing to do.

During the year, OMERS decreased its exposure to inflation-linked bonds, to four per cent in 2017 from six per cent in 2016, as well as government bonds, to seven per cent in 2017 from 11 per cent in 2016. Its credit assets increased slightly, rising to 18 per cent from 17 per cent. The greatest share of its asset mix was in public equity at 34 per cent, up from 28 per cent in 2016.

Indeed, OMERS’ public equity portfolio saw the biggest net return in 2017 at 14.7 per cent, compared to 7.1 per cent in 2016. Private investments held mostly steady, posting a 11.6 per cent return, compared to 11.8 per cent the previous year. And its infrastructure portfolio posted a return of 12.3 per cent in 2017, compared to 10.9 per cent in 2016.

At the end of January, OMERS expanded its presence in the cryptocurrency sector by creating a new company called Ethereum Capital Inc. Its objective, according to a news release, is to become the central business and investment hub for the Ethereum ecosystem, a technology touted as a backbone for enterprise applications developed using blockchain protocols.

During the annual results announcement, Simmons noted OMERS has no investments in cryptocurrency today and no plans to make them. “We’re certainly invested in the underlying technology,” he added.

The pension fund is also looking at emerging markets, added Simmons, with a team travelling to India in January to look at that market.
Matt Scuffham of Reuters also reports, Canada's OMERS fund seeks bargains after global equity selloff:
Canadian pension fund manager OMERS said on Friday a selloff in global equity markets provided a chance to pick up stocks on the cheap, after it reported an improved performance in 2017.

Investors have been left nervous after major world stock indexes slumped into correction territory at the start of the month but OMERS Chief Financial Officer Jonathan Simmons told reporters the decline provided a “buying opportunity.”

“We think it’s a bull market correction and, in underlying terms, the economies are doing well. We’re looking for good quality equities taking advantage of market conditions and we have real leverage in our pension plan right now,” he said.

Executives at Canada’s two biggest public pension funds - the Canada Pension Plan Investment Board and the Caisse de depot et placement du Quebec - have also identified opportunities created by current market conditions.

Simmons said valuations for private assets, such as infrastructure and real estate, remained prohibitive.

“We think it’s a very competitive market for those asset classes. We’ve seen prices continue to rise. That means we need to be prudent and careful as to how we put our money to work and take advantage of opportunities as we see them,” he said.

OMERS, or the Ontario Municipal Employees Retirement System, said it generated an 11.5 percent return in 2017, better than the 10.3 percent return in 2016 and ahead of a benchmark target of 7.3 percent.

Canada’s sixth largest public pension fund said its net assets rose to C$95 billion ($75 billion) at the end of 2017, compared with C$85 billion a year earlier.

OMERS said it achieved a 14.7 percent return from investments in publicly traded shares, more than double the return in the previous year.

Investments in fixed income assets such as bonds returned 4.3 percent. Investments in private equity, real estate and infrastructure produced returns of 11.6 percent.
Jacqueline Nelson of the Globe and Mail also commented on OMERS's 2017 results. You can read her comment here. I note the following:
In recent years, OMERS has made adjustments to its investment strategy, including buying up more private-market assets and adjusting its stakes in public-market assets. It has a multiyear plan to build a presence outside North America, where the vast majority of the pension plan's assets are invested. OMERS only has 9 per cent of its assets invested beyond Canada, the United States and Europe, up from 6 per cent last year.

That allocation to what OMERS calls "the rest of the world" will likely continue to tick up now that the fund has opened an office in Asia. It also made its first direct investment in South America in 2017, with a liquefied natural gas investment in Chile, and struck a real estate deal that gave it a new presence in Berlin.

Jonathan Simmons, chief financial officer at OMERS, said the fund is looking further abroad.

"We're looking at emerging markets," he said. "We had a group of people travel to India in January that were looking in that market."

The trip led to OMERS joining a group of institutions on a nearly $2.2-billion investment in Mumbai-based Housing Development Finance Corp. Ltd., and a major mortgage lender in the country. The consortium also included Singaporean sovereign wealth fund GIC and U.S. private-equity giant KKR.

Sourcing assets has become increasingly difficult for the pension fund amid the fierce institutional investor competition for private-market deals. That's showing up in areas such as renewable-energy deals, which are in high demand.

"Our infrastructure team has been very focused on that space for the past three or four years. We have not been successful on a point of entry," Mr. Latimer said, adding that while the fund would like to invest, prices have been high.
OMERS's CEO, Michael Latimer, also said the pension would not be investing in marijuana stocks (HMMJ.TO) but that it would invest in emerging technologies and start-ups through the OMERS Ventures platform:
"Think of all these themes that are playing out today with artificial intelligence and bio-science … it gave us a window into what else was going on," he said. "All of these businesses that were out there, young entrepreneurs trying to figure out how to disintermediate where probably 98 per cent of your balance sheet is, was really an opportunity for us to understand, to be sitting across from them, to be invested with them."
Now, I agree with Michael Latimer and Michael Sabia, pensions shouldn't be investing in pot stocks and bitcoin but there definitely are emerging technologies worth investing in.

As mentioned above, OMERS recently expanded its cryptocurrency presence with a $50-million Ethereum public company offering. And over the weekend, I learned PSP Investments invested $50 million in Vancouver-based D-Wave systems, a company that has developed a type of superfast processor that to date has largely been limited to use in research labs:



Clearly there are exciting opportunities in emerging technologies, however, making money isn't as easy as it sounds in this space. Take it from me, venture capital is fraught with risks but more established companies are a safer bet.

Anyway, back to OMERS's 2017 results. The pension put out a very simple press release which states the following:
OMERS, the defined benefit pension plan for Ontario’s municipal employees, achieved a net investment return of 11.5% (after all expenses), compared to a benchmark of 7.3%, and a net return of 10.3% in 2016. The combination of investment return and contributions led to an improvement in OMERS funded status in 2017, bringing it to 94%.

“All of our major asset classes performed well in 2017,” said Michael Latimer, President and Chief Executive Officer. “Our strategy is working. The investment return, combined with contributions from members and employers, improved our funded status. We are committed to meeting the pension promise over the long term.”

“OMERS funded status has improved for the fifth consecutive year,” said Jonathan Simmons, Chief Financial Officer. “Double-digit returns for two years in a row have also allowed us to reduce the discount rate on our pension obligations by a further 20 basis points in 2017.”

OMERS is an important part of Ontario’s retirement system and the broader economy. In 2017, almost 150,000 retired members received a monthly OMERS pension. In total, $4 billion in pension payments flowed back into the economy.

“Feedback from our members, employers and sponsors is important. We are reaching the halfway point in our 2020 Strategy with strong progress on our objectives,” said Mr. Latimer. “I want to thank all of our employees for contributing to a successful year.”

OMERS will publish its 2017 Annual Report in early March.

About OMERS

Founded in 1962, OMERS is one of Canada’s largest defined benefit pension plans, with more than $95 billion in net assets, as at December 31, 2017. It invests and administers pensions for almost half a million members from municipalities, school boards, emergency services and local agencies across Ontario. OMERS has employees in Toronto and other major cities across North America, the U.K., Europe, Asia and Australia – originating and managing a diversified portfolio of investments in public markets, private equity, infrastructure and real estate.
As stated in the press release, OMERS will publish its 2017 Annual Report in early March.

Below, I embedded the net returns by major asset class for the two last calendar years (click on image);


As shown, Public Equity gained 14.7% which isn't surprising given the S&P 500 gained 22% in 2017 and there were equally strong gains across European, Japanese and emerging market stock exchanges last year but the performance of Canadian equities wasn't as strong because energy dragged down the returns of the S&P/ TSX (gained 6% in 2017).

Interestingly, the performance of Private Equity (11.1%), Infrastructure (12.3%) and Real Estate (11.4%)  was very much in line with the gains OMERS posted in private markets in 2016.

As far as asset mix changes, I noted that OMERS cut its allocation to Government bonds and Private Equity by 4% and 2% respectively in 2017 and increased its allocation to Public Equity by 6% (click on image).


So, a lot of the returns are explained by this tactical asset allocation decision to cut allocations in government bonds and private equity in order to increase the allocation in public equities.

A few other key points I’d like to highlight:
  • The funded status, the ultimate measure of success for any pension, has improved significantly over the last five years. For all effective pusposes, I consider OMERS is now fully-funded but despite the strong gains, they still lowered the discount rate by 20 basis points. 
  • It should be noted that unlike Ontario Teachers' Pension Plan (OTPP) and the Healthcare of Ontario Pension Plan (HOOPP), OMERS and OPTrust are pension plans that do not have a shared-risk model where benefits are cut when the plans are in trouble (typically full or partial removal of inflation protection). This makes the job of OMERS's and OPTrust's senior managers that much harder when it comes to achieving fully-funded status because the only lever available to them is to cut the discount rate and increase the contribution rate when their plan experiences a deficit.
  •  OMERS trounced its benchmark by 420 basis points in 2017. I will caution readers to take such an outsized outperformance with a grain of salt because it's based mostly on a tactical asset allocation decision (less goverment bonds and private equity and more public stocks) and second, it may signal that the benchmarks in private markets don't reflect the risks of the underlying portfolios.
Let me just pause right there because I'm not taking anything away from what OMERS achieved in 2017 and making a solid tactical asset allocation decision is part of adding value, but I just covered the Caisse's 2017 results which were decent but not as strong as those of OMERS and I'm going to get some reporters asking me why.

You need a lot of detailed information to make comparisons of the performances between Canada's large pensions but major tactical asset allocation decisions like the one OMERS did will explain a lot of its outperformance (Note: I wonder if the fact that the plan doesn't have a shared-rsik model leads it to take more risk in tactical asset allocation).

It's also worth noting some pensions (HOOPP) hedge currency risk while others don't and some use a lot more leverage (HOOPP, OTPP) than others, so making direct comparisons isn't as straightforward as you think.

But again, I want to emphasize, 2017 was another great year for OMERS coming off a very strong 2016. It's obvious OMERS is doing something right since Michael Latimer took over the helm. The OMERS advatantage has proven to be very fruitful over the last five years (solid markets also helped a lot).


Lastly, even though OMERS will publish its 2017 Annual Report in early March, I urge you to go read all the documents on OMERS's site going over 2016 results, including highlights, the 20/20 strategy, governance, management discussion and a full discussion on compensation and analysis.

All these documents are available here. Below a summary table of executive compensation based on 2016 results (click on image):


As you can see, Michael Latimer is one of the highest paid pension CEOs in Canada and the world, and his total compensation jumped by almost $2 million last year to reach $5.2 million and given this year's results, I'm pretty sure he stayed at or near that level. Again, read the compensation discussion to understand the factors explaining this compensation.

One other HR note on OMERS's senior ranks. Sebastien Sherman, the Head of the Americas region at OMERS Infrastructure (Borealis Infrastructure), left the organization to join Blackstone which is starting its new multi-billion infrastructure fund (click on image):


It's a testament to the quality of the people when you see someone leave OMERS to join Blackstone but I'm not sure if Canadian pensions are too happy when one of their strategic partners hires away talented individuals (although I heard some Blackstone folks left that firm to join OMERS which is pretty impressive if true).

Below, Warren Buffett's Berkshire has $116 billion to spend on a deal, but the investor can't find anything cheap enough. Sound familiar? There are opportunities but everything is expensive now.

Also, Sit Investment Associates' Bryce Doty believes investors are in "denial" over how high rates could go this year and the painful impact it could have on stocks.

"We didn't pierce 3 percent this time, but the next 10-Year auction in a couple of weeks is probably certain to do that," he said recently on CNBC's "Futures Now." "I think it's going to just keep going. 10, 20 basis points a month gets you to 4 percent in a hurry."

He must not agree with me that it's a bond teddy bear market. If he's right, stocks and other risk assets will get clobbered as rates rise much higher than anticipated but pension liabilities will decline signficantly more, so it won't be such a terrible scenario for pension plans like OMERS.

However, if I'm right that we have yet to see the secular lows on US long bond yields and that it might come in the near future, well, assets will get clobbered and pension liabilities will soar to record levels. Let's hope he's right because my doomsday scenario for pensions is a real nightmare.

Lastly, take the time to watch a Canadian Club Toronto pension panel from exactly two years ago, a panel which was moderated by Bloomberg’s Pamela Ritchie and featured Mark Wiseman (former CEO of CPPIB), Ron Mock (CEO of OTPP) and Michael Latimer (CEO of OMERS). The clip is available here and is well worth watching.

Friday, February 23, 2018

The Fed's Balance of Risks?

Tae Kim of CNBC reports, The Federal Reserve thinks stocks and commercial real estate prices are getting too rich:
Federal Reserve policymakers believe financial market asset prices are high, according to the central bank's "Monetary Policy Report" to Congress on Friday.

"Valuation pressures continue to be elevated across a range of asset classes, including equities and commercial real estate," the report said. "Over the second half of 2017, valuation pressures edged up from already elevated levels. In general, valuations are higher than would be expected based solely on the current level of longer-term Treasury yields."

The Fed noted the price-earnings ratios for U.S. stocks were "close to their highest levels outside of the 1990s."

The central bank's "elevated" valuation comments are noteworthy given the market has sold off since late January. The S&P 500 has declined 4 percent in February through Thursday.

The Fed also is not too concerned yet over the levels of debt in the banking sector.

"Overall vulnerabilities in the U.S. financial system remain moderate on balance," the report said. "Vulnerabilities from leverage in the financial sector appear low, reflecting in part capital and liquidity ratios of banks that have continued to improve from already strong positions."
You can read the Fed's latest Monetary Policy Report here. I note the following on financial stability:
Vulnerabilities in the U.S. financial system are judged to be moderate on balance. Valuation pressures continue to be elevated across a range of asset classes even after taking into account the current level of Treasury yields and the expectation that the reduction in corporate tax rates should generate an increase in after-tax earnings. Leverage in the nonfinancial business sector has remained high, and net issuance of risky debt has climbed in recent months. In contrast, leverage in the household sector has remained at a relatively low level, and household debt in recent years has expanded only about in line with nominal income. Moreover, U.S. banks are well capitalized and have significant liquidity buffers.
I'm very surprised the Fed feels household debt isn't a problem when you read comments on how debt is on track to destroy the American middle class, but apparently Americans are getting better at saving.

As far as risks to the banking and financial system, here too I would caution readers to take these findings with a grain of salt. There are risks and there is a lot of leverage in the system. It also doesn't help when pensions start taking stupid risks like shorting volatility at will to achieve their return target.

[Note: Read Karl Gauvin's LinkedIn comment, The Truth About Short VIX Strategies.]

What else caught my attention in the Fed's Monetary Policy Report? This little tidbit on global inflation:
Inflation has generally come in below central banks' targets in the advanced economies for several years now. Resource slack and commodity prices--as well as, for the United States, movements in the U.S. dollar--appear to explain inflation's behavior fairly well. But our understanding is imperfect, and other, possibly more persistent, factors may be at work. Resource slack at home and abroad might be greater than it appears to be, or inflation expectations could be lower than suggested by the available indicators. Moreover, some observers have pointed to increased competition from online retailers or international developments--such as global economic slack or the integration of emerging economies into the world economy--as contributing to lower inflation. Policymakers remain attentive to the possibility of such forces leading to continued low inflation; they also are watchful regarding the opposite risk of inflation moving undesirably high. (See the box "Low Inflation in the Advanced Economies" in Part 1.)
I still feel that structural deflation forces are going to swamp the global economy and keep rates ultra-low for many more years.

Anyway, take the time to read the Fed's latest Monetary Policy Report here, it's well worth reading it very carefully as it's well written.

The Fed also addressed fears that shrinking its balance sheet will impact the economy. Greg Robb of MarketWatch reports, Good news — the Fed’s shift to quantitative tightening might not be as painful as expected:
A new study of Federal Reserve policy released Friday has questioned the conventional wisdom that long-term Treasury yields will rise by about 100 basis points due to the Federal Reserve’s plan to shrink its balance sheet.

The new study, released at a prestigious gathering of senior Fed officials and Wall Street economists in New York, says the exit from the unconventional monetary policy may not be as “painful” as expected.

“Our overall conclusion is that the size of the Fed’s balance sheet is less potent in moving the bond market than as perceived by many,” the experts said.

That’s good news for the economy. There has been a lingering fear that the Fed’s asset purchases had kept rates artificially low and that they might snap higher once the Fed started to shrink its $4.5 trillion balance sheet.

There was worry that bondholders would stampede toward the exit at the same time, similar to the “taper tantrum” of 2013, when the Fed signaled plans to reduce its economy-boosting bond buying and triggered a jump in market yields that well preceded any actual Fed move.

The paper was written by David Greenlaw, senior fixed income economist for Morgan Stanley, Ethan Harris, head of global economics at Bank of America Merrill Lynch, and two top academic economists, Kenneth West of the University of Wisconsin and James Hamilton of the University of California at San Diego. It was presented Friday at the U.S. Monetary Policy Forum sponsored by the University of Chicago Booth School of Business.

Last fall, the Fed announced plans to slowly reduce its balance sheet on auto-pilot, allowing holdings to shrink by $20 billion each month this quarter and moving up to a maximum of $50 billion per month by the end of the year.

So far, the paper noted, the Fed’s initial exit signals have had relatively little impact on the market, which have amounted to a “collective shrug.”

The flip side of this argument is that should the Fed have to flip the switch and use an asset purchase program again, it might not be strong enough to push Treasury yields, and borrowing costs, lower during the next recession.

This means the Fed will need some new ammunition to fight the next downturn. In the past, the central bank has typically slashed interest rates by 4% to spur growth during a downturn, but its target for short-term rates is now only between 1.25%-1.5%.

The Fed has not announced how low it wants to shrink its balance sheet. New Fed Chairman Jerome Powell discussed a target range of $2.5 trillion to $2.9 trillion in his confirmation hearing last fall.

The analysts behind the paper called on the central bank to announce a size soon. They said it was unlikely that the Fed would be able to shrink the balance sheet below $3 trillion without changing how it sets interest rates.

The experts make some policy recommendations:
  • The Fed should make a determination of the appropriate size of the Fed’s balance sheet over the long term and provide market guidance as soon as possible.
  • The Fed should preserve the right to buy mortgage-backed securities given the likely low policy ammunition around the next crisis.
  • The Fed should return to a balance sheet that consists mostly of short-term Treasury securities.
  • The central bank should consider larger and looser caps on rolling off securities, perhaps removing them completely by 2019.
All this talk about the Fed shrinking its balance sheet and its impact on the economy is much ado about nothing.

In fact, if my prediction that the US economy will slow significantly in the second half of the year comes true, I wouldn't be surprised if the Fed pauses its balance sheet reduction or signals a pause.

It all depends on how bad things get. Bridgewater's Ray Dalio sees 70 percent chance of recession before 2020 but doesn't see a bubble yet:
Billionaire investor Ray Dalio, who founded world’s largest hedge fund Bridgewater Associates, thinks there is a relatively high chance the U.S. economy will stumble into a recession before the next presidential election in 2020.

Dalio said the U.S. economy is not currently in a bubble. But he reasoned that it might not take long to get there and then to move on to a “bust” phase.

”I think we are in a pre-bubble stage that could go into a bubble stage ... The probability of a recession prior to the next presidential election would be relatively high, maybe 70 percent, Dalio said during an appearance at the Harvard Kennedy School’s Institute of Politics.

Dalio, whose fund invests some $160 billion, stepped down from the hedge fund’s day-to-day operations nearly a year ago, but his views on markets and the economy are still very closely followed.

At the event, Lawrence Summers, a former Treasury secretary and former Harvard president, asked Dalio questions including what advice he would give individual investors who may have been rattled by the market’s recent turbulence after years of steady gains.

Dalio said investors should not panic and need to have a sound plan. If people become scared after the market has tumbled, it is too late, Dalio said, adding that people should probably buy when they are frightened and sell when they are not.

“The greatest mistake of the individual investor is to think that a market that did well is a good market rather than a more expensive market,” he said.

Dalio refused to discuss the firm’s portfolio and said that many of Bridgewater’s moves could be easily misinterpreted, including recent short bets against a number of European companies. “Don’t read anything into that. You’ll probably be misled.”
Dalio's advice is sound and indeed, the last correction proved to be short-lived, but what if we get a nasty bear market that lasts three or more years? We haven't had a prolonged bear market in a long time, and we're due for one. It doesn't mean it will happen for sure but investors need to prepare for it.

On that note, take the time to read my last comment on the bond teddy bear market and learn why US bonds are still very important to diversify risk and help protect against major downside risks inherent in risk assets.

Below, CNBC's Dominic Chu looks ahead to what are likely to be next week's top business and financial stories. And Jeffrey Gundlach, DoubleLine Capital CEO, discusses his views on the bond market and US nominal GDP.

Lastly, I embedded a discussion between Lawrence Summers, a former Treasury secretary and former Harvard president, and Ray Dalio at the Harvard Kennedy School’s Institute of Politics. Take the time to watch this, great discussion.



Thursday, February 22, 2018

The Bond Teddy Bear Market?

David Ader wrote a comment for Bloomberg, Too Much is Being Made of the Bearish Bond Data (click on images to enlarge):
“The sky is falling; the sky is falling!” Substitute “bond prices” for “sky” and you’ll have a sense of the mood in the fixed-income market the last few months.

I won’t diminish the potential bearish impact the swelling U.S. budget deficit will have on the bond market as supply surges in the months and years to come. But we don’t know how much it will affect the market if there is no accompanying increase in inflation and gross domestic product. Still, that hasn’t stopped people from making too much of bearish data, while ignoring a soft underbelly that challenges the bearish narratives. That’s what I’m about to do.

Certainly, five increases in the federal funds rate since December 2015 and the doubling in 10-year Treasury note yields since mid-2016 would constitute a bear market by any measure, but what I suspect is coming is more of a teddy-bear market than a grizzly bear, at least based on recent statistics and hyperbolic stories throughout the press.


First, I’ve read, reread and read yet again articles about the deficit exploding. We knew of that danger well before the tax plan was enacted into law in December. Each report pretty much rehashes the same statistics in an attempt to explain the rise in volatility and interest rates. In reality, few dollars have been added to the deficit projections. When old news is rehashed as new information it can arouse emotions without adding more to the fundamental picture.

Second, there’s the selective use of data events, which I have also used to my advantage. Take the consumer price index. A greater-than-expected increase on Wednesday provoked a sharp selloff in the bond market and was followed by press reports of inflation coming back and, along with a weak retail sales report that same day, led to the term “stagflation” being thrown around.

But here’s the thing: January is a notoriously bad month for inflation. On average, it shows the second-highest monthly increase over the course of a given year and is the highest for the core figure, which excludes food and energy. This particular January had very cold conditions, which may help explain that two of the largest contributors to the gain in the CPI were energy and apparel. In other words, from an historical perspective we can expect month-over-month gains to ease.


Another weather quirk can be seen in the January employment report. While the 200,000 increase in jobs was not too threatening, the surge in wages caught the attention of the bears and is cited along with the CPI report as a reason to dump bonds. It’s not so simple. A lot of people were not at work due to bad weather, and maybe because of the flu, which explains the dip in hours worked. The 0.3 percent gain in average hourly earnings was skewed to a small segment of the workforce, the upper echelon. Production and non-supervisory folks, who account for 80 percent of the workforce, saw a more modest increase of 0.1 percent. These are the people who couldn’t get to work due to bad weather and whose hours worked dipped to 34.3 from 34.5 in December.


It’s also important to understand that the CPI data took a toll on inflation-adjusted earnings. Real average weekly earnings fell 0.8 percent in January, and real average hourly earnings dropped 0.2 percent. That might help explain the weak retail sales data that were largely ignored by the bond market.

Then there’s an empirical measure of sentiment in various forms, price action not being the least of them. One of the best contrarian indicators -- and one that has worked for me for almost 30 years -- is the Daily Sentiment Index. This is a survey of small traders in actively traded futures put out by Network Press. Essentially, the survey asks if you are bullish on a given commodity. When the index falls below 20 percent it means that more than 80 percent of the “market” is bearish. And when the market in question becomes that oversold, it typically marks an inflection point and foreshadows an impending reversal. The DSI for 10-year note futures slid under 12 percent a few days ago and remains a very oversold 14 percent, begging the question of who is left to be bearish.


So is Chicken Little right to run around yelling the sky is falling? At the end of 2017 I wrote that I expected 10-year yields to rise to around 2.85 percent to 2.95 percent, which they’ve done rather earlier than I expected. The evidence suggests yields at those levels provide value, at least in the near term. However, there’s a chance yields could probe the 3 percent to 3.25 percent range at some point toward the middle of the year as the sheer weight of increased issuance spooks both the Fed, due to the added stimulus of the tax plan, and the marketplace that has to buy many more bonds. Yields teasing into that range should be enough to boost the dollar and prove ample competition with a richly valued equity market.
This is an interesting article and I thank Drew Wells, one of my astute and faithful blog readers out in Vancouver for sending it to me.

I've been highly skeptical of bond bear market stories for a while and have relayed my thoughts in my macro comments thus far this year:
Now, I spend a lot of time going over bonds because the bond market is much bigger and far more important than the stock market. In order to understand risks and liquidity, you need to understand the bond market.

It so happens that today I met up for lunch with Simon Lamy, a former senior fixed income portfolio manager at the Caisse. Simon traded bonds for close to 25 years at the Caisse and not only was he one of the best fixed income traders ever at this organization, he was also one of the nicest guys there and I had the pleasure of working with him and my former BCA colleague, Brian Romanchuk, back in 2011 when we worked with external consultants to understand sovereign debt risks and opportunities.

Anyway, it's one thing writing about bonds but Simon is trading them actively for his one-man hedge fund, posting great returns and not answering to any boss (he's in an enviable position).

So, for me, it was a treat meeting up with him. I started off working on fixed income at BCA Research, I understand the macro environment, but it's totally different speaking to a bond trader who traded sizable positions and knows the Canadian and US bond market very well.

We first started talking about the Caisse's 2017 results which I covered yesterday. Simon wasn't particularly impressed, said the overall results came in line with the benchmark, and that apart from Private Equity, it wasn't a great year. Moreover, he said Canadian Equities underperformed in a year where the TSX/ S&P underperformed so he didn't see any value added there.

I actually updated my last comment to state the following:
A quick glance shows me that apart from Emerging Markets stocks, Private Equity really performed well in 2017, returning 13% versus a benchmark return of 10.5%. I also noted solid performance in Real Assets (Real Estate and Infrastructure) and decent performance all around except for Canadian Equities (Canadian mandate) which underperformed the index by 100 basis points in 2017 (but outperformed it by 150 basis points over the last five years).
And I reminded Simon that it's the 5-year (long-term) results that ultimately count most. He agreed but rightly noted, "it's been a bull market since 2009 and for all this talk of resilient portfolios, the Caisse hasn't been tested out yet apart from the minor correction that took a few weeks ago."

There I agreed with him and said: "100% correct. The real test for Michael Sabia and the senior managers at the Caisse and their resilient portfolios will come when we get a nasty bear market, this last correction was just an appetizer."

Anyway, enough about the Caisse, let's get back to my discussion with Simon on bonds. I jotted down some mental notes on things he told me:
  • Like me, Simon doesn't buy the whole big bad bond bear market story. Instead, he sees US bond yields going back to their historic norms trading between 2% and 4%, going back to the historic range of US nominal GDP growth. So he sees 3% as a long-term neutral level for the 10-Year Treasury yield, not the upper range of long bond yields when looked at over many years.
  • Importantly, he doesn't see sustained US wage inflation and I agree and have written my thoughts here.
  • He told me he would short US long bonds if the yield on the 10-year Treasury note fell below 2% and go long if it crossed 3.5% and approached 4%.
  • He thinks the market is going to test the psychologically important 3% level on the 10-year Treasury yield. "The market is almost there and barring a terrible US jobs report next Friday, we're likely going to test it." I was surprised when he said that because it has been my contention that we might test or briefly overshoot 3% but I had serious doubts because the US economy is going to slow markedly in the second half of the year.
  • Simon told me to watch supply and demand. "There are supply concerns now because typically when you see the economy expanding and the Fed tightening, you'd see a decrease in the supply of Treasuries but now because of the tax cuts and expanding deficit, you're seeing an increase. That puts upward pressure on yields. If the economy was slowing, no problem to absorb the increase in the supply of Treasuries because demand will be there."
  • As far as demand for Treasuries: "Forget the bid-to-cover ratio, that's not a good indicator of demand. Watch how the market reacts moments after supply hits the street. If yields rise (bond prices fall) moments after, then you know demand isn't strong even if the bid-to-cover ratio is high."
  • He didn't make any big call on the US economy, just focused on long-term trends. Told me that US GDP growth is made up of productivity growth which has averaged between 1.5% to 2% and population growth "so it's hard seeing GDP growth above 4% or below 2% for a sustainable period."
  • We spoke briefly about Canadian long bonds but he's not going long just yet and thinks the "Bank of Canada should have raised rates and instead is sitting on its hands using NAFTA as an excuse not to move." He added: "I just short the Bank of Canada's moves which is why I made great returns buying preferred bank shares when the Bank of Canada unexpectedly dropped rates a few years ago using the decline in the price of oil as an excuse to do so."
I'm not doing justice to Simon and our conversation was more intricate than the points above but he got me thinking maybe I've been too bullish on US long bonds (TLT) too early (click on image):


Still, given my firm views that the US economy will slow in the second half of the year, I'd be a buyer of US long bonds at these levels, especially if the yield on the 10-year Treasury note crosses 3% (I’m not convinced it will).

In fact, Drew Wells sent me the latest Markit US PMI report which was very strong and I thought to myself it's as good as it gets for the US economy.

I asked Francois Trahan his thoughts on the strength of this report and he shared this with me: "Brexit. Takes 18 months for a change in yields to show up in LEIs. The decline in yields around Brexit dropped yields below what would otherwise be for about six months. So some of this is artificial but real nonetheless."

Hope you enjoyed this comment on the bond teddy bear market. Please remember to kindly donate to this blog on the top right-hand side, under my picture. I thank all of you who take the time to donate and thank Simon Lamy for a great lunch, I really enjoyed our conversation earlier today.

Below,  Hayden Briscoe, UBS Asset Management, discusses why yields to on some US auctions rose to highest levels since 2008.

Wednesday, February 21, 2018

The Caisse Gains 9.3% in 2017

Jacob Serebrin of the Montreal Gazette reports, Caisse posts $24.6-billion profit, says it's ready for market correction:
The head of the Caisse de dépôt et placement du Québec said he believes a market correction is coming but that the provincial pension fund manager is much better prepared than it was in 2008.

While corporate profits have risen, Michael Sabia, the president and CEO of the Caisse, said the market returns that reflect future expectations are rising faster.

And that is leading to a more fragile market, he said Wednesday.

In 2008, the Caisse lost almost $40 billion.

This time, Sabia said, the fund manager sees a correction as an opportunity.

“Unlike the situation of la Caisse in 2008 and 2009, where we did not have any room to manoeuvre, we were not able to move assets and capital to benefit from the resurgence of the markets,” he said. “This time, we are prepared. This time, we have the flexibility to move substantial capital in a highly liquid way from one or two asset classes into others as we benefit from what would be a repricing of the market.”

But he doesn’t know when that correction will come.

“Our job is not to try to predict the markets. It’s not to try to time the markets. Our job is to be ready,” he said.

The comments came as the Caisse announced net investment results of $24.6 billion in 2017. That’s an annualized return rate of 9.3 per cent, which brought its net assets to $298.5 billion.

It’s the Caisse’s strongest annualized return since 2014, when it generated an annualized return of 12 per cent, or $23.8 billion.

In 2016, the Caisse reported an annualized return of 7.6 per cent, worth $18.4 billion.

Sabia also addressed the decision to not choose Bombardier’s bid to build train cars for the Réseau express métropolitain, the light-rail network being built by the Caisse.

He said the Caisse wears two hats: it’s an investor in Bombardier and a project manager when it comes to the REM.

“As an investor, we made an investment of $2 billion in the Bombardier Transport during one of the most difficult times in the history of that company,” he said.

That investment helped save Bombardier, he said, and shows the Caisse’s commitment to the company’s success.

“From a project manager point of view, our job is to build the best possible project at the best possible price, and that’s what we’re doing,” he said.

Sabia said the Caisse nearly abandoned the project in November.

“We got proposals in November, on the engineering and construction side of the REM, that were highly problematic,” he said. “It just wouldn’t work from a user point of view, from a cost point of view.”

But by “sticking to our guns, negotiating the way we did,” the Caisse was able to find solutions and save the project, he said.

The Caisse, which manages Quebec’s public pension plan as well as several other para-public pension and insurance plans, said it generated returns of between 10.9 per cent and eight per cent for its eight primary clients in 2017.

That variation is because different clients have different risk tolerances and different approaches to funding, Sabia said. While the provincial pension fund has a very long-term strategy, other funds, like the Commission de la construction du Québec pension plan, have less risk tolerance.

Equities, which represent 50 per cent of the Caisse’s overall portfolio, generated a return rate of 13.6 per cent and net investment results of $17.6 billion.

That was driven by strong stock market performance, particularly in the United States and emerging markets like China and South Korea, where the Caisse has invested in technology companies.

Real assets generated net investment results of $4 billion and had a return rate of 8.7 per cent.

Daniel Fournier, the CEO of Ivanhoé Cambridge, the Caisse’s real-estate subsidiary, said it is narrowing its portfolio of shopping centres, focusing on the most profitable ones and selling others. As well, it is making investments in distribution and logistics, particularly in China.

Fixed income, the category that includes bonds, generated net investment results of $3.2 billion, a return rate of 3.5 per cent.

During the past two years, Sabia said, the Caisse has diversified its holdings in this asset category.

That includes a credit portfolio focused on corporate credit and specialized financing, like the $1.5-billion loan it made to SNC-Lavalin in April to help it acquire WS Atkins, a British competitor.

The pension fund manager said it made $6.7 billion in new investments and commitments in Quebec alone in 2017.

Sabia said the Caisse has increased its focus on investing in Quebec’s private sector, describing it as the motor for economic and employment growth in the province.

Its assets in Quebec’s private sector have risen from $27.6 billion in 2012 to $42.5 billion in 2017.

A big part of that is a focus on helping Quebec companies grow internationally, said Christian Dubé, the Caisse’s executive vice-president for Quebec.

The Caisse is also making investments in Quebec’s AI industry, he said.

“For us, it’s the new economy,” Dubé said.

Investing now will allow the Caisse to position itself and give it a sense of who the major players will be in five to 10 years, Dubé said.
Second, Reuters reports, Canada's Caisse fund reports 9.3 percent return in 2017:
Canada’s second-largest pension fund, the Caisse de depot et placement du Quebec, on Wednesday reported a 9.3 percent return on its clients’ funds in 2017, helped by a strong performance from its equities investments.

The Caisse said its net assets totaled C$299 billion ($236 billion) at the end of 2017, up from C$271 billion a year earlier.

The fund manages public pension plans in the Canadian province of Quebec. It has diversified to become one of the world’s biggest investors in infrastructure and real estate as well as a major investor in global equity and fixed income markets.

Chief Executive Michael Sabia said the fund was continuing to build a portfolio that can withstand geopolitical risks and market volatility.

“We are putting a big emphasis on resilience. Resilience is exactly what we need in this environment,” Sabia told reporters.

He said investors were currently “incredibly sensitive” to the actions of central banks, amid concerns about how changes in monetary policy to curb inflation could impact interest rates.
Allison Lampert and Matt Scuffham of Reuters also report, Caisse CEO urges Bombardier to be ready for M&A activity:
Bombardier should be “on alert” for merger opportunities that will enable its transportation unit to compete with larger rivals in an industry that is consolidating to help reduce costs, the chief executive of its biggest independent shareholder said on Wednesday.

“I think, in an industry that’s consolidating to the degree that it is and given the scale issues associated with the size of the Chinese presence in that industry, the company needs to be always alert to M&A opportunities,” Caisse de depot et Placement du Quebec CEO Michael Sabia told reporters.

Germany’s Siemens AG last September opted to merge its rail business with France’s Alstom SA instead of Bombardier’s rail unit, leaving Bombardier facing a challenge to compete in a market dominated by China’s state-owned CRRC, the world’s largest train maker, and the combined Siemens and Alstom group.

Sabia was speaking after Canada’s second-biggest public pension plan reported a 9.3 percent return on its clients’ funds in 2017, helped by a strong performance from its equities investments.

The Caisse, which invests on behalf of workers and retirees in the Canadian province of Quebec, has a near 30 percent stake in Bombardier’s rail division, which has a $33 billion backlog and reported strong earnings last week.

However, earlier this month, it missed out on a contract to provide rail cars for one of the world’s biggest light rail systems in Montreal, a project led and financed by the Caisse, its largest independent shareholder.

Ontario transit agency Metrolinx also cut its vehicle order from Bombardier following a dispute over Bombardier’s ability to fulfill its contract.

“The core challenge (for Bombardier) is improving execution,” Sabia said.

The Caisse also has a 2.5 percent stake in the parent.

The Caisse said its net assets totaled C$299 billion ($236 billion) at the end of 2017, up from C$271 billion a year earlier.

The fund has diversified to become one of the world’s biggest investors in infrastructure and real estate as well as a major investor in global equity and fixed income markets.

Sabia said it was positioned to take advantage if the prices of assets decline.

“If a correction arises I would see that as a very significant opportunity,” he said. “We have the flexibility to move substantial capital from one or two asset classes into others.”

Sabia said the Caisse was looking at possible investments in blockchain technologies but dismissed the idea of investing in bitcoin.

“I‘m not signed up for lottery tickets. That’s what I think bitcoin pretty much is,” he said.
Lastly, Ross Marowits of the Canadian Press reports, Caisse ready to pounce as market fragility makes it open for correction:
The fragility of global markets caused by soaring stock prices has opened the door to a correction that Quebec’s Caisse de depot pension fund manager is ready to pounce on, CEO Michael Sabia said Wednesday.

“If a correction arrived to be honest with you, I would see that as a very significant opportunity,” he said during a news conference about its improved 2017 results.

The Caisse said it earned a 9.3 per cent return in 2017, ending a three-year streak of decreasing returns. The performance marginally surpassed its reference index and compared with a 7.6 per cent return in 2016.

Unlike the situation during the economic crisis of 2008-2009, the large institutional investor has the flexibility to move substantial capital between asset classes to benefit from a fall in stock prices, Sabia said.

Although economic growth is strong and largely synchronized around the world, he said markets are fragile, making them more susceptible to shocks from unexpected interest rate increases or a geopolitical crisis.

“Because of that fragility that we see in the markets today, we’re very focused on this fundamental principle of resilience so that we’re ready in the event that something does change in the markets,” he told reporters.

The U.S. faces the possibility of higher interest rates to curb inflation, he said, but urged the Canadian government to be “measured” in its response to lower U.S. corporate taxes or contentious trade disputes.

“I don’t think there’s an immediate need for significant reaction with respect to the Canadian tax system,” he said.

The federal budget is scheduled for Feb. 27 but Finance Minister Bill Morneau has said that the government has no plans to “act in an impulsive way” in response to tax cuts south of the border.

In response to questions from reporters, Sabia said the Caisse isn’t looking to invest in marijuana stocks or the Bitcoin, which he likened to lottery tickets.

Total Caisse assets as of Dec. 31 were $298.5 billion, up $24.6 billion in one year, while net deposits totalled $3.2 billion.

Its eight main clients received returns between eight and 10.9 per cent last year.

Returns were $110 billion over five years for a 10.2 per cent annualized return over the period. Net assets have increased by $122 billion since 2012, including $12.6 billion from its clients.

In 2014, the fund manager posted a return of 12 per cent, marking the beginning of a three-year streak of decreasing returns. It finished 2015 with a return of 9.1 per cent and 7.56 per cent in 2016.

Equities did the heavy lifting last year, rising 13.6 per cent to $149.5 billion, while fixed income was up 3.5 per cent to $96.7 billion. Real estate increased 8.7 per cent to $50.4 billion.

Real estate was the only portfolio that failed to exceed its reference index. However, Ivanhoe Cambridge CEO Daniel Fournier said it faced heavy competition from sovereign and international pension funds and the impact of the shared economy.

“A return of eight per cent is more than respectable in our sector for the years to come,” he said.

The Caisse said it has diversified its geographic exposure over the last five years by expanding global presence and more than doubling its exposure in growth markets.

Canada’s second-largest pension fund manager made $6.7 billion in new investments with Quebec’s private sector, which it said is the main driver of the economy and jobs. It is now a partner with more than 750 companies based in the province.
Remember, unlike other large Canadian pensions, the Caisse has a dual mandate to achieve its required actuarial return and to promote Quebec's economy. And both these mandates need to be profitable over the long run.

You can also read Nicolas Van Praet's Globe and Mail article on the Caisse's 2017 returns here. From that article, I note the following:
Over nine years as Caisse boss, Mr. Sabia has helmed a sweeping strategic shift that has seen the pension fund expand its international investments while increasing its exposure to what it calls more concrete, "less liquid" assets such as real estate in a bid to generate more stable returns. At last count, about 60 per cent of the Caisse's asset exposure was outside Canada.

Emerging-market equities did particularly well for the Caisse last year, generating a return of 28.4 per cent. Chinese and South Korean markets made up the bulk of the gains, boosted by the information technology sector as smart selection by external investment advisers paid off. Big stock holdings for the Caisse in Asia include positions in Chinese internet giants Alibaba, Tencent and Baidu.

The Caisse's two equity portfolios generated combined returns of 13.6 per cent for 2017. So-called "real assets," like infrastructure and real estate, returned 8.7 per cent while fixed income returned 3.5 per cent.

Among Mr. Sabia's highest priorities right now is the renamed Réseau Express Métropolitain (REM), a $6.3-billion light rail transit system cutting across Montreal that the Caisse is shepherding as the project's manager and main financier.

The CEO has already met with a handful of U.S. state governors to explain the greenfield infrastructure project and promote the Caisse's model. That approach reverses the typical government-leads scenario for big public works projects and sees the pension fund take the helm while Quebec and Canada participate as minority investors.
And the Globe and Mail article ends with this interesting note:
Mr. Sabia's mandate as Caisse president and CEO was renewed last year until March, 2021. No changes were made to his compensation.

The pension fund still hasn't hired a replacement for chief investment officer Roland Lescure, who left nearly a year ago to help Emmanuel Macron become president of France. Mr. Sabia said it was never his intention to replace Mr. Lescure with one person and that a broader shakeup of the senior ranks is coming as the Caisse seeks to build its capability. Mr. Lescure was elected to France's National Assembly and now sits as the representative of French residents living in Canada and the United States.
So, this answers my question of why the Caisse has yet to name a replacement for Roland Lescure.

You'll recall last week I covered the Caisse's $300 million REM cost overrun, dispelling many myths on this project:
 A few key points I want to make here:
  • The price tag of this project moved up to $6.3 billion, but this isn't a $300 million cost overrun. Basically, the CDPQ Infra group had estimated costs for constructing and for operating this project and went out to get bids (a very competitive bidding process). 
  • The group came a little short on its estimates of the capital expenditure of the project, so when the bids came in for construction, they fell short by $300 million, well within the normal margin of error for a mammoth infrastructure project of this size
  • However, the group overestimated the cost of operating this project so even though their estimates of capital expenditures were lower than the bids, the estimates of operating were higher than the bids, so it will cost less to operate meaning the margins are higher
  • Importantly, over the long run, this extra $300 million which the Caisse is kicking in as an equity stake (not debt, the Caisse isn't borrowing to fund this project) to construct this project is trivial if user fees stay as planned. Moreover, the lower operational/ maintenance cost will offset this higher capital expenditure, allowing the Caisse to generate an 8-9% annualized return for Quebecers over the long run (see Michael Sabia's interview below).
  • These are subtle but critical points which have been lost or glossed over by the media as they rush to claim "the price tag will be $300 million higher and the project is delayed by a year."
By the way, the media got that wrong too, the first phase of the project will commence in 2021, it's impossible for the entire project to be ready and operational by 2021.
It's funny because just today I had lunch with a wise former employee of the Caisse and he asked me: "Where does Michael Sabia come up with his 8%-9% projected returns on the REM and where is the independent governance on this project? Why don't they nominate an independent board to oversee it?"

I actually shared these concerns with an expert who told me as far return projections, "concessions were making 12-13% annualized with no revenue risk, so the return projections sound right."

On the governance, he said: "The Caisse assumes all the risks of the REM. The Quebec and federal government have contributed a sizable amount but once the project gets going, it's off their balance sheet. For them, it's an investment and they will both earn a return. The Caisse put over 50% equity in this project and assumes all the risks. I don't understand why an independent board overseeing this project is needed if the Caisse assumes all the risks. That doesn't make sense. Moreover, alignment of interests are there and if they do a great job, everyone walks away happy."

Anyway, the Caisse's 2017 results are out and you can read the press release here. It's important to note the full 2017 Annual Report is not available yet. It will be available in mid-April and when it is you can read it here.

From the press release, it's important to emphasize long-term (5-year) results:


It's not just that compensation is based on these long-term results, it's also that these are the results that ultimately matter for depositors and Quebec pensioners.

The press release states:
La Caisse focuses on equities that provide stable and predictable returns to reduce sensitivity to market highs and lows. In 2017, la Caisse’s return reflects strong equity market performance, but does not fully capture the surge in multiples for tech companies and companies with an accelerated growth profile. Conversely, la Caisse’s portfolio should also provide greater resilience in volatile markets.

Detailed information on the returns of each asset class is provided in the fact sheets included with this news release.
The most important table is the one below showing returns by asset class over the last five years and for 2017 (click on image):


A quick glance shows me that apart from Emerging Markets stocks, Private Equity really performed well in 2017, returning 13% versus a benchmark return of 10.5%. I also noted solid performance in Real Assets (Real Estate and Infrastructure) and decent performance all around except for Canadian Equities (Canadian mandate) which underperformed the index by 100 basis points in 2017 (but outperformed it by 150 basis points over the last five years).

Unfortunately, I can't get into more details as the 2017 Annual Report isn't available yet. When it is in mid-April, you will be able to read more details here, including details on compensation, benchmarks, and a lot more.

One thing I was curious to know is whether F/X cost the Caisse returns given the decline in the US dollar in 2017. I'm not sure if the Caisse partially of fully hedges foreign exchange risk, I know CPPIB and PSP don't so their performance will be impacted by the decline in the US dollar last year.

Other than that, it was another solid year for the Caisse but it will be interesting to see how the portfolio withstands a real correction that lasts. Just like CPPIB and others, I'm sure the Caisse bought the last correction.

Below, CTV News Montreal reports the return for Quebec's pension fund, the Caisse de Depot, was up in 2017 to 9.3 per cent, two points higher than in 2016.