IMCO's CEO On Measuring What Counts at Pension Funds
Many Canadian pension funds report annually on their net value add (NVA) — the extent to which their returns exceed chosen benchmarks, net of management fees and operating expenses. Sector observers sometimes treat this figure as a proxy for overall investment performance.
In recent years, many pensions have had to explain their negative NVA, particularly those with private assets that have tended to underperform public markets. In doing so, some pointed instead to their smoother long-term investment results as better indicators of overall investment performance.
But both NVA and return volatility are imperfect measures of investment success. NVA is hard to measure, typically quite small, and does not directly reflect pension objectives. And volatility does not reliably capture the risks that can impair long-term returns.
It may be time to assess pension performance through a simpler set of questions: Are target returns being met? Does the portfolio contain large risks? Are operations cost effective?
Overall return objectives as opposed to NVA
NVA can be useful when a strategy closely tracks its benchmark, such as with actively managed public equity mutual funds and their relevant indexes. It is less useful when the strategy differs materially from the benchmark, as is often the case with the private market strategies that represent a significant proportion of many pension portfolios.
NVA is also typically very small relative to total pension fund returns. CEM Benchmarking has reported that the 10-year average NVA across its pension fund database was just 18 basis points. The vast majority of overall returns are driven by investment decisions that have nothing to do with NVA, such as asset mix, asset class strategies, leverage, and currency exposure.
Most importantly, NVA says little about whether pensions are meeting the return objectives that flow from their liabilities. Rolling asset-class NVAs up into a total portfolio measure only shows performance relative to a mix of benchmarks. If the objective is to achieve a defined long-term return target, that target should be the primary measure of success.
Common secondary performance measures, such as comparisons with broad equity market indexes should, like NVA, also be approached with caution. Many indexes are too concentrated today to serve as realistic overall portfolio alternatives: US companies represent 63% of the MSCIACWI market cap; and the 10 largest US companies represent over 37% of the MSCI US index. And while peer fund comparisons can provide context for pension results, they should also be interpreted with care. Pension funds differ in term of their liabilities, inflows / outflows, risk tolerances, and investment strategies.
The best measure of investment performance for a pension is its own target return. Measures such as NVA, peer results, and broad market indexes can provide useful context, but none should be treated as a proxy for overall investment success.
Concentrations of risk as opposed to volatility
Pensions often prefer smoother year-over-year results, especially when they have net outflows. But return volatility is not a good proxy for the risks in a portfolio that can lead to weak long-term returns. Return smoothness may simply reflect exposure to private assets whose valuations adjust more gradually.
A better approach to assessing portfolio risk is to scan portfolios for the things that can create long-term problems like excessive leverage, large exposures to a single investment, manager, market segment, asset class, geography or currency, or inadequate safe harbours. This provides more insight into whether a portfolio has been well-constructed to achieve their target returns without taking excessive risk in any area.
Costs matter
Costs are a key input in any business, yet they are often overlooked in the investment industry. Returns are sometimes quoted before costs, high manager fees are common, and expensive operations are often tolerated. Pension costs deserve scrutiny because they directly reduce returns, are controllable in a way that markets definitely are not, often impact returns more than NVA, and reflect basic organizational discipline.
By themselves, common performance measures such as NVA and return volatility are imperfect gauges of overall pension performance. A more useful framework would focus on whether pensions are meeting their return objectives, avoiding large risks, and controlling costs. Things like NVA, peer results and return volatility can serve as context, but none is an adequate measure of success on its own.
Excellent comment by IMCO's CEO Bert Clark explaining the pitfalls of net value add (NVA) and return volatility and why "a more useful framework would focus on whether pensions are meeting their return objectives, avoiding large risks, and controlling costs."
One of the questions I get a lot is why we are paying senior executives at large Canadian pension funds millions in compensation if they cannot beat their respective benchmarks?
It's a fair question but it fails to address the risk side of the equation.
In an earlier comment, The Case for Avoiding Unnecessary Complexity, Bert Clark delved into why there are periods where concentration risk is high in an index and trying to beat it would entail taking unacceptable risk at a pension fund:
Big bets can also undermine the strategy of owning growth assets. Individual companies and market segments regularly reach excessively high valuations, then suffer steep drops in value with prolonged or no recovery. Japanese equities peaked in 1989, Nortel peaked in 2000, Russian equities peaked in May 2008, BlackBerry/Research In Motion peaked around 2008, U.S. technology stocks peaked in 2000, and North American REITs peaked in 2021. They all then fell in value. Some recovered over a very long time. Some are still recovering. Some will never recover.
A large allocation to any one of these companies or market segments would have materially detracted from an investor’s long-term portfolio returns. Avoiding the exuberance that can build around individual companies and market segments takes discipline. This is why IMCO explicitly avoids outsized allocations to any single asset class, sector, investment or theme.
He even states the following:
While the S&P 500 has been an effective way to gain diversified growth exposure over the last century, today investors with scale can build better diversified growth portfolios with exposure to both public and private assets, a balance of geographies and market segments (small-cap, large-cap, and different industries). At IMCO this is the approach we take.
Now, I want to make it clear: there is nothing wrong with adhering to a mostly passive strategy over the long run. This is what Norway's massive sovereign wealth fund has done since its inception, participating (more than others) in the bubbles when stocks surge and feeling the pain when a bear market strikes.
It does this in a very cost-effective way and many critics of the Maple 8 approach think our large pension funds should adopt the same passive model as Norway's Fund.
But as I keep stating, the objective function of a sovereign wealth fund isn't the same as that of a pension. The former wants to maximize returns over the long run while the latter wants to maximize returns without undue risk of loss. It's a subtle but important difference.
A pension fund starts with known liabilities over the next 75+ years and wants to make sure it has enough assets to cover those liabilities without placing the plan in a situation where a severe deficit occurs and members have to pay to make up the difference (which can happen).
So, when Bert Clark asks, "are target (actuarial) returns being met?", he knows that is ultimately what counts the most over the long run for any pension plan.
Now, I know there are critics who will tell me: "Leo, I get all that but when these pension funds are underperforming their own passive benchmarks over a three, four, and five-year period, there's a real problem with their strategy."
My answer is maybe there is, maybe there isn't; we need to measure a strategy over a longer period of time but I am also open-minded and see the structural changes impacting private markets large Canadian pension funds invest in.
And if there is a structural, long-term change impacting these markets, Canada's large pension funds will need to respond and figure it out.
That much I'm willing to admit and anyone who disagrees with me needs to really make their case.
Alright, let me wrap it up there but before I forget, IMCO announced a $300-million commitment to KingSett Real Estate Growth LP No. 9 (“KingSett LP9”), the ninth vintage of KingSett Capital’s Growth Fund strategy:
KingSett LP9 invests selectively across Canadian real estate sectors, including industrial, multi-residential, office and retail, with a focus on the Greater Toronto Area, Vancouver and Montreal. KingSett Capital (“KingSett”), a longstanding IMCO strategic partner, will seek to create value through leasing execution, operational improvements, structured capital solutions and asset-level repositioning. For IMCO clients, the investment provides targeted exposure to high-quality Canadian real estate assets that align with IMCO’s Real Estate strategy, supporting stable income and long-term value creation.
“Canada is a strategically important market for IMCO,” said Richard Varkey, Managing Director and Head of Real Estate at IMCO. “Through KingSett LP9, we gain access across the Canadian real estate market where we see attractive fundamentals, supported by KingSett’s skilled team and strong execution capabilities, as well as deep local insights. This investment supports our objective to deliver resilient performance in line with our clients’ long-term objectives.”
“We are pleased IMCO continues to be a core investor for KingSett, and that we are able to further expand our relationship through LP9,” said Rob Kumer, CEO, KingSett Capital. “IMCO’s collaborative and thoughtful approach reinforces our valued partnership as we pursue real estate investment opportunities across Canada.”
More broadly, IMCO invests approximately one-third of its assets under management in Canada across public and private markets, reflecting its commitment to supporting long-term client outcomes while contributing to the Canadian economy.
Good move, the folks at KingSett understand the Canadian real estate market better than most investors and it's good to leverage off their expertise.
Below, Ed Yardeni, Yardeni Research president, joins 'Squawk Box' to discuss the latest market trends, bond yields, state of the economy, and more.
Also, Adam Parker, Trivariate founder and CEO and CNBC contributor, joins 'Closing Bell' to discuss the 30-year treasury yield topping 5.33 percent.
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