Investing insights From the Canada Pension Plan

You or I may never manage a portfolio as massive as the Canada Pension Plan Investment Board’s (CPPIB) 188 billion in assets but we can learn a thing or two on how to invest our own money from the manner in which the CPPIB invests our surplus Canada Pension Plan contributions. Here are some highlights from the CPPIB 2013 Annual Report (available both online and in PDF formats).

Highly Diversified

The CPP Fund is invested in a three main asset classes — 50 percent in Canadian and Global public and private equity markets, 33 percent in fixed income and the rest in real assets like real estate and infrastructure. Retail investors may have the resources to invest profitably in private markets but we can capture broad market exposure to the main asset classes through mutual funds and direct holdings in stocks, bonds and real estate securities.

Equity Orientation

In as little as eight years, the Canada Pension Plan will start tapping into the CPP Fund to cover the shortfall between contributions and benefit payments. Even so, the CPP Fund has just 33 percent of its assets in fixed income investments for this reason:

History and expert opinion indicate that the investment returns required for CPP sustainability can be achieved only by taking a measured degree of risk. By far the most important single investment risk is the extent to which equity investments replace fixed income.

Investing a large percentage of one’s assets in equities also makes sense for individual investors who have a long time horizon and are able to handle any short-term volatility.

A Global Approach

The CPP Fund has just 17 percent of its equity portfolio allocated to Canadian stocks. One reason, which does not apply to retail investors, is that the fund’s gargantuan portfolio places limits on its participation in the Canadian market. But there is another reason for investing globally that is relevant to us:

Extending equity and debt investments across the world reduces the CPP Fund’s dependence on returns in any one country or region and hence reduces risk.

As Canadian residents, our job prospects, our housing market and the health of our pensions and Government transfers already depend a great deal on the Canadian economy. Therefore, it is prudent for us to take spread our investment bets globally.

Currency Diversification

It is interesting to note that the CPPIB does not hedge the foreign currency exposure in its equity portfolio. The CPPIB makes a very good case that individual investors will be well served by getting exposure to foreign markets as well as foreign currencies.

For foreign equities, however, the currency impact of exchange rate fluctuations on the volatility of total returns is minimal. By far the largest component of that volatility arises from the local equity market returns themselves. We see little reason to expect a sustained long-term trend to net returns from exchange rate movements for the widely diversified set of currencies associated with the Fund’s equity holdings. If a country persistently has substantially higher inflation than others, investors will demand a risk premium against the likely decline of its currency.

Also, the cost of hedging many growth markets’ currencies is prohibitively high. And, if these countries prove to have a significant long-term advantage in productivity and economic growth, their currencies will tend to strengthen vis-à-vis those of developed countries. Hedging would negate this potential gain to the Fund.

Finally, the Canadian dollar is highly linked to the price of oil and, to a lesser extent, other commodities. In principle, it is prudent to diversify currency exposure away from such a dominant but uncertain influence. Hedging would unduly tie Fund returns to the price of oil and other commodities as they drive the foreign exchange value of the Canadian dollar. Also, looking out over the long term, the primary asset that offsets CPP liabilities is the future contributions of CPP participants. If the Canadian dollar strengthens versus other currencies, it will most likely be accompanied by strength in the Canadian economy, and rising earnings – and hence plan contributions – of the CPP participants. This represents a natural hedge in the structure of the CPP, greatly reducing the need for explicit currency hedging of the foreign investments of the CPP Fund.

Active Management

The CPP Fund has a significant allocation to active management. The CPPIB has a large in-house investment team and also works with external managers. Small investors who actively manage their portfolios should note that the CPP decides to look for alpha only if it can reasonably expect additional returns to justify the extra cost and complexity of active portfolios. The CPP also carefully benchmarks the risk and returns of active management against a reference portfolio of broad market indices.

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