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Highlights of our External Program Alain Bergeron, M.Sc., CFA

Highlights of our External Program Alain Bergeron, M.Sc., CFA. Who We Are. CPP Investment Board Created in December 1997 First investments in March 1999 Crown corporation operating at arm’s length from government – independent, but accountable Clear fiduciary mandate

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Highlights of our External Program Alain Bergeron, M.Sc., CFA

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  1. Highlights of our External ProgramAlain Bergeron, M.Sc., CFA

  2. Who We Are CPP Investment Board • Created in December 1997 • First investments in March 1999 • Crown corporation operating at arm’s length from government – independent, but accountable • Clear fiduciary mandate • Provide cash management services to the Canada Pension Plan to pay benefits

  3. CPP Reserve Fund Projected Assets ($ billions) Fiscal year ending March 31 200 180 Asset Transition Period* 160 CPP Bonds and Cash in Ottawa CPP Investment Board Assets 140 120 100 80 60 * CPP bonds and cash currently administered by the federal government will be transferred to the CPP Investment Board during this period 40 20 0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 ACTUAL FORECAST

  4. External Active Program Objectives • Increase portfolio efficiency • Leverage external talent and ideas

  5. Active Management: The Promise E(R) σ

  6. Active Management: The Reality In aggregate, the frontier cannot increase. E(R) σ * Provided active management is properly defined.

  7. Today’s Presentation… Focus on three areas of distinctiveness* • Estimating managers’ skill • Ensuring efficient implementation • Ensuring appropriate manager compensation * This list is by no means exhaustive.

  8. Estimating managers’ skill

  9. How should one estimate it? Track record? How do we Define Skill? Skill The ability to execute positive expected value strategies (net of all costs) by identifying and taking advantage of asset mispricing.

  10. Skill Versus Luck Lucky Unskilled Skilled Unlucky Probability of under-performing benchmark* • Assume we could measure active managers skill and luck InsufferableManagers BlessedManagers DoomedManagers ForlornManagers * At the end of n years.

  11. The Fundamental Law of Active Management* where IR: Information Ratio IC: Information Coefficient TC: Transfer Coefficient In other words… IR: Skill IC: Forecasting ability TC: Portfolio Construction/Trading Breadth: Number of independent forecasts *Generalization of Richard C Grinold and Ronald N Kahn original work.

  12. Breadth Plays a Major Role

  13. 2. Ensuring efficient implementation

  14. +5% Long Security B -5% Short Security C Active Overlay Portfolio Total Portfolio = + Passive Portfolio An Active Portfolio lays over the top of another Portfolio • Example (simplified): • Passive portfolio with 4 securities (equally weighted) • Active manager thinks security ‘B’ will outperform security ‘C’

  15. Advantages • Removes the “long-only” constraint • Efficient use of large pool of assets • Increases internal flexibility • Active managers focus on adding value where they have skill • Simplified risk monitoring and performance measurement

  16. Disadvantages • Smaller universe of managers • Not all strategies are well suited to overlays • Operationally more challenging

  17. 3. Ensuring appropriate manager compensation

  18. With Traditional Fee Structures: • How much is one paying (% of alpha)? • How much is one paying for luck? • Do they provide the right incentives? “Most of economics can be summarized in four words: 'People respond to incentives.' The rest is commentary.” -- Steven E. Landsburg

  19. Our Fee Structure • Aligns interests • Minimizes moral hazard • Pays for skill • Minimizes the confidence needed in beliefs • Creates positive self-selection bias

  20. The Fundamental Law… … Generalized to an External Program context: IC : - Ability to estimate managers’ skill TC : - Implementation Efficiency - Portfolio Construction Breadth : - Number of independent forecasts in the program

  21. Concluding Comments • Generating Alpha is very difficult • To maximize expected alpha*, we chose a road less traveled… • Low weight to historical performance • Overlay implementation, even for physical equities • Negotiated a more efficient fee structure * Risk Adjusted, and properly defined.

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