CPBI Saskatchewan Regional Council Alternative Investments - Worth the Effort?

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1 CPBI Saskatchewan Regional Council Alternative Investments - Worth the Effort? PREPARED BY: Brendan George, Partner, George & Bell Consulting Inc. November 18 and 19, 2015

2 Agenda Current Economic Environment Overview of Alternatives History of Alternative Investments in Canada Reasons to Invest Recent Alternatives Trends: Portable Alpha Fees Liquid alternatives Socially Responsible Investing (SRI) Lending funds Use within H&W Trusts Co-investment funds Use within DC Pension Plans Case Studies: Public Sector Plan Private Sector Plan Conclusions Questions 2

3 Current Economic Environment Low inflation and low real GDP growth Record low interest rates (current 30-year Canadian bond yield = 2.4%) Volatile equity markets High correlation of equity markets (remember 2008?) Volatile currencies Traditional 60/40 equity/bond asset mix looks scary Institutional investors looking for new solutions: alternatives 3

4 Definition of Alternative Investments Everything apart from publicly-listed stocks and bonds Includes: Private Debt Infrastructure Debt Real Estate Timber Commodities Managed Futures Hedge Funds Infrastructure Equity Private Equity Farmland Gold Could Include: Mortgages Global Bonds High Yield Bonds Emerging Markets Equity/Debt 4

5 Reasons to Invest in Alternative Investments Increase fund s rate of return Decrease fund s investment risk Provide better match to plan liabilities (reduce assetliability risk) Increase investment income/yield Gain exposure to non-mark-to-market assets 5

6 Annualized Return Forecasted Risk-Return 10% 9% Expected Future Risk/Return 10-year Time Frame Private Equity 8% 7% Infrastructure Global Equities Emerging Market Equities 6% Real Estate Canadian Equities 5% 4% Hedge Funds High Yield Bonds Commodities 3% Mortgages Real Return Bonds 2% 1% Money Market Universe Bonds Long-Term Bonds 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% Standard Deviation Source: George and Bell 10-year capital market expectations 6

7 Canadian Money Market (T-bill) Mortgages Universe Bonds Long-Term Bonds High Yield Bonds Real Return Bonds Canadian Large Cap Equities Global Large Cap Equities Emerging Market Equities Commodities (Hedged) Canadian Real Estate (Direct) Infrastructure (Direct) Private Equity Absolute Return / Hedge Funds Asset Class Correlations 10 Year Expectations Canadian Money Market (T-bill) 1.0 Mortgages Universe Bonds Long-Term Bonds High Yield Bonds Real Return Bonds Canadian Large Cap Equities Global Large Cap Equities Emerging Market Equities Commodities (Hedged) Canadian Real Estate (Direct) Infrastructure (Direct) Private Equity Absolute Return / Hedge Funds Source: George and Bell 10-year capital market expectations 7

8 Real Estate Pros Attractive returns (e.g., 5% to 8%) Low correlations with traditional investments Low return volatility, returns are driven by appraisals Some inflation protection Cons High fees and administration expenses (approx. 1%) Low liquidity Decreasing capitalization rates 8

9 Infrastructure Pros High expected absolute returns (e.g., 7% to 9%) High expected cash yields (e.g., 5% to 7%) Income generated from assets may be used to match cash outflows Partial hedge against inflation Cons High fees (e.g., 1.5% plus 15% of outperformance over 8%); lower fees with direct or co-investments Low liquidity (better with listed infrastructure funds) Many attractive infrastructure investments are located outside of Canada (currency risk) Complex due diligence process and monitoring Exposure to other risks (e.g., business and political) 9

10 Private Equity Pros High absolute returns Wide array of investment opportunities Cons Low liquidity High return volatility Increased due diligence (manager selection is important) High fees Large minimum investment size 10

11 Canadian Pension Plan Allocations to Alternatives 60% 50% 40% 30% 20% 10% % Alternatives Fixed Income Equity Source: Pension Investment Association of Canada (PIAC) Asset Mix Reports ( ). Data represents over 100 reporting DB plans with total assets (2014) in excess of $1.4 billion. 11

12 Canadian Pension Plan Allocations to Alternatives 35% 30% 25% 20% 15% 10% 5% % Real Estate Venture Capital/Private Equity Infrastructure Other Assets Hedge Funds Alternatives Source: Pension Investment Association of Canada (PIAC) Asset Mix Reports ( ). Data represents over 100 reporting DB plans with total assets (2014) in excess of $1.4 billion. 12

13 Challenges with Alternative Investments Illiquid Legal Complexity Increased Due Diligence: Manager Selection is Important Lack of Historical Data (Modelling and Risk Budgeting is More Difficult) Lack of Performance Benchmarks and Manager Universes Increased Performance Monitoring Increased Committee Time and Education Increased Internal/Consultant Resources Appraisal-based Pricing Large Minimum Investment Size Lack of Diversification High Fees Governance Transparency Maintaining Target Allocations Currency Risk 13

14 Typical Implementation Process (up to 2 Years) Decide on Reason to Consider Alternatives Board/Committee Education Select Short-list of Alternatives for Consideration (Appendix A: Checklist) Model Impact on Fund Risk/Return Set Policy Asset Mix ($, %, Geography, Currency Exposure) Decide on Investment Vehicles: direct, pooled, segregated, fund-of-funds Set Timing Schedule for Investments Manager Due Diligence and Selection Contract and Fee Review Select Performance Benchmark Initial Funding Ongoing Cash-Flow Management and Monitoring Annual Review of Actual vs. Target Asset Mix 14

15 Reasons to Invest: Return Enhancement Ideas to improve fixed income returns in low interest rate environment: High yield bonds: below investment grade (BBB) Mortgages: loans on real estate Private debt: long-term debt, no ability to trade Emerging markets debt: loans to developing economies Core plus bonds: include all elements of fixed income strategies above Risks: credit, illiquidity, sensitive to economy 15

16 Reasons to Invest: Return Enhancement Ideas to improve equity returns: Emerging markets equity: publicly traded, developing economies Private equity: invest in private companies (some start-ups) Risks: currency, stock market volatility, illiquidity 16

17 Reasons to Invest: Risk Reduction Ideas to reduce volatility and downside risk in portfolio: Reduce public equity exposure to invest in: Real estate Infrastructure Commodities Timber Hedge funds Farmland May result in lower returns Risks: illiquidity, manager skill, appraisal pricing 17

18 Recent Alternative Trends Portable Alpha Liquid alternatives Lending funds Co-investment funds Fees SRI Use within H&W Trusts Use within DC Pension Plans 18

19 Portable Alpha Strategy separates the alpha (manager skill) and beta (index return) components of returns; i.e. success of the strategy depends on the manager s skill Examples: Manager purchases securities and uses derivatives to remove market exposure; i.e. left with manager value-added over index (alpha) Use of derivatives to gain exposure to long-bond rates, actual assets invested in alpha source such as hedge funds Use of derivatives: futures, forwards, options, swaps, repos 19

20 Liquid Alternatives Mature DB plans have negative cash-flows (benefits > contributions); need to generate income or sell assets to pay benefits Limits ability to invest in illiquid assets Potential solutions: High-yielding alternatives: real estate, mortgages, infrastructure, high yield bonds, private debt Liquid alternatives: REITs, listed infrastructure, commodities 20

21 Lending Funds A fund that provides loans directly to corporate borrowers Borrowers are typically small to medium size companies Advantageous in markets where there is a funding gap left behind by banks (e.g., Europe after the 2008 financial crisis) Alternative to fixed income investments: higher risk and return Credit quality of borrowers: below investment grade Loans are usually floating rate Low correlation to public debt and private equity 21

22 Co-investment Funds Co-investment: a number of investors join together to invest in large assets Historically popular in private equity funds: managers offered clients the ability to invest in a sub-set of particular companies Co-investment opportunities now offered in infrastructure: Large Canadian funds (e.g. CPP) offer opportunities to other smaller funds Some pooled funds offer co-investment opportunities to clients for specific assets 22

23 Fees Historically high fees charged on hedge funds, infrastructure and private equity: 2% asset-based fees 20% performance-based fees Fees charged on committed capital Acquisition and disposition fees Recent improvements due to competition and 2008 financial crisis: Lower flat fees Lack of performance fees Fees on invested capital instead of committed capital Removal of acquisition and disposition fees Large public sector funds offer alternative investment services to other plans e.g. OMERS, bcimc 23

24 Socially Responsible Investing (SRI) Historically little consideration of Environmental, Social & Governance (ESG) factors in alternatives Recent ESG considerations: guidance for investors published by SHARE in Canada and UNPRI globally, changes to Ontario PBA ESG factors can be built into fund manager due diligence, selection, reporting and monitoring Real estate: labour practices, LEED certification, health & safety, procurement of services Mortgages: environmental impact of real estate 24

25 Socially Responsible Investing (SRI) Infrastructure and private equity: Improve governance of fund management firms Fund managers can control underlying investments; can follow similar policies to public equities Challenges for ESG: blind pools, fund-of-funds Hedge funds: Improve governance of fund management firms ESG challenging: short-term investment periods, short-selling, transparency, compliance 25

26 Use Within H&W Trusts Differences from pension plans: Smaller funds Shorter duration liabilities Investment income sometimes taxable Use of alternatives is limited to: Mortgages Real estate Infrastructure 26

27 Use Within DC Plans Alternatives common within asset allocation funds, target date funds and custom balanced funds (improved diversification) Asset class funds: Ensure fund choices are understood by members Canadian real estate and mortgages have long histories in DC Plans Recent additions: Global bonds Direct real estate Listed infrastructure 27

28 Case Study 1: Public Sector DB Plan Plan Characteristics: $2 billion in assets Open to new members CPI-indexed pensions Exempt from solvency test Small funding deficit Long time horizon Positive cash-flows Focus: stability of member and employer contribution rates Investment Strategy: Invest for long-term return (CPI+3.5%) Reduce investment risk by diversifying away from traditional equities and bonds 28

29 Case Study 1: Public Sector DB Plan Alternatives of Interest: Canadian real estate: Core open-end pooled fund investments with multiple fund managers Limited number of direct investments and co-investments Global real estate: Open-end pooled fund investment with one fund manager Designed to ensure diversification and minimize withholding tax drag Infrastructure: Developed implementation strategy and pacing schedule Combination of closed-end pooled funds with different fund managers Limited number of secondary funds and co-investments Private Equity: Developed implementation strategy and pacing schedule Initially: fund-of-funds to achieve diversification Now: selection of direct funds split by vintage year, geography and manager 29

30 Case Study 2: Private Sector DB Plan Plan Characteristics: $100 million in assets Closed DB Plan Plan expected to be 100% retirees in 10 years Large solvency deficit Employer funds deficits Negative cash-flows Focus: minimize employer contributions; achieve 100% solvency ratio within 10 years Investment strategy: Risk reduction: increase fixed income weight and duration to better match plan liabilities Glidepath implemented; investment risk reduces as solvency ratio improves (no re-risking) Eventual purchase of annuities and plan wind-up 30

31 Case Study 2: Private Sector DB Plan Alternatives of interest: Canadian mortgages: Liquid, open-end pooled fund Monthly liquidity Manage allocation to target a specific duration for whole fixed income portfolio Canadian real estate: Liquid, open-end pooled fund 6-month liquidity Manage reduction in allocation over time Infrastructure: Pooled fund of listed global infrastructure securities Daily liquidity Reduce weight over time 31

32 Conclusions Are Alternatives worth the effort? Yes Not all Alternatives are the same Review purpose of new asset classes: increase return or reduce risk Some asset classes will not meet your objectives 32

33 Questions? 33

34 Appendix A 34

35 35

36 CPBI Saskatchewan Thank-you!

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