Highlights of our External Program
Alain Bergeron, M.Sc., CFA
Public Market Investments: External Active Management Program (August, 2005)
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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
CPP Reserve Fund Projected Assets
($ billions) Fiscal year ending March 31
200
180
Asset
160
Transition
140
CPP Bonds and Cash in
Ottawa
Period*
120
CPP Investment Board
Assets
100
80
60
* CPP bonds and cash currently
40
administered by the federal
government will be transferred
20
to the CPP Investment Board
during this period
0
00
01
02
03
ACTUAL
04
05
06
07
08
09
10
11
12
13
14
FORECAST
Public Market Investments: External Active Management Program (August, 2005)
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3
External Active Program Objectives
Increase portfolio efficiency
Leverage external talent and ideas
Public Market Investments: External Active Management Program (August, 2005)
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Active Management: The Promise
E(R)
σ
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Active Management: The Reality
E(R)
In aggregate, the
frontier cannot
increase.
* Provided active management is properly defined.
σ
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Today’s Presentation…
Focus on three areas of distinctiveness*
1. Estimating managers’ skill
2. Ensuring efficient implementation
3. Ensuring appropriate manager compensation
* This list is by no means exhaustive.
Public Market Investments: External Active Management Program (August, 2005)
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1. Estimating managers’ skill
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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.
How should one estimate it?
Track record?
Public Market Investments: External Active Management Program (August, 2005)
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Skill Versus Luck
Probability of underperforming benchmark*
•
IR=0.25
IR=0.50
1 Year
40%
31%
2 Years
36%
24%
3 Years
33%
19%
4 Years
31%
16%
5 Years
29%
13%
Assume we could measure active managers skill and luck
Insufferable
Managers
Lucky
Blessed
Managers
Unskilled
Skilled
Doomed
Managers
* At the end of n years.
Forlorn
Managers
Unlucky
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The Fundamental Law of Active Management*
IR  IC  TC  Breadth
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.
Public Market Investments: External Active Management Program (August, 2005)
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Breadth Plays a Major Role
0.60
0.50
E(IR)
0.40
0.30
0.20
0.10
0.00
0
50
100
150
200
250
300
350
400
450
500
Breadth
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2. Ensuring efficient implementation
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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’
30
15
+5%
Long Security B
30
25
25
10
20
15
-5%
20
5
15
0
10
5
-5
0
-10
A
B
C
D
Passive Portfolio +
-15
A
B
C
10
D
5
0
Short Security C
Active Overlay
Portfolio
A
=
B
C
D
Total Portfolio
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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
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Disadvantages
Smaller universe of managers
Not all strategies are well suited to overlays
Operationally more challenging
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3. Ensuring appropriate manager compensation
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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
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Our Fee Structure
Aligns interests
Minimizes moral hazard
Pays for skill
Minimizes the confidence needed in beliefs
Creates positive self-selection bias
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The Fundamental Law…
… Generalized to an External Program context:
IR  IC  TC  Breadth
IC :
- Ability to estimate managers’ skill
TC :
- Implementation Efficiency
- Portfolio Construction
Breadth : - Number of independent forecasts in the program
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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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