The CPP and better beta

In a case study for the Rotman International Journal of Pension Management, Don Raymond, senior vice-president of public market investments with the CPPIB, explains how the fund finds the sweet spot between alpha and beta.

“Starting with the cornerstone liquid asset classes within the reference portfolio, the Better Beta Portfolio adds additional sources of market-based returns to provide the benefit of increased diversification, as well as potentially higher returns to the overall portfolio,” says Raymond. “Examples of additional sources of beta include private debt, infrastructure, and real estate.”

In what Raymond refers to as the “total portfolio approach,” the fund strives for optimal efficiency by considering prospective investments in terms of their marginal risk and return contribution to the total portfolio. Using this approach, specific weightings for individual asset classes are not targeted. Instead, the fund focuses on the risk/return attributes of proposed investment strategies to allocate active risk.

“Private equity, for example, is considered a security selection strategy within equities and not an asset class by itself,” says Raymond. “Most organizations manage their private and public equity portfolios largely independent of one another. We manage these in an integrated fashion based on the belief that if returns from private equity were continuously observable, then these would be reasonably highly correlated to the public equities in the same sector and geographic region. There would also be a time-varying liquidity premium (modest in the early years but quite large today) and company-specific returns and risks.”

“This belief,” he adds, “is justified by the fact that private and public companies in the same sector and geographic region are subject to the same macroeconomic forces and that public markets often serve as an exit mechanism for private equity investments.”

So how does it all work in practice? Using the example of a $200-million buyout in the technology sector in the U.S., Raymond explains that the process would be the same whether the investment was the result of a capital call from one of the fund’s external investment fund partners, a co-investment with the partners, or a direct investment made by the board’s internal direct-investing team.

“The investment would be funded by selling $200 million of a market capitalization basket of publicly traded American technology stocks,” he says. “The private equity investment is benchmarked relative to this passive public equivalent, and, provided it outperforms the benchmark, it has added value to the portfolio.”

Real life, he points out, is a little more complicated than this, as the different leverage inherent in private equity is taken into account by selling a beta-adjusted quantity of public equities and buying beta-neutralizing bond exposure. Also, infrastructure investments—a broad range of assets with very different risk/return characteristics—would be funded and benchmarked accordingly.

As an example, Raymond explains how established assets with low earnings volatility—such as water distribution networks and toll roads—are relatively low-risk and would be funded and benchmarked primarily with fixed income components of the reference portfolio. Conversely, the higher risk associated with developing and building new infrastructure would be funded from a combination of equity and debt.

“Categorizing investments by risk/return attributes rather than traditional labels offers a better appreciation of the expected contribution of each investment to the portfolio and permits a more accurate assessment of actual outcomes,” he says. “This also presents a substantial organizational challenge, as it requires nearly seamless integration of the three investment departments with the portfolio design and investment research and operations departments. This, in turn, requires a culture that values teamwork and constant communication, combined with supporting risk and performance reports.”

The bottom line is that it is much easier to describe than to implement in practice. In terms of compensation, the internal managers of the alpha portfolios are compensated based on four-year rolling returns, in an effort to “strike a balance between the long-term investment mission and a reasonable accountability time frame.” Bonuses—a four-letter word these days—are only handed out after costs have been recouped.

A deliberate trade-off made by the CPPIB was to define the reference portfolio as a key attribution point for determining value added due to management decisions, says Raymond.

“While in theory a single-step process to portfolio construction (e.g., net liabilities to actual portfolio) is optimal when compared with a two-step process (e.g., net liabilities to reference portfolio and then reference portfolio to actual portfolio), the practical benefit is a system of clear management accountability. Continued diligence and focus by the board and management on the reference portfolio is, therefore, critical to achieving the long-term mission of the CPP Investment Board.”

To comment on this story, contact us.