Public Market Investments: External Active Management Program (August, 2005)

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Highlights of our External Highlights of our External ProgramProgram

Alain Bergeron, M.Sc., CFAAlain Bergeron, M.Sc., CFA

Who We AreCPP 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

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($ billions) Fiscal year ending March 31200

ACTUAL FORECAST

180

160

140

120

100

80

60

40

20

0

CPP Bonds and

Cash in Ottawa

CPP Investment

Board Assets

* CPP bonds and cash

currently administered

by the federal

government will be

transferred

to the CPP Investment

Board during this period

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

Asset

Transition

Period*

CPP Reserve Fund Projected Assets

Public Market Investments: External Active Management Program (August, 2005)

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External Active Program Objectives

Increase portfolio efficiency

Leverage external talent and ideas

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Active Management: The Promise

E(R)

σ

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Active Management: The Reality

* Provided active management is properly defined.

In aggregate, the frontier cannot increase.

E(R)

σ

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1. Estimating managers’ skill

2. Ensuring efficient implementation

3. Ensuring appropriate manager compensation

* This list is by no means exhaustive.

Today’s Presentation…

Focus on three areas of distinctiveness*

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1. Estimating managers’ skill

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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?

How do we Define Skill?

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Skill Versus Luck

• Assume we could measure active managers skill and luck

Probability of under-performing benchmark*

BlessedManagers

ForlornManagers

DoomedManagers

Lucky

Unlucky

SkilledUnskilled

InsufferableManagers

* At the end of n years.

1 Year 2 Years 3 Years 4 Years 5 YearsIR=0.25 40% 36% 33% 31% 29%IR=0.50 31% 24% 19% 16% 13%

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The Fundamental Law of Active Management*

whereIR: Information RatioIC: Information CoefficientTC: Transfer Coefficient

BreadthTCICIR

In other words…IR: SkillIC: Forecasting abilityTC: Portfolio Construction/TradingBreadth: Number of independent forecasts

*Generalization of Richard C Grinold and Ronald N Kahn original work.

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Breadth Plays a Major Role

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0 50 100 150 200 250 300 350 400 450 500

Breadth

E(I

R)

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2. Ensuring efficient implementation

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• Example (simplified): – Passive portfolio with 4 securities (equally weighted)

An Active Portfolio lays over the top of another Portfolio

0

5

10

15

20

25

30

A B C D

Passive Portfolio

=

0

5

10

15

20

25

30

A B C D

+5%

-5%

Total Portfolio

-15

-10

-5

0

5

10

15

A B C D

Active Overlay Portfolio

+

Long Security B

Short Security C

– Active manager thinks security ‘B’ will outperform security ‘C’

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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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Smaller universe of managers

Not all strategies are well suited to overlays

Operationally more challenging

Disadvantages

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3. Ensuring appropriate manager compensation

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How much is one paying (% of alpha)?

How much is one paying for luck?

Do they provide the right incentives?

With Traditional Fee Structures:

“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:

IC : - Ability to estimate managers’ skill

TC : - Implementation Efficiency - Portfolio Construction

Breadth : - Number of independent forecasts in

the program

BreadthTCICIR

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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.