public market investments: external active management program (august, 2005) 1 highlights of our...
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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
3Public Market Investments: External Active Management Program (August, 2005)
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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.