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Pension Funds Review Investing Strategy.... Passive Approach Seen As Risky

By KAREN HOWLETT
Source: Ontario Teachers Pension Plan
Monday, December 3, 2001 - Globe and Mail Print Edition, Page B1

Two of Canada's biggest public sector pension funds are reviewing their passive investment strategies after finding that index funds are a lot riskier than executives had originally thought.

Both Ontario Teachers Pension Plan Board and Canada Pension Plan Investment Board are questioning long-held assumptions about index funds.

The theory that index funds generate more predictable returns is simply not true, said Leo de Bever, Ontario Teachers' senior vice-president of research and economics. Index funds simply mimic the performance of a market benchmark by replicating the stocks or bonds that make up an index. Fund executives are now finding that passive investing is much more volatile, and therefore risky, than they had predicted, he said. "We're coming to the conclusion that passive indexes are somewhat dangerous."

Teachers has been a big believer in index funds since it began investing in equities 11 years ago. The fund was restricted to holding all of its assets in provincial government debentures until 1990. Today, about three-quarters of its Canadian equity portfolio is invested in index funds tied directly to the Toronto Stock Exchange.

The fund giant's review will have a huge impact on the pension sector because other funds tend to follow its lead, industry observers said. Teachers manages $73-billion in assets on behalf of about 230,000 working and retired school teachers in the province, ranking it Canada's second-largest pension fund.

The CPP Investment Board got the go-ahead this year to begin actively managing its $12-billion equity portfolio. It hired Goldman Sachs investment banker Donald Raymond in September to help develop its thinking on active investing.

Over all, the ratio of active to passive management of Canadian equities was three to one last year, according to a survey of the top 100 pension funds done by Benefits Canada Magazine. Passive investing operates on the theory that owning a basket of stocks in an index fund would by definition create a diversified portfolio, one where the risks could be measured based on the market's historical performance. Any volatility in returns, it was assumed, came from the portion of the investment portfolio that was actively managed. The thinking was that pension executives who actively manage Canadian equities, for instance, take more risk in an effort to beat the broad TSE 300 index against which their performance is benchmarked.

"We kind of lulled ourselves into a state of mind that you could put a large part of the system on automatic pilot," said Keith Ambachtsheer, president of Toronto pension consulting firm KPA Advisory Services Ltd. "That was a good model through most of the nineties. It's now become dysfunctional."

In Canada, much of the risk associated with passive equity funds is explained by the makeup of the country's premier stock exchange. The TSE is dominated by a small number of companies that account for a huge chunk of the overall market capitalization.

It was one stock, Nortel Networks Corp., that made it abundantly clear just how vulnerable the overall market is to the fortunes of a single sector or company. At its peak, the telecommunications company accounted for a staggering 30 per cent of the TSE 300. The one-time stock market darling's share price has plunged to $12.20 on Friday from its record closing high of $123.10 on July 26, 2000, wiping out billions of dollars of value from the overall market. This type of concentration problem "will certainly rear its head at another time in the future," the CPP's Mr. Raymond said. Teachers owned 37.8 million Nortel shares as of Dec. 31, 2000, its biggest single equity investment.

"The lesson we've drawn from that is if you think you are controlling risk by saying, 'Well, we are just passive investors in a market index,' you're dreaming," Mr. de Bever said. Passive investing was particularly popular during the late 1990s when stock markets were soaring, making it difficult for managers running active portfolios to beat the overall TSE 300 benchmark index. But the markets began steadily declining last year and have been in sharp retreat since the terrorist attacks on Sept. 11. As a result, Canadian pension funds are facing major losses in the value of their portfolios and new challenges in meeting their obligations.

"The high returns of the 1990s are now well behind us," Teachers chairman Robin Korthals said in a statement dated Aug. 21. "Achieving the pension plan's funding requirement on a continuous basis is going to be a real challenge." Teachers' long-term goal is to create a surplus by growing assets faster than liabilities so that it has enough money to pay out pensions. To match average liability growth, assets must generate an average real return (after inflation) of 4.5 per cent a year.

The fund sidestepped the full impact of the crash in technology stocks last year by reducing its exposure to the sector and by pulling money out of the stock market. It finished 2000 with a total return of 9.3 per cent. In the first six months of this year, however, Teachers lost 2.7 per cent or $1.9-billion. Gains in Teachers' fixed-income and inflation-sensitive assets such as commercial real estate properties made up for declines in its equity investments last year. Returns on its Canadian equity portfolio fell to 13.5 per cent in 2000 from 30.4 per cent in 1999, when stock markets soared on the back of flying technology stocks.

Teachers shifted its asset mix policy last year from stocks and bonds to inflation-sensitive assets by reducing the equity component to 60 per cent of total assets, compared with 69 per cent in 1996. The fund is now looking at whether it should focus on managing overall risk in its portfolio rather than risk in just the actively managed investments, Mr. de Bever said.

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