Inside CPP Investments’ TPA engine

It has been two decades since CPP Investments, Canada’s largest pension fund, first adopted the total portfolio approach, swapping out asset class labels for underlying drivers of performance as guidelines to portfolio construction.

Looking back on the revolution, the C$780 billion pension giant outlined in a recent paper the five pillars of TPA through which it achieves “disciplined flexibility”, allowing the fund to preserve “the ability to deliver exposures efficiently and adjust by choice rather than necessity”.

While CPP Investments made the first foray into TPA in 2006, it wasn’t until 2016 that the fund “institutionalised” the framework and set targeted market risk and desired exposures to economic drivers at a total fund level. It then separated the investments into an active portfolio and a highly liquid, passive “balancing portfolio”.

Central to CPP Investments’ TPA framework is the idea of “relative value” which determines how capital competes across its active strategies, the paper said. The process shifts the focus of evaluation of active risk away from headline IRRs to alpha excluding all costs but taking into consideration liquidity consumption and balance sheet capacity.   

This is especially useful for discerning the true value-add of private investments, which need to generate a rate of return above market beta and also compensate for the liquidity consumption and reduced optimality they cause in the portfolio.

“Traditional asset-class silos obscure these trade-offs. Allocation bands can implicitly treat private assets as inherently diversifying or alpha-generating,” said the paper, co-authored by Sally Shen, Derek Walker and Geoffrey Rubin from CPP Investments’ insight and total fund teams.

“Under the relative value framework, public and private investments compete explicitly on a common risk-adjusted basis, taking these considerations into account.”

The relative value framework applies to both new and existing investments as the decisions to resize or sell down assets carry the same importance to new deployments, the paper said.

“The relative value framework is integrated with exposure management as a continuous, repeatable process: capital allocation affects portfolio exposures; exposures are measured against strategic targets; deviations trigger rebalancing actions.”

The other four pillars around the relative value framework are factor exposures [See CPP evolves total portfolio approach], liquidity, leverage and currency.

Canadian funds have been big proponents of applying leverage in pension management and CPP Investments began using this tool over a decade ago. Its leverage is managed at a total fund level and assessed alongside the funding capacity and collateral demands and other balance sheet factors.

The paper emphasised that leverage is not used as a tool to scale risk and boost return but as a tool to support diversification. To meet CPP Investments’ return target, an unlevered portfolio is likely to be overexposed to the growth factor whereas with leverage, it can “provide a more attractive mix of beta that moderates inherent growth and inflation biases”.

Leverage is also used as a tool to recalibrate risk levels across the total fund.

“For example, if higher-risk private-market exposures increase, total fund leverage can be reduced to maintain the calibrated risk target. If it declines, leverage can increase accordingly,” the paper said.

“In this sense, leverage functions as a balance sheet risk stabiliser: it absorbs shifts in portfolio composition and risk conditions while preserving overall portfolio risk.”

Leverage goes hand in hand with liquidity management which the fund considers on two dimensions: market liquidity (the ability to transact without great price impacts) and funding liquidity (meeting cash obligations).

“Liquid capital—unencumbered assets within the passive balancing portfolio—is structured to absorb shocks while remaining invested… In contrast, the active portfolio is treated as illiquid to preserve the integrity of long-term investment strategies,” the paper said.

“Resilience is monitored through multi-horizon liquidity coverage ratios, which test whether coverage assets, net of haircuts and combined with forecasted inflows, are sufficient to meet stressed obligations. Leverage capacity is explicitly linked to these thresholds.”

The fund conceded that TPA does require investors to be able to handle more portfolio complexities, but in an environment defined by geopolitical upheavals and regime shifts, “prudent design and adaptability matter more than speed”.

“The total portfolio approach cannot eliminate uncertainty, but when properly implemented, it does help build resilience to it. In doing so, it creates a durable institutional advantage for long-horizon investors like CPP Investments, strengthening our ability to weather the storms ahead.”