Pipes over promises

The Canadian Pension Plan Investment Board (CPPIB) is shunning European sovereign bonds, with the $152.8-billion fund’s head of investment saying European infrastructure offers far more attractive risk/return opportunities.

Mark Wiseman, CPPIB’s executive vice-president of investments, told delegates at last week’s Milken Institute Global Conference 2012 in Los Angeles that the fund had chosen not to invest in the bonds of European governments.

“If we buy a German bund all we are really getting is the full faith and credit of the German government and we have all learnt that that isn’t worth much,” Wiseman says.

“On the other hand what we have is a hard asset, for example we will buy the gas distribution in Germany and we will make a substantial spread on a regulated asset that is essential to the operation of the German economy.”

Wiseman says that the fund can achieve a return of upwards of 500 basis points above German bunds.

“We will make a substantial spread over German bunds and, quite frankly, I would rather own the gas pipes than a promise from Angela Merkel. I think this is a better risk and we are getting paid 400 to 500 basis points over bunds.”

Make-up of the maple
Fixed income makes up 36.1 per cent of the overall portfolio, and includes marketable and non-marketable Canadian government bonds, corporate bonds, other debt, absolute-return strategies, money-market securities and debt-financing liabilities.

Infrastructure makes up around a third of CPPIB’s inflation-sensitive asset bucket, which also includes inflation-linked bonds and real estate.

Inflation-sensitive assets make up 17.7 per cent of the overall portfolio.

The long-term view
Wiseman told delegates CPPIB was a long-term investor that tried to formulate investment strategies around a 25-year time horizon but also framed decisions in terms of a 75-year outlook.

In keeping with its long-term outlook, Wiseman told the conference that the fund was much more concerned about the risk of inflation than deflation in the world economy.

To do this, the fund has extensive real estate and infrastructure holdings that act as a hedge against inflation and is also looking to innovative ways to invest in commodities.

“Being a Canadian fund, we are naturally long commodities, and are increasingly buying commodities in the ground and thinking about an investment program where we are actually buying reserves, literally in the ground, that will be extracted in decades to come.”

Sharing the stage with Wiseman was Joseph Dear, chief investment officer of CalPERS.

Both Dear and Wiseman pointed to a movement away from traditional asset allocation models, with investors increasingly looking use a risk-based approach.

“It amazes me that people still are talking about asset allocation. If there is one thing we have learned from the financial crisis, it is that assets – when you least expect it – all tend to behave the same way or all tend to behave differently. But when you care about it the most, they don’t behave the way you expect in normal circumstances,” Wiseman says.

“What we have done and been thinking about for quite some time – and others are beginning to follow – is trying to get away from asset labels.”

CalPERS goes the Canadian way
CalPERS’ Dear told the conference that Canadian funds had been leaders in adopting a risk-based approach, and noted CalPERS was not as far down the road as its Canadian counterparts but was heading in the same direction.

The $233.6-billion fund has implemented an alternative-asset classification that attempts to address major risks the fund could face and protect against significant capital loss as a result of a major market event.

The restructure of asset classes resulted in assets being classified in five main groupings: growth, income, inflation, real assets and liquidity.

The fund also has an absolute-return strategy component of the overall portfolio.

The new structure allows the fund to allocate according to how these particular assets perform in low and high-growth markets, and the prevailing inflation environment.

Both the liquidity and inflation-hedging portfolios have a 4-per-cent target allocation.

Dear says that CalPERS risk-management processes are now aimed at protecting capital during major market events and providing a framework for assessing the portfolio in its entirety.

“We are shifting the whole approach to our capital allocation from asset class, such as this much equity, this much fixed income and so forth, to really a risk-factor based approach,” he says.

“Now, our friends in Canada have been pioneering this and showing the way in how to move away from the classic approach of the past 30 years and trying to figure out how you construct a portfolio in an environment that is going to be much tougher than we have had before, and how to get a better understanding and management of risk to protect yourself against a big drawdown.”

Wiseman told the conference that traditional asset labels bunched different assets such as government and corporate bonds together, despite the fact that they may have very different underlying risks.

“A bond could be a US government bond or a corporate distressed bond, which is, essentially, equity waiting to happen. But you would put both of those in your fixed-income portfolio and you then used to say I have this much allocation to bonds. It is nonsensical.”

Likewise, Wiseman says that CPPIB does not make a distinction between private and public equities.

“We allocate 65 per cent of our portfolio to equities regardless of whether it is public or private and look through these asset labels. I think this has got to catch on, not just for institutional investors, because this isn’t a particularly complicated way of looking at the world.”

CPPIB typically thinks of private equity as having a 1.3 beta, according to Wiseman. Dear says that CalPERS looks for a return of about 300 basis points above its public market benchmarks as the premium for the illiquidity of private equity.