Going Where Opportunity Is Next

Leo de Bever CEO Alberta Investment Management Corporation Edmonton, Alberta, Canada
The traditional asset classes of stocks and bonds are likely to see lower real returns in the coming years. Institutional investors should, therefore, take the long view and pay less attention to investment categories and more to return on risk. Diversifying into unlisted, alternative investments that offer illiquidity premiums can be an especially fruitful strategy.

lberta Investment Management Corporation (AIMCo) was established in 2008 as an Alberta crown corporation to manage nearly US$70 billion of provincial pension, endowment, and Treasury reserve assets for more than 25 clients. The guiding idea was that an organization run on commercial terms and overseen by an independent board could earn higher returns than a management team that was part of a government. Our goal at AIMCo is to maximize longterm return based on a limited tolerance for risk. Without us, our clients could passively invest in listed stocks and bonds and earn index returns net of implementation costs. Incremental return on risk can come from actively managing listed assets and from capturing an illiquidity premium on longdated private investments. We have a long-range view on capital, so we try to make use of both cash and patience to earn illiquidity premiums. The rate of return does not increase just because an asset is illiquid, but with good management, such investments can earn a 25% incremental return. Having assets of $70 billion gives AIMCo economies of scale. If our clients were to manage their funds individually, their costs would likely be two or three times higher. We operate on a cost recovery basis and do not have marketing overhead. Even though our compensation is competitive with other institutional managers, our costs are one-third to one-fifth of typical costs for external management. Nearly 85% of our assets are managed internally. Total costs are approximately 0.4% of assets, about half of which is associated with the 15% of assets that are managed externally.
This presentation comes from the Fixed-Income Management 2012 conference held in San Francisco on 1011 October 2012 in partnership with CFA San Francisco.

Aftermath of the Financial Crisis

The 200809 financial crisis did not cause an ordinary recession, and the developed world is not experiencing an ordinary recovery. Finding exceptional value in traditional, listed assets has become difficult. Yet, the next 510 years are likely to provide attractive opportunities if investors are willing to consider less traditional investments. Austerity and the Threat of Stagnation. Global economic growth for 2012 will probably turn out to be 2.02.5%, which is about half of what is needed to absorb labor force growth. Europe is in the worst shape, with growth of 0.5%, whereas India and China are each expected to grow about 7%. North America will likely grow 2.0%, with Alberta growing 2.5% because of the nascent oil sands investment boom. Most OECD (Organisation for Economic Co-Operation and Development) economies suffer from John Maynard Keyness paradox of thrift. Consumers are reducing debt accumulated prior to 2008. Despite strong balance sheets, corporations are not spending because of low economic growth. Governments are focusing on austerity to combat rising debt-to-GDP ratios from health and pension commitments that exceed revenues. If the goal is to reduce debt-to-GDP ratios, low GDP is not the way to do so. Most OECD countries need pump-priming to mobilize excess capacity. Privately financed infrastructure and corporate investment projects offer the best short-term option. Inflation or Deflation? Government austerity and private sector deleveraging are keeping inflation low, as is technological change on capital and consumer goods prices. But inflation is ultimately determined by the ratio of money to output. Given the enormous amount of money being created, inflation will likely win eventually.
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Since the Great Depression, U.S. monetary and fiscal policy has had an inflationary bias, as shown in Figure 1. Between 1800 and 1930, every economic boom was followed by a bust, mass unemployment, and deflation. Deflation increased the real burden of debt and created widespread bankruptcies. During the Great Depression, Keynes challenged the social cost of this process, and since then, governments have softened the depth and duration of economic downturns. The result is that U.S. consumer prices, as indicated by the U.S. Consumer Price Index (CPI), that did not move for 130 years (18001930) have increased 16-fold in the last 80 years. Credit Markets. Government bond yields have fallen to historical lows, as Figure 2 illustrates, so there are only two outlooks for bonds: terrible and really terrible. Investors may experience a few years of stable, low rates, but a return to even modestly positive real interest rates and a moderate increase in inflation would mean capital losses for long bonds. Investment-grade credit spreads look attractive by comparison. AIMCos fixed-income strategy has a defensive, short-duration, high-quality credit bias. Because bonds have performed better than stocks over the past 10 years, some funds are still tempted to immunize 15-year duration pension liabilities. Implementing that strategy today would simply lock in low or negative future bond returns. Equity Markets. The U.S. equity market seems overvalued. With interest rates close to zero, all financial assets have become overpriced. Despite being more volatile, high-quality stocks are likely to do better than bonds over the next 510 years.

Figure 3 shows the CampbellShiller cyclically adjusted price-to-earnings ratio (P/E) for the S&P 500 Index. It divides the current stock price level by the 10-year average inflation-adjusted earnings. In 1999, this version of the P/E was so far above its historical average of 16 that a market decline was seemingly just a matter of time. My team and I pulled back, going from 70% equities to 48% equities, and that strategy was validated in 2000. Stocks have been artificially supported by central bank easing, but although the CampbellShiller P/E suggests overvaluation, the gap is much smaller than in 2000.

Market Outlook
The prevailing wisdom is that GDP growth in North America will be a mediocre 23% for the next 510 years. I strongly believe that much better growth is possible if countries make better use of emerging technologies. Europe has a harder road ahead: Its demographics are worse, as are its fiscal imbalances. Northern Europe will probably persevere, but excessive austerity in southern Europe will continue to hinder recovery. To deal with the high unfunded cost of pensions and health care, most OECD members will likely create inflation to reduce their debt-to-GDP ratios. Because of such measures, long bonds will have low or negative total returns in the next few years, whereas equity returns will be on the low end of the long-term average, which implies that stocks will offer a better return on risk than bonds. Many defined benefit pension plans still set their pension liability discount rates equal to their expected returns on pension assets instead

Figure 1.  U.S. Inflation Rate and CPI, 18002010

Percent 30 25 20 15 10 5 0 5 10 Post-Civil War Railroad Boom Post-WWI Korean War OPEC I and II 1800 = 100 1,600 800 400 200 100 50

Great Depression 15 25 1800 10 20 30 40 50 60 70 80 90 1900 10 20 30 40 50 60 70 80 90 2000 10 CPI (right scale) Inflation Rate

Source: Based on data from the Handbook of Labor Statistics, U.S. Bureau of Labor Statistics.

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Figure 2.  U.S. 10-Year Bond Yield, 19532012

Yield (%) 16 14 12 10 8 6 4 2 0 55 60 65 70 75 80 85 90 95 00 05 10 Source: Based on data from Thomson Reuters Datastream.

Figure 3.  CampbellShiller P/E for the S&P 500, 18812012

P/E 45 40 35 30 25 20 15 10 5 0 1890 1900 10 20 30 40 50 60 70 80 90 2000 10 Black Monday 2008 Financial Crisis Greenspan Put Black Tuesday Bernanke Put (22.9) Tech Bubble

of using a reasonably risk-free rate. By definition of expected return, such a strategy has a 50% chance of being wrong. Many U.S. plans still use a 78% discount rate, which will be a stretch even with a 100% allocation to equities. Figure 4 demonstrates the 30-year range of outcomes for a Canadian pension plan with (1) a starting funding ratio of 100%, (2) an asset mix of 60% global stocks and 40% Canadian bonds, and (3) a discount rate for liabilities of the CPI plus 4.25%, the long-term return for this asset mix. Given that assumption about long-term returns, the average funding ratio over all 30-year periods is near 100%. The best 1% (99th percentile)
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outcome implies a 2.94% compound rate of growth in the funding ratio; the worst 1% (1st percentile) is a 2.33% compound rate of decline. The 19822011 line illustrates how 60/40 pension managers fooled themselves into thinking that 7% real asset growth was the new norm and that it could outstrip liability growth by almost 3% a year. A plan that was 100% funded in 1980 would have achieved a 200% funding ratio within just 6 years and almost 300% by the end of the 30-year period. But such growth was not sustainable. The 12-year period ending in 2011 shows a 1.49% average funding ratio growth and thus a drop in the funding ratio of about 17%. An assumption that long-term average
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Figure 4.  Cumulative Asset Growth over 30-Year Horizon for a Canadian Pension Fund
Funding Ratio (Year 0 = 100%) 400 Growth (%) 4.73

200

2.34

100

50

2.28

25 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 Years 99th Percentile (2.94%) 100% 50th Percentile (0.02%) 19822011 (3.03%)

4.52

1st Percentile (2.33%) 20002011 (1.49%)

Source: The underlying data are from the DimsonMarshStaunton Global Returns Data going back to 1900.

returns are achievable in the short run underestimates the negative impact of short-term volatility.

Investing between the Cracks

Pension plans typically allocate assets to asset class silos (e.g., stocks and bonds). But the scarce resource is risk, and we ultimately manage for the best return on risk. For example, some of my clients dislike BB rated bonds because they are riskier than other bonds. Yet, they are comfortable owning the riskier equity of the BB rated bond issuers. The relevant comparison is between the return on risk for a BB rated bond and any asset in the rest of the portfolio. The best opportunities are often found in assets that do not fit nicely into an asset class category; that is, they fall between the cracks of listed and unlisted asset class silos. In the 1990s, managing for better return on risk led some pension plans to introduce commodities, infrastructure, and timberland into the asset mix. At the time, these assets were still viewed as novel alternatives to stocks and bonds. Today, they have become mainstream and, in some cases, overpriced. Infrastructure may return as a good option because cash-strapped governments will need private capital to build sewers, water mains, roads, and bridges. New alternative niches are smaller and more labor intensive to find and administer.
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Given that pension funds manage assets that are not needed for a long time, return on risk should ideally be evaluated over a long horizon. Unfortunately, it is often hard to maintain that perspective when poor short-term returns lead to client disappointment. Pension regulation can get in the way as well. Pension fund obligations may be long term, but many plans have a three-year valuation cycle and must show a short-term balance between assets and liabilities. Basel III increased capital requirements for certain niche business lines (e.g., insurance products, infrastructure debt, and private debt and loan financing for private equity). As a result, banks have exited, creating opportunities for other institutional investors.

Disruptions and Opportunities

There is good reason to believe that the rate of innovation is accelerating. Technological change ultimately boosts GDP growth, but it is disruptive in the short term. In almost every developed country, the labor share of GDP is falling. As Brynjolfsson and McAfee say, humans are in a race with machines.1 The Industrial Revolution began with machine power replacing muscle power.
1Erik

Brynjolfsson and Andrew McAfee, Race against the Machine: How the Digital Revolution Is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy (Digital Frontier Press, 2011).

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Today, machine power is replacing brainpower. An innovative boom often leaves displaced workers in its wake in the beginning. As technology matures, workers adapt to the new technology while new applications and shifts in demand patterns create new career opportunities. As shown in Figure 5, a price index for hardware and software indicates prices are falling. Before the 1990s, it rose at an average of 3.2% a year, but then it leveled off and has declined. I recently visited a facility that had just installed a new robot at a cost of $2 million, an amount that will be recovered in six to nine months. Similarly, short payback periods are occurring not just in robotics but in logistics as well. So, Robert Gordon of Northwestern University is probably wrong when he argues that growth will be slow and that it will mostly support pensions and health care for an aging population.2 Brynjolfsson and McAfee are probably correct in saying that the future will be superior if better-educated humans learn to work with more sophisticated machines.

that produce better seeds, plants that fix their own nitrogen, and substitutes for meat. Energy.Most economic revolutions involve radical changes in the production, conversion, or storage of energy. AIMCos energy investments include conventional sourcesoil, gas, and coal and businesses that make those sources more efficient or environmentally friendly. We also invest in businesses that are making solar, wind, and distributed generation more efficient. Materials.The materials intensity of GDP is falling, but high growth in developing economies is still increasing total resource demand. AIMCo invests in forests because wood is a renewable commodity that has an attractive real return, especially as a source of biofuel. One of the businesses we invest in converts wood chips into carbon neutral synthetic oil. Enabling Technology.There may be particularly good opportunities for such enabling technologies as robotics, logistics, and information management that improve productivity or relieve the labor shortages we are experiencing in Alberta. These technologies could also offer an important way to reduce health care costs.

Four Investment Themes

AIMCo concentrates on four sectors in its investment strategy: food, energy, materials, and enabling technology. The first three capitalize on growth in Asia; the fourth should help improve standards of living at home. Food. Food demand will double between now and 2030 as emerging Asian markets shift to a higher-protein diet. Land supply is inelastic, so there are opportunities in improving the productivity of agriculture to avoid relative price escalation. AIMCo is looking for investments in companies
2Robert J. Gordon, Does the New Economy Measure up to the

Conclusion
Given the mediocre outlook for a traditional asset mix, we need to imagine a better future and have the courage to look beyond conventional asset allocation approaches. Looking at the world from a return-on-risk perspective strengthens the case for finding substitutes for bonds and taking advantage of emerging technologies.
This article qualifies for 0.5 CE credit.

Great Inventions of the Past? Journal of Economic Perspectives, vol. 14, no. 4 (Autumn 2000):4974.

Figure 5. Index of Hardware and Software Prices since 1947

2005 = 1 4 Annual Growth Trend, Pre-1990s (3.2%) 2

Index

0.5

0.25 47 57 67 77 87 97 07 Source: Based on data from the U.S. Bureau of Economic Analysis.

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Question and Answer Session

Leo de Bever
Question: Does AIMCo have a home-country bias? How do you address that issue? de Bever: In fixed income, we operate primarily in Canadian and U.S. securities and hedge foreign exposures back to Canadian dollars. Most of our equity exposure is global, and most of it is unhedged. Our Canadian weight is two to three times Canadas 3% weight in global equities, which is still far less of a home-country bias than the typical U.S. pension fund. Question: When constructing a portfolio, how do you model the expected returns, volatility, and correlation coefficients of your alternative positions? de Bever: Investors have to do the best they can to capture risk and return when given an opportunity. If they take the time to figure it out to five decimal points, the return opportunity will probably be gone. We dont try to diversify risk within an asset class, such as infrastructure. The benefits of diversification are lost once a portfolio has more than 100 assets, and a typical pension plan has thousands of assets. Adding an infrastructure investment that equals 1% of total assets is a big concentration risk for the infrastructure portfolio but not for the total portfolio. Question: How do you manage the distraction of short-term volatility when dealing with AIMCos board of directors? de Bever: We have a professional board with a wide range of investment, risk, and other expertise. Above all, they provide sober second thoughts. My pension clients have boards drawn from their own membership, which presents a greater challenge, particularly when it comes to understanding the vagaries of short-term return on risk. We spend considerable effort on risk education. Question: Are there any frontier investments that you would not invest in? de Bever: I avoid jurisdictions where I cannot rely on stable rules. Despite spending a lot of time in China, I find it hard to invest in the country directly. India should present great opportunities, but I have not been able to get past some obstacles. After Argentina expropriated Repsols local assets, I lost interest. But I do invest in Chile because it is a stable environment; it needs foreign capital, so being transparent is in its best interest. Question: What policies would make the United States a better environment for investment? de Bever: Policies that make it easier to get things done would improve the investing environment. To protect what was, developed economies often slow down what can be. An improved standard of living depends on working smarter: doing more with less. Given technologys enormous potential for increasing our medium-term standard of living, we should encourage its adoption and create more skills for these new areas instead of protecting declining activities.

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