CPP’s sad lesson

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  By Guest Blogger Sinan Terzioglu

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In the world of finance, change is ever-present. Investment strategies evolve and benchmarks shift. Few know this better than the managers of the Canada Pension Plan Fund who recently released their annual report and acknowledged the fund trailed its benchmark in 2023.

A single year of underperformance is not exactly headline news, as Andrew Coyne recently pointed out in his Globe & Mail article. However, Coyne highlighted page 39 of the report where the CPP fund managers conceded they have trailed the benchmark over the entire 18-year period since the fund began actively managing the pension contributions of millions of Canadians.

In an attempt to outperform the broad markets, CPP fund managers pick individual stocks and bonds rather than investing in low cost ETFs. Relative to the benchmark, the CPP Fund earned a “negative 0.1% annualized or negative $42.7 Billion since inception of active management in 2006.”

Taking a broader view of active management since its first publication in 2002, S&P Global has been releasing semi-annual reports (SPIVA) comparing the performance of active equity and fixed income funds against their passively managed benchmarks over various time horizons. Year after year, the SPIVA reports have clearly shown that most active fund managers underperform their benchmarks. In the SPIVA report summarizing the last 20 years ending 2023, S&P researchers concluded:

• After one year, nearly 73% of active fund managers underperformed their indexes (across 22 equity categories)
• At the five-year horizon, 95.50% of active stock fund managers lagged their indexes
• After 15 years, there were “no categories in which the majority of active managers outperformed” across domestic and international equities

How much are Canadians paying for this active management? In 2006, the CPP Fund had a reasonable 150 employees and today boasts more than 2,100 with compensation across all its staff averaging more than $500,000 per year. The funds 5 highest paid employees are now paid nearly $4 million per year. Fees paid to external managers totaled $36 million in 2006 and are anticipated to total approximately $3.5 billion in 2024. Total fund expenses are now anticipated to be more than $5.5 billion per year. Since 2006, fund expenses have totaled over $46 billion.

With the evidence increasingly mounting that active management is not a value-added service, it begs the question of why the country’s largest pension fund, which manages over $600 billion in assets on behalf of approximately 22 million Canadians, continues to disregard the reality that the high cost of active management is detrimental to long term performance.

Pension funds are not afraid to cast a wide net in search of investment opportunities. In addition to publicly traded equities and fixed income securities, pension funds invest in alternative assets, mostly private (i.e. no quoted daily price) such as real estate, toll roads, private credit, private equity, ports, airports and even crypto currencies. Alternative assets offer diversification benefits but can also suffer catastrophic losses which is well evidenced by the largest pension funds in Canada losing significant sums after failed crypto currency related investments.

Without Mr. Market to offer a daily quote, alternative assets that are not publicly traded can appear less risky, however, over confidence in an asset class can easily lead managers to overweight one asset class in favor of another. For example, the Ontario Teacher’s Pension Plan had only 10% of its assets in public equities through the final months of 2023. As a result, the pension plan significantly underperformed its benchmark as equity markets soared in the last two months of 2023.  A large pension fund with a long term horizon of decades should never attempt to time the equity markets with such a large portion of its assets.

In the world of investment management there are few voices more respected than Howard Marks who is the billionaire co-founder of the investment management firm Oaktree Capital. He has been writing a widely followed investment memo since the early 1990’s. In his September 2023 memo Marks wrote:

“My memos got their start in October 1990, inspired by an interesting juxtaposition between two events. One was a dinner in Minneapolis with David VanBenschoten, who was the head of the General Mills pension fund. Dave told me that, in his 14 years in the job, the funds equity return had never ranked above the 27th percentile of the pension fund universe or below the 47th percentile. And where did those solidly second-quartile annual returns place the fund for 14 years overall? Fourth percentile!  I was wowed. It turns out that most investors aiming for top-decile performance eventually shoot themselves in the foot, but Dave never did.”

This anecdote underscores an important lesson which is that in the financial markets taking higher risks in search of outsized gains is not required to achieve strong long term performance.  Fortunately, the long term rates of returns achieved by Canada’s largest pension funds have been satisfactory but we can learn from their mistakes.

More than 70% of Canadians currently employed will not have employer pension plans when they retire so it is up to themselves to save and invest in their own personal pension plan. The best way to do is this is by investing in a balanced and diversified portfolio of low-cost ETFs which include government bonds, corporate bonds, preferred shares, REITs, Canadian, US and international equities while consistently avoiding the traps that some of the managers of Canada’s largest pension funds and individual investors haven’t been able to such as:

• Trying to time the market  – an investor that missed the 40 best days in the US market over the last 20 years would have lost 1.10% per year vs a gain of 9.80% per year had he/she remained fully invested
• Illiquid private credit – many Canadian investors were lured in by high yields which were unsustainable and as a result lost significant sums as interest rates rose
• Fear of missing out – excitement is the enemy of investment success and speculative investments like crypto currencies and popular meme stocks like GameStop and AMC have led to significant losses for many
• High costs – the average Canadian mutual fund still costs ~2% per year which is far too high relative to ETFs which cost significantly less
• Trading too much – studies show investors with the highest monthly turnover in their portfolios have earned significantly less then the least active investors

Successful long term investing should be boring. Patience, discipline, and the ability to ignore market noise are key. Most importantly, always remember that trying to outsmart the markets usually ends up costing you and always keep the following by Morgan Housel, the author of The Psychology of Money, in mind:

“The biggest secret in investing is that average returns sustained over an above average period of time lead to extraordinary returns.”

Sinan Terzioglu, CFA, CIM, is a financial advisor with Turner Investments, Private Client Group, Raymond James Ltd.  He served as vice-president of RBC Capital markets in New York City and VP with Credit Suisse in Toronto.