Public Market Investments: External Active Management Program (August, 2005) 1 Highlights of our External Program Alain Bergeron, M.Sc., CFA

Who We Are CPP Investment Board Created in December 1997 First investments in March 1999 Crown corporation operating at arm’s length from government – independent, but accountable Clear fiduciary mandate Provide cash management services to the Canada Pension Plan to pay benefits

Public Market Investments: External Active Management Program (August, 2005) 3 3 ($ billions) Fiscal year ending March ACTUALFORECAST CPP Bonds and Cash in Ottawa CPP Investment Board Assets * CPP bonds and cash currently administered by the federal government will be transferred to the CPP Investment Board during this period Asset Transition Period* CPP Reserve Fund Projected Assets

Public Market Investments: External Active Management Program (August, 2005) 4 External Active Program Objectives Increase portfolio efficiency Leverage external talent and ideas

Public Market Investments: External Active Management Program (August, 2005) 5 Active Management: The Promise E(R) σ

Public Market Investments: External Active Management Program (August, 2005) 6 Active Management: The Reality * Provided active management is properly defined. In aggregate, the frontier cannot increase. E(R) σ

Public Market Investments: External Active Management Program (August, 2005) 7 1.Estimating managers’ skill 2.Ensuring efficient implementation 3.Ensuring appropriate manager compensation * This list is by no means exhaustive. Today’s Presentation… Focus on three areas of distinctiveness*

Public Market Investments: External Active Management Program (August, 2005) 8 1.Estimating managers’ skill

Public Market Investments: External Active Management Program (August, 2005) 9 Skill The ability to execute positive expected value strategies (net of all costs) by identifying and taking advantage of asset mispricing. How should one estimate it? Track record? How do we Define Skill?

Public Market Investments: External Active Management Program (August, 2005) 10 Skill Versus Luck Assume we could measure active managers skill and luck Probability of under- performing benchmark * Blessed Managers Forlorn Managers Doomed Managers Lucky Unlucky Skilled Unskilled Insufferable Managers * At the end of n years.

Public Market Investments: External Active Management Program (August, 2005) 11 The Fundamental Law of Active Management* where IR: Information Ratio IC: Information Coefficient TC: Transfer Coefficient In other words… IR: Skill IC: Forecasting ability TC: Portfolio Construction/Trading Breadth: Number of independent forecasts *Generalization of Richard C Grinold and Ronald N Kahn original work.

Public Market Investments: External Active Management Program (August, 2005) 12 Breadth Plays a Major Role

Public Market Investments: External Active Management Program (August, 2005) Ensuring efficient implementation

Public Market Investments: External Active Management Program (August, 2005) 14 Example (simplified): –Passive portfolio with 4 securities (equally weighted) An Active Portfolio lays over the top of another Portfolio Passive Portfolio = +5% -5% Total Portfolio Active Overlay Portfolio + Long Security B Short Security C –Active manager thinks security ‘B’ will outperform security ‘C’

Public Market Investments: External Active Management Program (August, 2005) 15 Advantages Removes the “long-only” constraint Efficient use of large pool of assets Increases internal flexibility Active managers focus on adding value where they have skill Simplified risk monitoring and performance measurement

Public Market Investments: External Active Management Program (August, 2005) 16 Smaller universe of managers Not all strategies are well suited to overlays Operationally more challenging Disadvantages

Public Market Investments: External Active Management Program (August, 2005) Ensuring appropriate manager compensation

Public Market Investments: External Active Management Program (August, 2005) 18 How much is one paying (% of alpha)? How much is one paying for luck? Do they provide the right incentives? With Traditional Fee Structures: “Most of economics can be summarized in four words: 'People respond to incentives.' The rest is commentary.” -- Steven E. Landsburg

Public Market Investments: External Active Management Program (August, 2005) 19 Our Fee Structure Aligns interests Minimizes moral hazard Pays for skill Minimizes the confidence needed in beliefs Creates positive self-selection bias

Public Market Investments: External Active Management Program (August, 2005) 20 The Fundamental Law… … Generalized to an External Program context: IC : - Ability to estimate managers’ skill TC : - Implementation Efficiency - Portfolio Construction Breadth : - Number of independent forecasts in the program

Public Market Investments: External Active Management Program (August, 2005) 21 Concluding Comments Generating Alpha is very difficult To maximize expected alpha*, we chose a road less traveled… Low weight to historical performance Overlay implementation, even for physical equities Negotiated a more efficient fee structure * Risk Adjusted, and properly defined.