Pension committees are still managing their plans the same way after a decade of tough financial results. The focus remains on asset returns, with little attention on the funded status of the plan. There are many reasons why pension funds have not changed their approach. Committee members have changed over the past decade and have not experienced the financial pain due to the first two perfect pension storms (declining bond yields and equity market returns). Pension committees have also been reluctant to make changes to asset mix due to the fear of being wrong. Moreover, the current approval structure within pension committees does not facilitate quick decision-making and, at the same time, pension committees are not sure what changes they should make.

Dynamic de-risking is an approach where the asset mix of the plan changes as the funded status of the plan changes. Typically, this results in less risk (i.e., fewer equities and more bonds) in the plan as the funded status improves. Dynamic de-risking allows a pension fund to de-risk its plan when it is affordable (i.e., when the funded status improves).

The underlying premise of dynamic de-risking is that pension plans will sell outperforming assets and lock in those gains to reduce the likelihood of the deficit increasing in the future. There are three key factors involved in creating a dynamic de-risking solution.

First, the pension committee pre-approves an asset mix schedule that allows the investment manager to alter the plan’s asset mix as the funded status of the plan changes.

The investment manager then evaluates the funded status of the plan on a daily basis. This allows asset mix changes to be made in accordance with the pre-approved asset mix schedule.

Finally, the plan develops a clearly stated financial objective. This could involve reducing the volatility of contributions by 10% once the plan becomes fully funded. Or it could be a target funding level of 110% for an eventual annuity purchase.

Dynamic de-risking differs from traditional liability-driven investment (LDI) solutions because it does not require plan sponsors to make a one-time adjustment to their asset mix. Instead, dynamic de-risking gradually removes market-based risk from the pension plan based on the plan sponsor’s financial objectives and current market conditions. This gradual approach appears to be more palatable because it provides a balanced approach where investment returns and cash contributions are used to close the funding gap.

Soami Kohly is Vice-president, McLean Budden.

The private equity model, in particular, has key structural advantages that enable it to deliver attractive long-term results during periods of low growth and limited multiple expansion. When successfully implemented, private equity is characterized by three primary sources of value creation that distinguish it from other asset classes:

• a focus on long-term results through direct and active ownership of private companies;
• involved boards and a strong alignment of interests between management and investors; and
• a reliable funding model through the committed capital structure of a private equity fund.

These structural advantages underpin the demonstrated ability of private equity managers to grow revenue and improve earnings margins through operational improvements, which is critical at a time when normalized P/E multiples remain relatively high while future growth prospects remain uncertain.

Unencumbered by the vagaries of broad investor sentiment and insulated from the relentless pressure of quarterly earnings reports, private ownership enables investors to drive significant changes in strategy and operations, which translate into sustainable profitability gains. Furthermore, a private equity manager’s ability to support promising portfolio companies with patient sources of capital allows for a longer-term perspective on capital allocation decisions and, significantly, control over the timing and manner of exit. While initial public offerings are often perceived as the most lucrative exit route for private equity managers, trade sales and strategic acquisitions continue to provide attractive exit options and are likely to continue to do so given the significant cash accumulating on corporate balance sheets.

Despite current market conditions, there remain buying opportunities for those with capital to invest in the private markets, as a result of reduced deal competition, distressed/motivated sellers and lower valuations in select market niches.  However, successful implementation remains the key to achieving long-term outperformance.  A professionally managed program offers significant sector and geographic diversification, but access to the best fund managers remains imperative. There is a wide dispersion of returns amongst private equity managers and access to the very best managers continues to be difficult for new investors. Designing and building a profitable, diversified private equity program is time-consuming and challenging – and beyond the scale and resources of many institutional investors. However, successful fund managers and advisors have built global teams, successful track records and a compelling value proposition that can deliver attractive net returns to investors through commingled funds and segregated accounts tailored to meet their individual investment and governance objectives.

While the global capital markets headlines remain grim, Canadian institutional investors of all sizes have numerous, increasingly innovative investment options available to them as they seek to diversify their portfolios and access the long-term value creation opportunities available through hands-on, active ownership of private companies.

Stuart D. Waugh is Managing director & Managing partner, Northleaf Capital Partners.

There are a few major reasons investors like market neutral strategies. To start, they offer low correlations to traditional asset classes like fixed income and equities – and also to other hedge funds. And, most importantly, they offer lower volatility over market cycles along with downside protection at the worst times. Consider that between 1990 and 2005, the standard deviation of market neutral returns ranged from 3.1 to 3.9% depending on the arbitrage strategy used by the portfolio manager. Compare that to the S&P 500 during the same period, with a standard deviation of returns at about 14.4% (and nearly 18% for the TSX). These indices also tended to have much lower Sharpe ratios over the same period.

But what about the Canadian experience? To be sure, the hedge fund industry in this country is small compared to the global universe. But it is growing. Assets under management in Canada have grown from just $5.4 billion in 2003 to $20 billion today. The hedge fund industry here has also become more robust due to the growing availability of short liquidity in the Canadian market. Indeed, the value of lendable equity securities in Canada has doubled in the last three years and now sits at nearly $400 billion.

Yes, the size of the market matters — but what makes the Canadian market truly unique is the role that sectors play. Canada’s equity market is highly concentrated in just three key sectors – energy, materials and financials – and there isn’t much liquidity in between. Dealing with this level of sector concentration presents a major challenge to managers of market neutral strategies, especially if they stick to simple Barra factors as a way to explain return variance. Barra factors include basics such as yield, volatility, value, size, momentum, non-estimation universe, growth and financial leverage.

This approach works in many global markets – but in the highly concentrated Canadian market, they fall short of explaining what drives performance. Because sectors are a major driver in Canada, market neutral investors here must pay close attention to the role they play in a specific strategy.

Taking a sector neutral approach

For Canada, a “sector neutral” approach is key. Achieving this means going beyond energy, materials and financials and truly understanding how the different sectors in the Canadian market work together. This can be done by looking at the performance of “super sectors” that better reflect the fundamentals of the Canadian market. These super sectors, which are groupings of sectors with similar characteristics, are divided into resources, consumer, industrial and interest-rate sensitive. Super sectors provide key insights into where alpha lies in the Canadian market – and they also explain a good portion of return variance and dispersion.

Investors looking for a market neutral approach in Canada should make sure that managers are looking closely at the impact of all the sectors in the market. Only then can a strategy offer the necessary risk-control benefits and alpha generation. As the hedge fund industry continues to evolve in this country, managers must continue to study and understand the nuances of the Canadian market: an understanding of sectors is key.

Andrew Marchese is Head of Canadian Equities and Portfolio Manager, Pyramis Global Advisors

The first strategy of broad diversification has become better known by investors over the past decade, as evidenced by the growing allocation to commodities, real estate and external managers that pursue a variety of absolute return strategies uncorrelated to underlying market returns.

The second strategy employed by CTAs is risk management based on QAA models that focus on downside volatility and correlation as opposed to dollar-based asset allocation. QAA seeks to first establish a level of acceptable portfolio downside volatility, and then allocate portfolio resources so underlying investments will contribute in a pre-defined way to the overall portfolio downside volatility target.

Historically, various QAA models have been proposed and, in general, they all seek to optimize return to volatility based on some measure of expected return. A shortcoming of all standard QAA models is they tend to be static whereas markets are dynamic. Average historical returns are also not a good estimator for future current returns. Moreover, optimizing to a static level of risk breaks down in the real world because volatilities are dynamic.

A solution to the problems of static QAA models is to simplify the model at the front end and manage risks dynamically. A simplified asset allocation model only needs to set the baseline by getting the story right, so to speak. Utilizing average downside volatilities and correlations is sufficient. Also, return expectations can be removed from QAA models because various asset classes display remarkably similar long-term Sharpe ratios.

From this basic model, real world risks can be dynamically managed through the tracking error of real results versus model results. For example, limits can be established for downside volatility or VaR, and all portfolio positions can be calibrated downward if these limits are breached in real time

The third CTA strategy of long/short investing seeks to limit losses and maximize profits by being invested on the right side of the market. Underlying this approach is an awareness that market real returns can and have been negative for very long periods of time, and that bear markets should be viewed as opportunities for gains and not as just another risk to be managed. For fund managers with limited ability to go short, long/flat investing using overlay strategies can achieve the same objective of limiting losses and maximizing profits. A safe haven for negative real rates of return is cash.

Although market returns are generally positive over very long periods of time, they are neither stable nor predictable. However, understanding the strategies employed by CTAs can offer valuable insight into available tools to generate stability and predictability in portfolio returns.

Roland P. Austrup is Chief executive Officer and Chief Investment Officer, Integrated Managed futures Corp., a division of Integrated Asset Management.

As the U.S. economy continues its unsteady recovery, the U.S. real estate market presents investors with a unique opportunity to acquire distressed assets. There are $181 billion in known distressed assets, with nearly 24% in office and 21% in multi-family.1 The large number of distressed assets that were acquired by banks and companies at the peak of the cycle now require recapitalization. In an effort to improve their balance sheets, banks may accelerate their real estate divestitures. The challenging IPO market may force capital-starved companies to seek alternative sources of capital. As a result, investors with access to equity and/or debt can acquire these distressed assets at attractive valuations.

There are several factors for non-U.S. investors to consider when investing in U.S. real estate through private vehicles, especially the Foreign Investment in Real Property Tax Act (“FIRPTA”) which was enacted by the U.S. Congress in 1980 and encompasses all forms of U.S. real estate. In general, non-US investors do not incur U.S. tax liability from income and gains realized from investing in various types of U.S. assets (e.g. equities and bonds) however, they are subject to FIRPTA on gains realized on the sale of a U.S. corporation or REIT that owns U.S. real estate or on a capital gain distribution from a REIT. Investors can mitigate or eliminate FIRPTA through standard or leveraged blockers or through non-U.S. blockers.2

Outside of the US, Europe and Canada are experiencing very different economic environments that offer investors distinct opportunities. Europe is seeing a slow and tiered recovery. The ongoing sovereign debt crisis will constrain bank lending and therefore net new supply of commercial real estate. Many government-owned banks are seeking to reduce their total commercial real estate exposure by 2013. As indicated by several key private equity players, some investors have scaled back their investment or withdrawn from the European market entirely. Meanwhile, Canada’s stable economic and political climate makes the property market highly attractive to both domestic and international investors. With many investors seeking an asset class that offers diversification, lower volatility, current yield and a degree of inflation protection, the Canadian real estate market is well positioned for investment.

Ultimately, the economic downturn and subsequent uneven recovery has introduced opportunities for both distressed sellers and sophisticated investors in the public and private global real estate markets alike.

Eric Bonner is Senior vice-president, Brookfield Asset Management LLC

1 Real Capital Analytics.

2 A blocker corporation is a type of C Corporation in the United States that has been used by tax-exempt or foreign investors to protect their investments from taxation when they participate in private equity or hedge funds.

Alongside with growth in the industry, plan sponsors have become far more sophisticated and knowledgeable about individual strategies and their managers. This increasing sophistication is quickly changing the way they invest: more pension funds are now moving away from the fund-of-funds approach and into direct manager selection. The move to direct investment makes sense for a number of reasons.  To start, the economics of the direct approach can be more cost effective.  At the same time, large pension funds are now more interested in customizable hedge fund strategies that will fit within their portfolios and can help offset other risks that exist across the pension fund. In addition, growing hedge fund experience and sophistication among pension funds has made it more economical and affordable for them to bring talent in-house, rather than hiring external managers.

The importance of due diligence

While direct hedge fund investment has its advantages, it also involves a host of new risks that must be understood and managed. And while plan sponsors have become very sophisticated in how they use hedge funds to mitigate the risks within their portfolios, more work needs to be done in the area of operational due diligence.

Conducting operational due diligence in the hedge fund space begins with two key questions: Does the manager or the firm have the operational capabilities to support the investment strategy? And, are their resources and managers capable of executing a strategy and running a sound business? To be certain, these questions are important during the hiring process — but are they part of a plan sponsor’s review and ongoing evaluation process? If they aren’t, then they should be.

Plan sponsors must also ensure that they have a clear understanding of the key partners involved with the manager, including the prime broker and the administrator. Due diligence in this area should focus closely on the books and records of the fund, in addition to regular auditing and ensuring investors receive timely and accurate information.

As the industry continues to evolve, plan sponsors must clearly be able to assess and understand the hedge funds they invest in. Moreover, they need to monitor them and make sure that those funds continue to deliver value while avoiding the operational risks.

Joe Morgart is Senior Vice President, Alternative Investment Strategies