Pension funds must invest today with an investment horizon of upwards of 30 years making them true long term investors.
The Ontario Teachers' Pension Fund was analyzed to determine how it allocates its assets to provide a risk adjusted return.
The allocations were then used to create a model portfolio of ETFs which was then back-tested over the last seven years to determine its performance.
I personally have a very long term investment horizon. Being 35 years old with an average life expectancy of 81, I want the investments I make now to serve me for the very long term. With this time horizon in mind I think an investigation into the methodology behind pension fund investments is extremely prudent.
Pension funds are investing now to provide their members with monthly income 50 years from now at a defined rate for the entire life of the pension, for those people who are fortunate enough to have a defined benefit pension. Furthermore, in the case of the pension fund that I will be investigating the monthly income received by its members is inflation protected. Major areas that pension funds focus on are asset allocation, risk management and investing in assets that offer the potential for predictable cash flow for the long term. I believe that these highlighted areas should not only be utilized by pension funds, but also by individuals creating their own portfolios for the long term. (Note in my mind the long term means more than 10 years).
I have decided to investigate the Ontario Teachers' Pension Plan (OTPP), as it publishes easily accessible annual reports and also has demonstrated the ability to generate impressive returns over an extended period of time. The OTPP has an annualized return of 9.7% over the last 10 years, provides a defined pension to over 130,000 members, manages over $139 billion in assets and deals with a demographic who on average retire at 59 and collect their pension for 5 years longer than they were contributors. (see OTPP News Article).
Obviously the assets that they are capable of purchasing are nowhere near what the average investor could even touch; however, I want to focus more on how they have been allocating their assets and how they manage risk, since these two lessons can be applied to anyone's portfolio.
The following table shows how the OTPP allocated assets in the major categories of equities, bonds, real rate of return bonds, natural resources, real estate and infrastructure.
Net Investment by Asset Class with amounts in billions of Canadian Dollars
Real Rate Products
These values can be found from the OTPP Annual Reports Archive.
Before we discuss what the allocations mean, first let us familiarize ourselves with the purpose of each of these asset classes within our own long term portfolio.
Equities: I am sure we are all familiar with these. We buy equities with the intention of obtaining investment growth as well as investment income (dividends).
Fixed Income: These include traditional government, provincial, corporate, etc. bonds as well as real return bonds, which are bonds linked to inflation. Their purpose is to help stabilize your portfolio through investment security and steady income.
Natural Resources: These include physical commodities, oil, gas, timberland, agriculture, mining etc. They again help the risk adjusted return of the portfolio by providing protection in the case of high inflation.
Real Estate and Infrastructure: This is another group that tends to provide returns linked to inflation, which again helps to protect the overall portfolio.
Now looking at the above table I chose to look at the 2012 and 2013 asset allocations compared with the 2006 and 2007 asset allocations in order to see how the OTPP responded to the recession.
The most obvious observation is the percentage of the portfolio that was linked to equities pre and post recession. The weighting of that asset group has been significantly reduced, with the funds being redistributed to bonds, natural resources and real rate products. This is likely a very smart move as inflation has only one direction to move and increasing their exposure to products whose returns are linked to inflation provides a better risk adjusted return than simply leaving the bulk of the portfolio in equities. With respect to inflation although it seems to be rather muted right now, I believe that it will show its full force in the very near future. The Consumer Price Index (CPI) is the measure of inflation; however, the weightings within this index have been altered numerous times. More on this in another article. I firmly believe that if one's portfolio can withstand the onslaught of inflation over the long term as well as being tax efficient, it will benefit your portfolio much more than stock picking.
One may argue that for investors with long term time horizons the equity exposure currently suggested by the OTPP is too small since these individuals can 'weather the storm' of another downturn; however, the management behind a fund as large as this with a time horizon far beyond our own suggests otherwise. Saying this, as an individual investor I may be more inclined to gravitate toward dividend growth stock as an inflation hedge as opposed to real return bonds or infrastructure.
Another takeaway from the above table is the willingness to reallocate assets. Building a buy and hold portfolio without reference to current economic trends puts you in a riskier position than making changes to prepare for these trends, such as the inevitable rise of interest rates and inflation.
Fortunate for us small time investors we can still build a low cost portfolio modeled after the OTPP using ETFs. I am going to build such a model portfolio and back test it over the last 7 years to determine its annualized performance. Although historical performance does not guarantee future results, asset allocation using a diversified portfolio has been proven to improve risk adjusted returns and capital protection.
To build this model portfolio I am going to use ETFs allocated with the same weightings as the OTPP's 2013 annual report.
The model portfolio will be built using a hypothetical $100,000 invested in 2007. The percent weighting, dollar amount, income stream and management fees will be outlined in the table below calculated based on the ETFs' value as of August 14, 2014.
XRB - iShares Canadian Real Return Bond ETF - Distributes 1.88%
BND - Vanguard Total Bond Market ETF - Distributes 2.08%
VT - Vanguard Total World Stock ETF - Distributes - 2.31%
VAW - Vanguard Material ETF - Distributes - 1.77%
VNQ - Vanguard REIT ETF - Distributes - 3.65%
GII - SPRD Global Infrastructure ETF - Distributes - 1.94%
Asset Allocation in 2007
Real Return Products
This model pension portfolio can be constructed for an annual MER of 0.20% which I believe to be quite reasonable for the type of risk adjusted returns it is expected to generate.
Back-testing this portfolio using the available data from Google Finance we obtain the following results. Note: Some of these ETFs have not been in existence for 7 years, in these situations I went as far back as possible and made a note of the date it began.
Real Return Products
Analyzing these results we can observe a CAGR of 4.78% which may sound low, but keep in mind the time frame chosen went from August 2007 until August 2014. Furthermore, if one were to analyze the performance of each stock during various periods we can clearly see how this portfolio is indeed risk adjusted based on how one asset class outperforms another during these periods.
I think this exercise to analyzing how the 'big money' allocates their assets provides us with many good indications as to how our own portfolio should look. Personally I might reduce my exposure to one of the asset categories like real return products and instead look at adding a dividend growth ETF simply based on my age. The reason pension funds do not have as high of an equity exposure is their need to provide pensions to their 130,000 members each year and not just in 30 years.
I think allocating assets in such a way as demonstrated above will provide a portfolio that is indeed risk adjusted and provide satisfactory returns over the long term.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.