CTVglobemedia. Maple Leaf Sports + Entertainment. North American Oil Sands Corporation. Samsonite. These are only a few of the private equity investments reaping rewards for the Ontario Teachers' Pension Plan that were listed in a recent full-page ad in the Globe and Mail.

But real estate continues to be the most popular non-traditional asset class for Canadian pension plans seeking broader diversification, and significantly fewer Canadian pension funds than their U.S. counterparts have dipped their toes in other alternative waters.

Real estate brings steady returns

Research conducted by Greenwich Associates in 2006 and presented by principal Leah Hansen to a recent Mindpath conference shows that about 6% of institutional assets in both Canada and the U.S. were invested in alternatives, but the distribution among asset classes is quite different.

In the U.S. 1.9% is allocated to hedge funds, 3.9% to private equity and 4.3% to real estate. In contrast, Canadian pension funds invested 1.5% in hedge funds, 2.6% in private equity and 5.5% in real estate. 

"Real estate is a popular investment for pension plans because of its low volatility and steady returns," says Towers Perrin Investment Consultant Bob Bevan. "The way it is recorded on the balance sheet is also attractive as we move to a mark-to-market world."

However, Bevan says there is a limited supply of quality real estate in Canada because closed-end funds sell out fast, and open-ended funds that don't have the cash flow to redeem units on an ongoing basis are less viable.

 "In most cases, tax issues also preclude investment in U.S. Real Estate Investment Trusts," he notes. "Because an influx of foreign capital has been so rare until now, few U.S. REITS have set up 'blocker companies.' As a result, a Canadian pension plan investing in these vehicles would be treated as a U.S. limited partnership and exposed to federal, state and municipal taxes."

Nevertheless, Bevan believes that it doesn't take a fund as large as the OTPP, OMERS or the Caisse to assemble a real estate portfolio.

"One of my clients has done very well by buying into eight funds marketed by Northern Trust over the years as they came out. Also, LaSalle Investment Management, a Chicago-based company, has recently raised money from a number of mid-sized corporate plans for purchases of Canadian commercial real estate," he says.

Higher U.S. allocations

Although real estate is currently the most typical alternative investment held by Canadian institutions, over half of the 255 Canadian institutional investors interviewed by Greenwich expect to increase their allocation to other alternatives, including hedge funds and private equity.

However, when it comes to alternatives, pension plans in this country still have to go a long way to catch up with their U.S. counterparts. The overall percentage of Canadian institutional assets in alternatives may be comparable to the U.S., but the number of individual American institutional investors currently holding these asset classes in their portfolio is significantly higher.

For example, in 2006 the Greenwich data reveals that the proportion of funds invested in these nontraditional categories were as follows:

Real estate:      Canada 31%; U.S. 53%
Hedge funds:   Canada 15%; U.S. 36%
Private equity:   Canada 15%; U.S. 48%

Keith Walter, a senior VP at MFC Global thinks one reason for this disparity is the "wait-and-see" approach many Canadian funds outside the large public-sector plans are taking. "The health of Canadian pension plans has improved over the last few years so many funds are questioning whether they really have to move into these relatively new asset classes," he says.

Canada Mortgage and Housing Corporation's investment strategy has certainly been successful. CMHC has a fully funded defined benefit pension fund of $1.2 billion, which currently has a strategic allocation of 8% to real estate.

Even though the fund does not currently have exposure to hedge funds or private equity, Director of Investments and Pension Funds Karen Bailey says they will consider these and other alternatives again as part of an asset allocation mix review slated for this year. "What we have been doing is going well.  However, if we can get better with lower risk by diversifying into some alternatives, we will certainly look at it. But if it doesn't make sense for the size of our fund, we will have done our due diligence."

Size of the pension fund is a critical factor when it comes to alternatives, say Hillsdale Investment Management's COO Aron Kaul and Christopher Holt, the president of Holt Capital Advisors. "The pension side is really skewed by a handful of large Canadian investors — Teachers, the Caisse and CPP, which are the most active. If you take them out, the average level of  alternative investments would be even lower," says Kaul. "However, the public plans have the in-house expertise."

"The structural camp says plans are smaller in Canada. Nevertheless, I've seen research showing that plans of similar size have a propensity to invest in hedge funds on both sides of the border," adds Holt. "Another contributing factor is that in the U.S. and the U.K. there is legislation that encourages boards to look at alternative investments in the context of a prudent investor type of definition, but that does not seem to be the case in Canada."

"With listed markets only expected to return 5% for bonds and 8% to 8.5% for equities, and equity markets being correlated currently, I think there is an onus on plan sponsors to think about a more intelligent way to invest," says Janet Rabovsky, Watson Wyatt's Toronto investment practice leader.

 She believes the real reason U.S. pension funds have moved into alternatives more quickly is that as a general rule, American investors are more entrepreneurial. "The idea of taking risk and actually being rewarded is a much easier sell in the U.S. Canada is more like Australia, where they call it 'the tall poppy syndrome' — if you get too far out of your place, we'll lop your head off. No one wants to be different."

The duration of private equities is a much better match for pension plan liabilities because they are typically 10-15 year investments, yet Rabovsky suggests a lot of board members are concerned about putting their necks on the line because their terms are only three to four years. "But for those who have gone down that road, it's been a very healthy place to be."

Controlling risk

In spite of the fact that evaluating and integrating alternative investments may be a daunting prospect for many DB pension funds, experts agree that most investment committees and CIOs would be remiss if they don't actively consider the merits of alternatives at regular intervals.

"They certainly offer lots of opportunity — not just with respect to rates and return — but in terms of diversification and risk reduction," says Hansen. For Kaul, the biggest advantage is that "if you put alternatives in the portfolio, the plan sponsor can simply pick their volatility and gain much more control over their return stream."

However, Rabovsky cautions that governance is of massive importance for DB funds paddling in alternative waters.

"You cannot go into illiquids and more complex investments without good governance. This means skilled people who know what they are investing in and what they want to get out of it. They also have to be able to actively market the sector, whether it is a public or private market. And last but not least, they must have small decision-making groups, because a board of 10 is never going to make a good decision," she says. — S.S.

Giving DC investors alternatives

If few DB plans are playing in the alternative space, nontraditional options for DC investors are even more limited. "Standard Life and Great West Life have real estate funds on their platforms, and when we do a review of investment options with our clients who are with these providers, we try to get these funds in," says Bevan. "In addition, Kensington Capital Partners has just brought out a private equity fund for retail investors, so the insurance companies may be interested in setting up funds to hold units. The challenge of offering private equity on a DC platform is that if a person wants to retire and annuitize, the investment isn't liquid."

Rabovsky says her firm would like to see a portfolio approach. "If educated people can't get their heads around this stuff, what about the average DC member? We think target date funds should include alternatives in some form because it is the only way DC plan members are going to be able to invest in them."

As the institutional manager for Manulife, MFC Global manages asset allocation funds globally for Canadian, U.S. and Asian clients. "We do more than $40 billion of business around the globe where we knit together from public markets the asset classes that give us the right exposure," says Mark Schmeer, the head of equities and CIO of MFC Global in the U.S.

"Our DC asset allocation products in Canada include emerging markets, high yields, income trusts and mortgages as standard offerings on the Manulife DC platform. John Hancock in the U.S. has a broader set of investments including REITS and commodities among other things. We expect the Canadian funds will also evolve in that direction," confirms MFC Global Senior VP, Keith Walter.

Currently none of Sun Life's target date or target risk funds include real estate, hedge funds or private equity, but Sun Life's Manager of Investment Manager Research for Group Retirement Services Kathrin Harke says Barclay's Global Investors is considering adding alternatives to their asset allocation portfolios, which are available on the Sun Life platform.

She also notes that Sun Life customers can take advantage of their "open investment selection" program, which allows sponsors to add any fund to their platform provided a minimum asset level of $3 million is invested in that fund and certain operational criteria are met, including daily valuations.

"In addition, there has been some interest in using alternatives as part of a balanced fund from a few very sophisticated plan sponsors with in-house expertise, says Harke. "There are different ways to set this up, but you probably need something in the eight-digit range to add a fund to our platform." — S.S.