Canadian Pension Plan Active Overlay Program
Jul 6th, 2006 | Filed under: Institutional Investing, Investment Management Fees, Portable Alpha & Alpha/Beta SeparationIn April 2004, Canada’s national public pension plan awared the first of 4 “notional mandates” of $500 million each. The four overlay managers were tasked with providing the CPP with the holdings of a hypothetical market neutral equity fund. The CPP Investment Board then sold the hypothetical “shorts” out of their passive equity portfolio and used the proceeds to overweight the hypothetical “longs”. The managers were then compensated based on the performace of the hypothetical portfolio, or the “active overlay”.
In a press release dated April 4, 2004, the CPP described the program in the following terms:
“Under the program, each firm will manage the equivalent of a $500 million equity portfolio within the total CPP portfolio of $66.3 billion. Unlike traditional programs where external investment firms are given cash to invest, each manager in the Active Overlay Program will have the right to identify securities in the CPP Investment Board’s public equity portfolio that it believes are overvalued. These securities will be sold and the proceeds used to purchase other securities the manager believes have greater investment potential. The managers are not permitted to sell stocks short. Structuring the mandate in this fashion is an innovative way to mitigate transaction costs while pursuing superior risk adjusted returns. It also provides a clear and powerful tool for quantifying the performance of each investment manager.”
[…] While this article makes reference to market neutral index-overlays, it does not specifically discuss market-neutral equity overlays such as the one used by the Canadian Pension Plan (see post). Still, concepts such as the “notional amount” are critical to both forms of overlays… “One common way to curtail exposures involves the use of acceptable over- and underweights (ranges) applied to an agreed-upon notional amount. The notional amount of the mandate together with other risk control parameters will determine the size of positions the manager can take. The notional amount could be set equal to the total plan value of $2,000 million. Alternatively, it would be perfectly reasonable if the overlay manager agreed to manage to a predetermined notional amount, of for example, $500 million, supported by $50 million in cash transferred.” […]
[…] As Lueb points out, the separation of alpha and beta needn’t be physical. Alpha can be generated from a notional amount of assets (similar to the Canada Pension Plan overlay program). “It’s hard to say how much assets are invested in alpha because we look at it in terms of value at risk. That’s one of the benefits of being able to decouple them (alpha and beta), as you don’t necessarily need underlying assets to generate alpha,†said Mr. Lueb.” […]
[…] AllAboutAlpha contains only one posting (out of 300+) on the topic. In 2004, the Canada Pension Plan began using an active overlay strategy that amounted to synthetically shorting against their $80 billion passive portfolio. The CPP awarded four $500m “notional mandates” to manage in a market neutral (read: all alpha) strategy. But that was three years ago. Since then, no one seems to have seen much of the term “overlay”. […]