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‘Invest like a pension fund,’ they say. But what does that mean?

It means looking beyond stocks and bonds – and not fretting over short-term results

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Any family looking to preserve its wealth will, at some point, come across the old adage “invest like a pension fund.”

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It sounds serious, like a promotion to some higher league of capital preservation. But for family advisers, the adage means something less fanciful, more personable and maybe not what some clients expect.

To “invest like a pension fund” means more than simply focusing on hard numbers and returns on investments. It means planning a family’s needs and expenses across generations. It’s about understanding what a family wants to do with its wealth in the future — and only then can a true discussion of wealth preservation, asset mix and risk tolerance begin.

Nancy Marshall explains: Clients come to her wondering whether they should preserve their wealth in the typical fashion, by investing in common-variety stocks and bonds. Or, because they already have amassed sizable wealth, maybe they should start thinking more like an institutional investor, says Marshall, who is director of strategy and development at Prime Quadrant, a multi-family office in Toronto.

Institutions have a different way of looking at their holdings. Yes, large pension funds, foundations and endowments are fixated on capital preservation and matching the best asset mix with the right amount of risk.

But they are also constantly aware of matching those assets to liabilities. In other words, pension funds must constantly take future expenses into account.

This fixation on liabilities is key in understanding how a pension fund invests.

“It’s back to the whole question of, what is the purpose of this capital?” Marshall says. “What I always tell prospective clients and families that I’m speaking with is, please don’t come to me and tell me that if we can achieve 15 or 12 or 10 per cent with your capital, you’ll be happy. Because that’s not really the way to solve the equation,” she says.

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Higher returns = volatility

Family members will inevitably have ideas of what to do with their wealth. Perhaps the aim is to start a family foundation. Or maybe the goal is to act like a family bank, investing in businesses that the family’s subsequent generations hope to start.

If, on the other hand, a family is concerned merely with earning a high return on investment, they may be exposing themselves to volatility that doesn’t match their current or future plans.

“You really need to understand what’s the purpose of the capital. Where am I going to use it? And once you know that, then you can start to match those assets to those liabilities,” Marshall says. And of course a family’s plan can change over time, just as the liabilities of a pension fund change.

In order to afford those liabilities, pension funds look to other asset classes rather than just publicly traded stocks and bonds.

Given their enormous size, institutional funds are like dreadnaughts on the financial high seas. (The Canada Pension Plan Investment Board administers around $500 billion in assets and is one of the largest in the world.) Yet, their broad asset mix gives them a degree of nimbleness.

Their diverse holdings typically include real estate (from office blocks and industrial property to shopping centres and multi-use properties) as well as infrastructure. They also hold private equity and privately traded debt. The list goes on. It’s also common for institutional funds to have stakes in hedge funds, which help counterbalance broad market movement. (“They zig when other asset classes zag,” as Marshall says.)

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Private investment can be cheaper

Investments in the private markets (such as private equity) tend to have a slightly longer-term horizon. They can be a little less liquid, at least relative to ordinary, publicly traded stocks.

But as portfolio manager Todd McLay at Precedence Capital in Saskatoon notes, investments such as private equity don’t have that extra premium on their share price because they aren’t on the public stock market.

“If you give up that liquidity premium, you will actually be able to buy the asset — or the cash-flow stream — as an investor cheaper with a private investment,” McLay says.

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Plus, a private asset likely won’t suffer the same volatility as one on the public market, he adds. This helps balance a family’s investments with its needs over time. Also, since a lot of families have made their wealth by starting their own businesses, they often prefer to invest in other businesses privately rather than through public stocks.

Dealing more directly with another company is what they’re used to. That’s where their expertise lies.

“They like consistent, steady, secure, owning the actual asset,” McLay says, adding that large institutional funds such as the Canada Pension Plan and Ontario Teachers’ Pension Plan similarly seek that kind of consistency.

The final element is then knowing what role or function an asset can play within a family portfolio. One function is timing, as in timing the asset’s duration to a family’s liabilities.

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When will you need cash?

It’s the same kind of calculation that institutional fund managers must make. “Pension funds match the duration of assets to the timing of liabilities,” explains Rob Harder, portfolio manager at Family Wealth Group in Winnipeg. “They need X amount to pay out to pensioners in a certain year, so they are going to hold some bonds that come due at that time to cover that off.”

But then, here’s the catch: “In today’s environment, bonds are a challenging asset class to hold. We’re in an inflationary environment, and that’s the time when bonds have a negative return,” he says. “But it doesn’t mean that bonds don’t have a role in risk mitigation in a portfolio. They still do.” So, in this case, bonds may play different roles in a portfolio at different times.

Or, as another example, infrastructure investments or real estate can help add diversity to holdings, but they also may be used as a relatively steady, longer-term investment, especially if a family doesn’t need that money right away. Just as pension funds do, a family may use an investment for different purposes over time.

And so, this returns to the fundamental question of looking at the family’s strategy for what it wants to do with its wealth, just as institutional fund managers need to constantly reassess liabilities.

“There’s a saying in the family advising space that when you meet one ultra-affluent family, you’ve met one ultra-affluent family,” Marshall at Prime Quadrant says. “Because, of course, every family is different. So, everybody’s plan is different — and, quite frankly, that probably means that everybody’s asset allocation is different as well.

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