What drives the value premium? (EP.52)

Episode Summary

Executive Summary: Episode 52 marks the podcast’s one-year anniversary and centers on four themes: a critique of a Parliamentary Budget Office report claiming CPPIB’s active management beat passive investing, a discussion of MD Financial/Scotiabank fee reductions via manager reshuffling, an evidence-based review of whether value still earns a premium, and practical guidance on when to claim CPP. The hosts stress benchmarking quality, risk adjustment, and case-by-case retirement planning.

Main Topics: CPPIB active management vs passive benchmarking (Priority: 5/5): The hosts dissect a PBO report claiming CPPIB’s active strategy outperformed indexing, arguing the benchmark was poorly chosen because it compared CPPIB’s diversified, illiquid asset mix to a simple 70/30 stock-bond portfolio and even assumed similar fees. Risk-appropriate benchmarking and asset-class matching (Priority: 5/5): A custom benchmark using infrastructure, credit, government bonds, REITs, global equities, and listed private equity produced similar returns to the 70/30 benchmark but materially higher volatility, suggesting CPPIB’s apparent outperformance may be overstated when risk is matched. MD Financial takeover and fee reduction (Priority: 3/5): The hosts discuss MD Financial’s post-Scotiabank realignment of portfolio management responsibilities, noting the move appears to shift assets toward Scotia-owned managers and reduce annual investment fees, though only modestly in many cases. Does value investing still work? (Priority: 5/5): They review a broad literature on the value premium, contrasting behavioral and risk-based explanations, and conclude the evidence leans toward a risk-based explanation that should persist despite a long stretch of underperformance. When to take CPP (Priority: 5/5): The episode explains CPP claiming rules, age-based benefit adjustments, dropout years, and survivor considerations, emphasizing that optimal timing depends on health, income history, taxes, expected returns, and household circumstances. Podcast milestone and listener context (Priority: 1/5): The episode notes it is the 52nd episode and the first anniversary of the Rational Reminder Podcast, framing the discussion as a year-end reflection on evidence-based financial decision making.

Key Arguments: The PBO comparison is misleading because it benchmarked CPPIB’s multi-asset, alternatives-heavy portfolio against a simple 70/30 stock-bond portfolio rather than a risk-matched benchmark. Fees were not fairly isolated in the PBO analysis because the report appears to have used the same operating-cost assumption for both active and passive portfolios, even though passive indexing would likely be much cheaper. When the portfolio is matched more closely to CPPIB’s actual asset mix, returns are similar to the 70/30 benchmark but volatility is much higher, indicating that CPPIB’s higher return may mainly reflect taking more risk. A much more equity-heavy benchmark could have matched the custom benchmark’s volatility and produced a higher return, implying that exotic illiquid assets were not obviously rewarded on a risk-adjusted basis over the sample period. Even if CPPIB did generate alpha, the evidence on active managers sustaining outperformance is poor, especially at the scale of a giant pension fund. The value premium has existed historically, and the strongest evidence suggests it is a risk premium rather than merely a behavioral mispricing, so it should be expected to persist. The research reviewed shows that valuation/book-to-market explains returns better than overreaction proxies like past returns or sales growth once factors are controlled for. CPP claiming should not be treated as a one-size-fits-all decision; the best choice depends on longevity, portfolio returns, tax effects, RIF/OAS interactions, dropout years, and spouse benefits.

Data Points: Episode number: 52 - Marks one year / 52 weeks of the podcast CPPIB reported fee/cost assumption: 84 basis points - Hosts believe the PBO report effectively used the same operating-cost assumption for both active and passive strategies CPPIB asset mix: infrastructure: 8.5% - Part of the CPPIB portfolio cited as a reason the benchmark should be risk-matched CPPIB asset mix: credit investments: 9.1% - Part of the CPPIB portfolio CPPIB asset mix: government bonds, cash, absolute return: 10% - Part of the CPPIB portfolio CPPIB asset mix: real estate: 12% - Part of the CPPIB portfolio CPPIB asset mix: other real assets: Just over 3% - Part of the CPPIB portfolio CPPIB asset mix: public equity: 33% - Only about one-third of the portfolio is public equities CPPIB asset mix: private equity: Just under 24% - Substantial alternatives exposure PBO main benchmark: 70% global equities / 30% Canadian nominal bonds - The primary comparison portfolio criticized by the hosts Alternative benchmark return: 6.86% annualized - Return of the hosts’ risk-appropriate benchmark over June 2006 to March 2019 70/30 benchmark return: 6.68% annualized - Return of the simpler benchmark over the same period CPPIB outperformance in report: About 1.2% per year - PBO report’s implied active-management advantage over its benchmark Alternative benchmark standard deviation: 11.01% - Volatility of the hosts’ risk-appropriate benchmark 70/30 benchmark standard deviation: 8.08% - Volatility of the simple stock-bond benchmark 100% equity benchmark return: 7.36% annualized - A fully equity portfolio was said to match the custom benchmark’s volatility closely 100% equity benchmark standard deviation: 11.18% - Used to compare risk with the CPPIB-like benchmark CPP early-claim reduction: 0.6% per month / 7.2% per year - Benefit reduction for claiming before age 65 CPP early-claim max reduction: 36% - Claiming at age 60 vs. 65 CPP early-claim max at age 60: $738/month - Maximum benefit cited for early claim CPP deferral increase: 0.7% per month / 8.4% per year - Benefit increase for delaying past 65 CPP deferral max increase: 42% - Claiming at age 70 vs. 65 CPP max at age 70: $1,638/month - Maximum benefit cited for deferral CPP claimants in 2016: 312,000 - Number of people who started CPP in 2016 Claiming at age 60 in 2016: 126,000 - Largest claiming cohort cited Claiming at age 65 in 2016: 93,000 - Normal-age claim cohort Claiming at age 70 in 2016: 4,800 - Very small number of people who delayed to 70 Current CPP contribution rate: 10.2% - Split between employee and employer, or fully paid by self-employed individuals US 10-year value premium: -3.29% annualized - Growth beat value by this amount over the last decade US 3-year value premium: -7.24% annualized - Recent underperformance of value vs growth Developed international (EAFE) 10-year value premium: -2.75% annualized - Value lagged growth in developed ex-US markets Canada 10-year value premium: +3.19% annualized - Canada was relatively insulated from the global value slump Average 10-year NACUBO endowment return: 5.8% - Referenced as a comparison point for endowment performance Largest endowments alternatives allocation: 58% - Assets over $1 billion, heavily tilted to alternatives Smallest endowments alternatives allocation: 11% - Assets under $25 million, much lower alternatives exposure

Pivotal Quotes: "Based on these findings, we conclude that the empirical support for the overreaction hypothesis is quite weak." — David Blitz, Bart van der Grient, and Matthias Hanauer (as quoted by the hosts): Used to support the argument that valuation/book-to-market, not behavioral overreaction proxies, is driving the value premium "Look, active management works" — Hosts paraphrasing the problematic takeaway from the PBO/CPPIB report: Summarizes the headline they argue was irresponsible because of poor benchmarking "If we disentangle the contribution to return of various factors, valuation is significant while the overreaction indicators are not" — David Blitz, Bart van der Grient, and Matthias Hanauer (as quoted by the hosts): Highlights the paper used to support a risk-based explanation for the value premium

Implications: Listeners should be skeptical of headline claims without proper risk-adjusted benchmarking. The episode reinforces indexing discipline, explains why value may still merit a premium, and shows CPP timing decisions should be personalized rather than rule-based.