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Oh, Canada!

The masters of risk budgeting at Ontario Teachers' have joined the ranks of the biggest hedge fund investors -- and taken the hunt for alpha into their own hands.

Robert Bertram, an avowed trivia buff, likes to test his wits before breakfast. Every weekday morning, he shows up at the Timothy's World Coffee on the ground floor of his Toronto office tower at 7:00 sharp, when the doors open, because the first seven customers who correctly answer that day's trivia question win a coupon for free coffee. It's not the free cup of joe that Bertram, the investment chief of Ontario Teachers' Pension Plan, wants. It's the satisfaction of being right, which he is more often than not: Stuck into the cork of his office's bulletin board is a thick wad of coupons -- testimony to his mastery of minutiae.

"The questions aren't that hard, and it's a nice way to start the day," says the professorial, gray-bearded Bertram. "You can get a coffee and a scone for just C$1.20." In U.S. currency, that's breakfast for less than a buck.

When it comes to investing, Bertram has been cashing in his coupons since he came to Ontario Teachers' 14 years ago. The Saskatchewan native has completely transformed what was a fund of nonmarketable, nonassignable debentures -- C$17 billion ($13.7 billion) worth of paper courtesy of the Ontario government -- into a model of diversification and risk management.

Bertram and his team have gained renown for their pioneering work in risk budgeting -- allocating risk, instead of capital, across the fund's asset classes. Less well known is how that innovative approach has enabled Ontario Teachers' to become one of the world's leading investors -- if not the leading investor -- in alternative assets: Fully 40 percent of its net C$79 billion portfolio is dedicated to nontraditional investments, from real estate and timber to energy infrastructure and commodities. Ontario Teachers' also ranks as perhaps the single biggest investor in hedge funds, with 5.4 percent of its total assets, or C$4.1 billion, invested with more than 130 external hedge fund managers around the world at the end of 2003.

No other public pension plan has done as much with so little fuss or fanfare. California Public Employees' Retirement System made headlines in 2000 with its decision to invest up to $1 billion in hedge funds; to date, the largest U.S. pension fund has invested less than $900 million of its portfolio's $170 billion in the asset class. Other pension plans have since surpassed CalPERS's mark: The Massachusetts Pension Reserves Investment Management Board and the Teacher Retirement System of Texas have invested $1.5 billion and $1.13 billion, respectively, in hedge funds. The most aggressive investor in hedge funds, the Pennsylvania State Employees' Retirement System, last year boosted its allocation from $3 billion to $5 billion, nearly all invested, but PennSERS, unlike Ontario Teachers', relies on funds of hedge funds.

Under Bertram's guidance, Ontario Teachers' made its first external hedge fund investment in 1996, placing $100 million with a fund of hedge funds as a means of testing the market. Since then the investment staff has largely eschewed funds of funds, preferring to do its own due diligence on managers and invest directly.

But the amount of money managed outside doesn't begin to reflect the full extent of Ontario Teachers' hedging activities. Inspired by its external successes, the plan enthusiastically embraced hedgelike investing in-house: At the end of 2003, its internal absolute-return strategies, from fixed-income arbitrage to long-short portfolios, accounted for an additional C$6.6 billion, or about 8.7 percent, of the then C$75.7 billion portfolio. Taken as a whole, internally and externally hedged assets totaled C$10.7 billion last year, or 14.1 percent of Ontario Teachers' assets under management.

"A lot of attention gets paid to plans with hedge fund investments of $1 billion or more, but these guys have had much larger investments for a much longer period of time," says Michael Litt, a partner and client investment strategist at FrontPoint Partners, a hedge fund in Greenwich, Connecticut, and the former head of the global pensions group at Morgan Stanley. "They've done it very successfully -- and they've done it very quietly. Ontario is really ahead of the curve."

Bertram's moves have been a rousing success: Ontario Teachers' has posted a compound annual return of 11.1 percent since 1990, when he was named chief investment officer. Last year the portfolio returned 18 percent, handily outstripping its composite benchmark of 13.5 percent and beating the six other major pension plans in Ontario and Quebec.

Paradoxically, that success is the cause of Bertram's greatest challenge: finding a way to manage Ontario Teachers' first-ever funding shortfall. Falling interest rates and increased pension benefits left the fund with a C$6.2 billion deficit at the start of this year, a far cry from 1998, when it had a C$10 billion surplus. The deficit hasn't shrunk. Although the portfolio was up 5.3 percent through June 30, 2004, interest rates on Canadian real-return bonds fell from 2.8 percent in January to 2.2 percent by mid-June. Canadian RRBs pay a rate of return indexed to inflation as measured by the consumer price index and play a major role in the asset mix of the pension fund: They constitute 9.4 percent of the portfolio and form the basis upon which the cost of the plan's future benefits is calculated. As interest rates fell, Ontario Teachers' liabilities rose -- a difficult and frustrating scenario.

After 1998, Ontario Teachers' fell victim to its own success -- as did many of its peers in the pension plan business. The plan's surging returns proved irresistible to its sponsors, the government of Ontario and the Ontario Teachers' Federation. The government wanted to use the extra money to eliminate the payments it was then making to cover the pension fund's historical, pre-1990 unfunded liability of C$7.8 billion, and the teachers fought to use the surplus to boost pension benefits and lower the retirement age. Both got their way and agreed to spend down the entire C$10 billion surplus, as well as the next C$6 billion the fund was expected to generate. The government eliminated its own debt, and teachers were granted early retirement (with some reduction in pension benefits) at age 50 instead of 55.

The combination of higher benefits and falling interest rates made it significantly more difficult for the plan to meet its liabilities. Exacerbating matters, the number of pensioners has grown enormously, more than doubling from 46,000 to 93,000 in the past decade. Today there are just 1.7 contributing teachers for every pensioner; in 1990 the ratio was 4.1 to 1.

For Bertram, who argued unsuccessfully to protect the plan's surplus, this adds up to a bitter reality: Had the plan sponsors left well enough alone, Ontario Teachers' would now have a surplus of roughly $18 billion. Instead, it is facing its first-ever funding shortfall.

"Professional firefighters, even if the fire is on the other side of the county line, can't stand around and watch a house burn down," Bertram says. "I'm not saying our house is burning down yet, but we can't walk away. We can't say, 'Well, we told you so!' Our professional responsibility doesn't end -- we have to deal with it."

Dealing with it means finding innovative ways to invest without taking on more risk. Given the fund's deficit, Bertram can't build more risk into the portfolio; he can only minimize it, even as he works to maximize returns by cutting every basis point of excess cost. Although Ontario Teachers' is still far better funded than many U.S. state pension plans -- as of January 2004, its funding ratio was 94 percent, compared with the median U.S. state pension funding ratio of 79 percent, according to a study by Wilshire Associates -- Bertram is painfully aware that its day of reckoning is not far off. If Ontario Teachers' still has a deficit by December 31, 2005, the teachers' federation and the Ontario government will have to make up the difference, either by raising the contribution level that teachers pay -- political poison ivy -- or by taking other unpleasant steps, such as eliminating the automatic inflation protection for future retirees on their future pension benefits.

Between now and then, Bertram's task seems almost Herculean: At present funding and interest rate levels, the pension fund will need to earn 25 percentage points above inflation next year to avoid a shortfall come January 1, 2006 -- a bit of a stretch, to put it mildly, in an environment where, according to Wilshire Associates, the assumed rate of return for public pension plans' equity investments is about 7.75 percent a year. Bertram is not about to turn his back on the problem, but finding a solution will undoubtedly test his ingenuity.

Bertram has faced tough choices since he joined Ontario Teachers' 14 years ago, after the provincial government, to close the fund's multibillion-dollar deficit, decided to reorganize it, creating an independent corporation to manage its assets in the hope that hiring an investment team -- and giving it some degree of autonomy -- would help boost returns. The newly appointed independent board of directors named Claude Lamoureux, who had spent 25 years as an executive with Metropolitan Life, rising through the ranks to head the company's Canadian operations, as president and CEO of Ontario Teachers' and brought in Bertram as investment chief.

Bertram was an unusual choice. The tall, cheerfully blunt statistician grew up on a farm in Saskatchewan, the 12th of 14 children. As a teenager he helped run the farm while his father attended university, an experience, Bertram says, that primed him for a career in portfolio management: He quickly learned to manage cash flow and estimate crop yields. As an undergraduate at the University of Calgary, Bertram discovered an affinity for statistics while studying history: His first job out of college was as a phone traffic engineer, forecasting holiday call volume for Alberta Government Telephones.

The hardworking Bertram took a couple of years off from AGT to get an MBA from the University of Alberta before returning to spend the next 18 years at the company, which in 1990 was privatized as Telus. Rising through the ranks, Bertram took charge of a disparate array of financial activities, including the management of AGT's C$2 billion pension fund, as well as other investments. His department oversaw treasury operations, investor relations, risk management, credit and collections and billing. The range of Bertram's duties kept him busy but distracted him from what quickly became his primary interest: investing.

"I thought that if I came here, to Ontario Teachers', I could just concentrate on investments," he says. "If I'd stayed there, I would have had to do all of this bill collection stuff. I sat in on some of those calls -- I made some of them, too. They weren't so hard, really, but I liked investing better."

Bertram's initial assignment was to build a professional investment team, which quickly set to work reducing Ontario Teachers' exposure to fixed income and increasing its exposure to equity. The chore was complicated by the government's requirement that 70 percent of the value of the plan had to consist of Canadian assets (a rule that still applies). From the beginning, necessity drove innovation: Handed a portfolio of nonmarketable government debentures, the staff turned to an array of swaps and derivatives to synthetically capture equity returns.

The transformation of Ontario Teachers' portfolio mirrors the maturation of Bertram's investment philosophy: In the early '90s he and his team began to doubt the adequacy of adding equity index funds to capture market returns. To meet future liabilities, the plan had to consistently deliver 4.3 to 4.5 percentage points above the consumer price index (the threshold has since risen to 5 percentage points). Bertram began to focus his sights on investment management processes that would provide top-quartile performance. The need to find previously unrecognized, underutilized sources of value-added returns drove him toward alternatives.

"We had to turn this organization in a new direction and really go after value-added product in all asset classes: public equities, fixed income and private equity," Bertram says. "Adopting that strategy started us down the road toward hedge funds."

Managing alternatives also meant finding new ways to calibrate risk beyond traditional portfolio optimization models. Bertram wanted a risk management tool that could encompass all of the portfolio's risk, across the entire range of its investments. In 1995 he hired Leo de Bever, who has a Ph.D. in economics from the University of Wisconsin and is a former chief economist at Chase Econometrics Canada, to head research and economics. The seasoned quant was immediately intrigued by the challenge of understanding the risks inherent in the active management program, which at that point included a fast-growing private equity portfolio, launched in 1991 with $100 million and seven initial investments, and a real estate portfolio, also launched in 1991, with the purchase of three Canadian shopping malls. De Bever transformed risk management from a control system into a methodology for evaluating investment alternatives across the entire portfolio.

"To me, the real value comes from using risk management as a tool to modify your strategy," says de Bever, who left Ontario Teachers' last spring to join Manulife Financial Corp. as head of global investment management. "You take a look and say, 'Well, given the risk, and given the expected returns, where is the best place to put my dollars?'"

De Bever ultimately designed a customized risk budgeting system that adds up the risk across the entire fund and gives it an aggregate total. The system also indicates which returns cost the least in terms of actual risk taken. Asset allocation as a means of portfolio optimization became a thing of the past; rather than budgeting capital for each department, Bertram began budgeting risk.

"When you start with risk, you get multiple solutions to the asset mix dilemma," Bertram says. "We've reduced the market exposure, or beta -- which is expensive relative to its volatility -- and increased the value-added exposure, which is not as expensive."

Risk budgeting, de Bever explains, essentially split the portfolio "into a bunch of index funds and a bunch of what were essentially hedge fund strategies." Internally, managers had begun hedging currency exposures as early as 1991; the adoption of risk budgeting meant that the plan could begin to integrate external hedge funds into the portfolio, a process that began in 1996. Ontario Teachers' initial hedge fund investments came under Neil Petroff's oversight (Petroff, who joined Ontario Teachers' in 1993, oversees fixed income, international equity indexes, currency, and alternative investments) -- but first, Ontario required disclosure from those managers. And de Bever, who had a vast portfolio to protect, demanded real transparency.

"My only problem with hedge funds is that what passes -- or masquerades -- as an absolute-return strategy often has a lot of risk in it, and a lot of opaque risk, at that," de Bever says. "Every fund seems to tout a Sharpe ratio of 2 or 3, and that is just not humanly possible to sustain."

Ontario Teachers' now asks its external hedge fund managers to report their positions to the corporation's risk system on a daily basis (or as often as they are able). That transparency allows the staff to calculate various risk measures, determine return on risk, guard against excessive leverage and identify style drift and position concentration.

The risk budgeting system also fueled the research and development of hedged strategies used by Ontario Teachers' own investment staff. Across the entire portfolio, investment managers focused on adding alpha at the least cost, or risk, instead of merely aiming to beat a given benchmark. "If you have everything under one umbrella," de Bever observes, "and you can manage most of your assets yourself, it's much easier to grasp the aggregate exposure -- and our portfolio managers naturally gravitated to it, as well."

"It really facilitated the change [to alpha-oriented management]," says Brian Gibson, who oversees C$23 billion in public equities for Ontario Teachers', including C$15.3 billion in active global equities, and who initiated his group's internal long-short program in 1999. "I don't think we could run any long-short program without the kind of robust risk management system that we have; that system laid the foundation for what we do now."

To the untrained eye, Ontario Teachers' stakes in alternatives are largely invisible: All of the them, from private equity to timber, are subsumed under more traditional-sounding asset classifications. As of December 2003, 46 percent of the Ontario Teachers' portfolio was invested in equity, 26 percent in fixed income and 28 percent in inflation-sensitive instruments, such as real-return bonds, real estate, energy infrastructure and timber.

The fund's 14.1 percent in internal absolute-return strategies and external hedge funds (which include everything from event-driven arbitrage to multistrategy funds) is classified under the fixed-income heading, based on the assessment that hedge funds -- no matter what securities they invest in -- behave more like fixed-income instruments, with lower volatility. This view was inspired by Ontario Teachers' innovative risk assessment discipline, and it set the plan's approach apart from its peers.

Ontario Teachers' decision in 1996 to treat the plan's inaugural hedge fund of funds as part of the portfolio's pool of fixed-income investments -- rather than as an equity allocation, even if the managers were running long-short strategies -- proved a savvy move. Hedge fund returns lessened the blow when Ontario Teachers' portfolio was buffeted by the bear market that began in 2000, and when stock markets roared back in 2003, Ontario enjoyed the full benefit of its equity allocation.

"If those allocations were made from fixed income as opposed to equity portions of the portfolio, then they won in 2003," says Rosalind Hewsenian, a senior consultant with Wilshire Associates who has advised numerous public pension funds on hedge fund allocations. "Some managers missed the market rebound."

In the eight years since the inception of the external hedge fund program, Ontario Teachers' has built up a sizable roster of managers. Although Bertram is reluctant to name them, the plan does disclose some of its largest investments. As of December 2003, Ontario Teachers' had invested more than $50 million apiece with several hedge funds, including the III Fund, a fixed-income arbitrage fund run by Warren Mosler; Arrowstreet Global Opportunities Offshore Fund, run by Peter Rathjens of Arrowstreet Capital in Boston; and Black Diamond Capital Management's BDC Offshore Fund II, an event-driven, distressed-debt fund overseen by James Zenni.

The portfolio of external hedge funds has posted positive returns in every year since 1996 except 1998, when Russia imploded and Long-Term Capital Management collapsed and the portfolio lost 0.4 percent. The hedge fund portfolio added $340 million in value to the total pension fund in 2003, (a return of an estimated 8.5 percent), and rose about 3 percent through mid-June of this year, according to Ronald Mock, who leads the external hedge fund program. Speaking at the Global Alternative Investment Management Forum in Switzerland in June, Mock mentioned that Ontario Teachers' would likely add another $300 million to its external hedge fund assets, which would bring the total to about C$4.5 billion. Historically, external hedge funds have constituted between 5 and 6 percent of the total portfolio, and that percentage will likely remain constant as total assets under management rise.

But finding good managers is getting harder, and Ontario Teachers' decision to rely on Mock to lead the due diligence process has been controversial. Before joining Ontario Teachers' in 2001, Mock was the president and CEO of Phoenix Research and Trading Corp., a Canadian hedge fund management firm that was decimated in early 2000 by fixed-income trader Stephen Duthie. Mock was caught unawares when news broke that Duthie had built up a $3.3 billion unhedged position in U.S. Treasury notes in the Phoenix Fixed Income Arbitrage fund, one of the firm's two master funds. The position triggered a margin call from Bank of New York Corp., and the resulting loss, more than $100 million, destroyed both the fund and the firm. The Ontario Securities Commission fined Duthie C$90,000 and barred him from trading for 20 years, but it also sought to punish Mock, as captain of the ship, for failing to spot the trouble in time. Mock lost his registration with the commission in early 2003 and is not allowed to reapply for five years. Ontario Teachers' management has since closed ranks around him and protects him fiercely from the press. No one at the pension plan would comment on his past.

Bertram's greatest concern about hedge fund investing is simply the speed at which pension plans are piling into the market and allocating money to untried managers. He and Mock are all too aware that the inrush of capital may hurt returns industrywide. "If the skill set becomes more average, fewer managers are going to outperform -- the median is going to move to the left," Bertram says. "We're counteracting that as best we can by trying to go with our hedge funds to places where the crowds are thinnest."

Bertram won't say just where that is or elaborate on specific strategies, but the pension plan's shift in hedge fund allocations from one year to the next is revealing. Between 2002 and 2003, Mock and his team reduced exposure to equity-market-neutral strategies dramatically, from 21 percent of the hedge fund portfolio to just 5 percent. Allocations to risk arbitrage were scaled back from 14 to 3 percent, mortgage-backed securities from 5 to 3 percent, distressed debt from 8 to 6 percent and loan origination strategies from 4 to 3 percent. Allocations to convertible arb, at 15 percent, and fixed-income arb, at 9 percent, remained constant. The winners of fresh capital were the multistrategy funds, a segment that saw its percentage allocation climb from 18 percent to 22 percent. Managed futures and event-driven strategies, which weren't even listed as categories in 2002, commanded 6 percent and 8 percent of the portfolio, respectively, at the end of 2003. Meanwhile, the category listed simply as "other" jumped from 6 percent of the total portfolio to 20 percent.

Bertram's search for investment professionals capable of delivering consistent absolute returns is not limited to external managers: He's equally willing to give capital to the fund's own managers to run hedged investing strategies in-house.

Active equities head Gibson, who joined Ontario Teachers' as a portfolio manager in that division in 1995, was promoted to head it in 1999 and began working to develop a long-short program almost immediately. He launched the research process with just a few investment professionals. Just getting the internal systems in place to handle short-selling -- including educating the trading desk about how to observe short-selling rules on different exchanges -- took some time, he says. But Gibson felt it would be an ideal way to add returns to what had been, until that point, a long-only equity division.

"Even though it had never been done before -- on the equity side -- we were allowed to go ahead with it," Gibson says. "The philosophy here is that if something makes reasonable sense, and we think we can make more money doing it, we're encouraged to give it a try."

Now, five years later, the long-short program is the pride of the global equities division. Twelve investment professionals on Gibson's staff of 20 work on long-short funds and oversee a total of C$3.2 billion in investments (the net market exposure of long and short positions is close to zero). The division currently runs five different long-short programs: One has a geographic focus, one has an industry focus, one focuses on global stock selection, and two are style-related. Two of the five programs are particularly unusual in that they are short counterparts to the long-only funds of two of Ontario Teachers' best external asset managers, essentially turning them into absolute-return portfolios.

Gibson works with just seven long-only external managers, each of whom has a particular approach to the market. Their returns set the standard for Gibson's staff: If Ontario Teachers' long-short teams are able to consistently outperform their seven outside managers? they stand to win more capital. So far, so good: For the past three years, as of September 30, the five internal long-short portfolios posted a compound annual rate of return that was 4.44 percentage points above their benchmarks (either the Standard & Poor's 500 index or the MSCI Europe, Australasia, Far East index, depending on the portfolio). The group of external managers, by contrast, outperformed these indexes by a compound annual 1.25 percentage points. If the internal managers fail to outperform the outside funds, the capital flows elsewhere. The added advantage of having long-short programs in-house is that they allow Gibson to adjust his total equity exposure in response to Bertram's requests at the macro fund level. No individual manager has to suddenly give back capital -- and disrupt his portfolio -- just because Ontario Teachers' needs to reduce its equity exposure; Gibson can make adjustments within his own division with overlays, at considerably less cost to the pension fund as a whole.

Ontario Teachers' broadly diversified investment program is now the envy of Bertram's peers -- at least in Canada, where it's better known than it is in the U.S. Above and beyond the fund's terrific 2003 return of 18 percent, Ontario Teachers' has posted a five-year compound annual return of 7.7 percent and a ten-year compound annual return of 10.0 percent -- making it No.1 among its six major competitors in Ontario and Quebec during each of those time periods. FrontPoint's Litt doesn't think that Bertram's alternatives program has any real peers in the pension fund space -- the closest comparisons he can come up with are the major endowments, like those of Harvard University, Princeton University and Yale University.

"I think there are a lot of other pension plans that five years from now would like to be where Ontario Teachers' is today," Litt says. "These guys are very smart about portfolio construction and correlation offsets."

Bertram is justifiably proud of the way his staff continues to innovate and find new means to add value. The team he and Lamoureux have assembled over the past 14 years bears little resemblance to the original handful of managers, which focused so closely on equity-index swaps: This is a crew of deal makers and active asset managers, some 250 strong. (The pension plan as a whole now has 500 employees, including those on the plan management side.) But despite its size, Ontario Teachers' prides itself on its nimbleness.

"If somebody from Bob's team brings in a good investment idea today and needs, say, $200 million by 5:00 tomorrow, I will put together a board meeting and get the approval for it," says Lamoureux. "Generally, we do like to have more notice than that, but it can be done."

One simple, hard truth remains: Performance aside, Ontario Teachers' still faces a funding shortfall. The plan's liabilities have grown. And although interest rates are projected to edge higher in the coming months, lessening the burden, they haven't moved upward as sharply as 1.5 percentage points, which is what it would take for the pension plan to regain a surplus. Bertram already knows that he can deliver exceptional returns at low cost -- the proof is pinned to his bulletin board. Now all he needs are for interest rates to rise, ever so gently, like the steam from his first cup of morning coffee.