June 24, 2002
Edmonton, Alberta
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Table of Contents -
Part 1
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to Part 2
(Financial Statements and
Investments)
- The Heritage Fund was established in 1976 and operates under the authority of the
Alberta Heritage Savings Trust Fund Act. On January 1, 1997, a new Act was passed that sets out a revised investment framework for the Fund. The statutory mission of the Fund is:
"To provide prudent stewardship of the savings from Alberta's non-renewable resources by providing the greatest financial returns on those savings for current and future generations of Albertans."
- The Standing Committee on the Alberta Heritage Savings Trust Fund reviews and approves the business plan and annual report of the Fund. The Standing Committee has representation from the major parties of the legislature. The Standing Committee receives regular reports on the performance of the Fund and conducts public meetings on an annual basis in different locations in the Province. The purpose of these meetings is to update Albertans on the management of the Fund and to solicit input from Albertans on the Fund's objective.
- The Ministry of Revenue is responsible for the Fund and its investments. The Minister of Revenue is required to report on the performance of the Fund quarterly within 60 days of the end of the quarter and make public the annual report within 90 days of the end of the fiscal year.
- The business plan of the Heritage Fund is published as part of the provincial budget and the income of the Fund is consolidated into the revenue of the Province.
- An Investment Operations Committee (IOC) was established to add private sector financial and business oversight of the Fund's investment policies and operation. The IOC is chaired by the Deputy Minister of Revenue and consists of private sector members. The Committee reviews and makes recommendations with respect to the business plan, annual report and investment policy statements for the Fund. The Committee meets at least quarterly to review performance and fund management.
- The investment portfolio of the Heritage Fund is managed by a group of highly qualified and experienced professionals in Alberta Revenue's Investment Management Division (IMD). External managers (specialized private sector investment managers) are used to manage specific investment mandates.
It is an honour to present the 26th Annual Report of the Alberta Heritage Savings Trust Fund. The Heritage Fund was created in 1976 as an innovative way to save the proceeds from non-renewable resource revenue for the benefit of current and future generations of Albertans.
Over the past 26 years, the Fund has generated approximately $25.6 billion dollars in investment income. The Fund’s income is transferred to the Province of Alberta’s main operating account, the General Revenue Fund, where it is used for Albertans’ priorities such as health care, education, roads, tax reductions and debt repayment.
Today, the Heritage Fund has investments around the world including Canada, the United States, Europe, Australia, Asia and the Far East. The Fund is comprised of investments in bonds, mortgages, equities, real estate and derivative products.
Fiscal 2001-02 proved to be one of the most difficult years in the history of financial markets. World events, dramatic declines in technology stocks and slowing economies caused significant declines in world stock markets during the first half of the year. Central banks responded by lowering interest rates to provide liquidity and stimulate economic activity. In the second half of the year, investor and consumer confidence improved and financial markets began to recover.
As of March 31, 2002, the Heritage Fund closed out the year with a fair value of $12.4 billion, a net increase of $290 million from the previous year. The Fund’s increase in value of $496 million was offset by transfers to the General Revenue Fund of $206 million, representing investment income determined on a cost basis of accounting. The Fund records investments and investment income on a cost basis that excludes unrealized gains and losses. The $290 million increase in value of the Fund represents net unrealized gains during the period. On a fair value basis, the Fund recorded a rate of return of 4.2% over the year and 4.6% over four years on an annualized basis.
Over the year, the asset mix of the Fund has continued towards the goal of 65% equities and real estate and 35% fixed income securities. This mix will help obtain higher rates of return over the long term. The key to achieving long-term, sustainable performance is to maintain a prudent, diversified portfolio, long-term focus, and investment discipline. The performance of the Fund is measured over the long term, since volatility in equity markets can produce fluctuations in performance from year to year.
The Heritage Fund is a symbol of pride to all Albertans. As we look towards the future of the Fund
in the 21st century we will continue to provide strong leadership and stewardship while exploring new initiatives and alternatives for the benefit of all Albertans and future
generations
[original signed]
Honourable Greg Melchin, CA
Minister of Revenue
The business plan for the Heritage Fund describes the mission, specific investment objectives of the Fund, and how the Fund’s performance will be measured. The business plan is reviewed annually and is published as part of the Provincial budget. The Investment Operations Committee (IOC) reviews and makes recommendations regarding the business plan and the investment policies for the Fund. The business plan is then reviewed and approved by the Minister of Revenue, Treasury Board and the legislature’s Standing Committee on the Alberta Heritage Savings Trust Fund.
The three goals of the Fund, as outlined in the plan, remain as follows:
- Earn income to support the Government's consolidated fiscal plan.
- Make investments to maximize long-term financial returns.
- Improve Albertans' understanding and the transparency of the Heritage Fund.
Investments in the Heritage Fund are held in two portfolios, the Endowment Portfolio and the Transition Portfolio. In order to improve Albertans' understanding and the transparency of the Fund and its operations, the fixed income securities held in the Transition Portfolio have been combined with the fixed income securities held in the Endowment Portfolio for reporting purposes. Based on current transfers of $300 million per month, substantially all of the assets held in the Transition Portfolio will be transferred to the Endowment Portfolio by June 30, 2002. The rapid decrease in the size of the Transition Portfolio makes separate comparisons of the portfolio's income and assets from period to period no longer meaningful.
During the fiscal year ended March 31, 2002, the cost of investments transferred from the Transition Portfolio to the Endowment Portfolio totalled $3.6 billion. As at March 31, 2002, the Endowment portfolio comprised 92% of the Heritage Fund net assets, at cost, while the Transition Portfolio comprised 8%. A breakdown of investments held in the Endowment Portfolio and Transition Portfolio is included in the Heritage Fund financial statements note 3(s).
The Heritage Fund 2001-04 business plan outlines various performance measures and benchmarks that are reviewed annually to determine ongoing suitability which are presented
below.
The investment objective of the Fund is to optimize long-term financial returns subject to an acceptable level of risk. By legislation, Alberta Revenue operates under the "Prudent Person Rule". This assigns to the investment manager the responsibility to restrict investments to assets that would be approved by a prudent person. Investment funds with long-term investment horizons and an objective to optimize long-term returns, invest a significant amount of their assets in equities. Equities have historically provided investors with higher total returns (dividends and capital gains) than interest bearing securities. The Heritage Fund Endowment Portfolio follows a similar strategy which, over a four-year period, should generate a real rate of return of around 5.0% at an acceptable level of risk. However, this can result in more volatility in capital gains and less interest income.
The Fund's investment policy statement is reviewed and recommended annually by the Investment Operations Committee to the Minister of Revenue. The investment policy statement is then approved by the Minister of Revenue and forms the reference document for Alberta Revenue as the investment manager. The investment policy statement must be consistent with the business plan of the Fund and it provides the overall investment framework as well as specific policies and guidelines such as:
- A quality constraint for fixed income securities of investment grade (a minimum of a "BBB" credit rating or equivalent).
- Investment limits by asset class.
- A summary of the legislative authority and governance structure, including specific duties of the investment manager.
- Requirements to adhere to the "prudent person" rule when making investments.
- How investment performance is to be measured and what benchmark is to be used in assessing performance.
- Controls with respect to the use of derivatives.
The investment strategy is to invest in a diversified portfolio to optimize long-term returns at an acceptable level of risk. As liquid, marketable securities are transferred from the Transition Portfolio, the securities are reinvested based on the allocation policy established for the Endowment Portfolio. The asset allocation policy for 2001-02 is based on the following long-term benchmark asset mix for the Endowment portfolio of the Heritage Fund.
Fund Value
The fair value of the Heritage Fund increased this year by approximately $290 million to $12.4 billion at March 31, 2002. The Fund performed well considering it was one of the most turbulent and volatile years in the history of financial markets. During the year, world stock markets experienced the negative effects of the events of September 11, significant declines in value of technology stocks and slowing growth in US and non-North American economies which spilled over into the Canadian economy. Toward the end of the year, financial markets began to strengthen as investors and consumers grew more confident in the economic recovery.
Investment Income
The Fund recorded net income of $206 million during fiscal year 2001-02. Over the year, income of
$444 million from investments in bonds, notes, short term paper and $38 million from real estate investments was offset by losses of $276 million from investments in equity markets.
The Fund accounts for its investments on a cost basis. Investment income on a cost basis excludes unrealized gains and losses. Investment income on a fair value basis includes unrealized gains and losses. The investment income on a fair value basis for fiscal year 2001-02 is $496 million.
Investment income earned by the Heritage Fund is not reinvested in the Fund. Instead, all of the net income is transferred to the Province's main operating fund, the General Revenue Fund, and is used for Albertans’ priorities like health care, education, roads, tax reductions and debt repayment. Unrealized capital gains and losses are not included in amounts transferred to the General Revenue Fund. Over the last five years, net realized capital gains included
in investment income totalled $598 million.
The Government of Alberta financial statements are prepared on a consolidated basis which eliminates the income the Heritage Fund earns from Alberta Government and Provincial Corporation securities totalling $33 million for the year ending March 31, 2002. On a consolidated basis, Heritage Fund income was $173 million.
Investment
Asset Mix
In 1998, most of the investment portfolio consisted of fixed income securities held in the Transition portfolio. Over the past five years, the Transition portfolio has gradually been phased out as assets, at cost, have been transferred to the Endowment portfolio. As at March 31, 2002, investments in the Endowment portfolio are managed according to the following policy asset mix:
Fixed income securities 35%
Equities and real estate 65%
On a combined basis, equities account for 52.3% or $6.6 billion of the Fund's total investments. Fixed income securities such as bonds, notes, short-term paper and other interest bearing securities continued to decrease. Fixed income securities now account for 43.0% of the Fund's total investments or $5.4 billion. Real estate accounts for 4.7% of the investments or $0.6 billion.
Generally, fixed income securities are less volatile and provide a steady stream of interest income. Equities are more volatile and produce capital gains or losses. Over the long term, equities are expected to produce higher rates of return than fixed income securities.
Heritage Fund Rate of Return
In order to generate higher long term rates of return, it was decided to have a portfolio with a significant commitment to equities and real estate.
As the Fund increases its investment in equities, there is greater potential for variations in performance from year to year. During the year ended March 31, 2002, the Heritage Fund posted a return of 4.2%. Positive returns from the Canadian bond market, real estate, Canadian equities and US equities were offset by negative returns from non-North American equity markets.
The performance of the Heritage Fund is measured over the long term. Over the past four-year period, the fund generated an annualized return of 4.6%.
The performance of the Heritage Fund investments is measured against various market-based indices. Value added by investment management is accomplished through asset mix decisions and security selection.
Fixed Income Investments
The Canadian bond market performed well this year. The Scotia Capital (SC) Universe Bond Index measures the performance of marketable Canadian bonds with terms to maturity of more than one year. Over the past year, the SC Universe Bond Index increased by 5.1% while the short term SC 91-Day T-Bill Index increased by 3.7%.
The Fund's actual rate of return over the year from long-term Canadian bonds was 5.9%, 80 basis points better than the benchmark SC Universe Bond Index. The Fund's return from short-term securities was 4.8% or 110 basis points better than the benchmark SC
91-Day T-Bill Index. The out-performance was due to higher weight in corporate bonds and good duration management.
The Fund's Canadian fixed-income portfolio is comprised of diversified holdings in corporate, federal, provincial and municipal bonds, notes and short-term paper.
Over the year, investments in bonds, notes, short term paper, provincial corporation debentures and loans declined from 63.9% to 43.0% of total investments as the Fund continued its transition to a higher weight in equities. Fixed income securities now total $5.4 billion, down from $7.7 billion a year earlier.
Canadian Equity
Investments
The Canadian stock market rebounded strongly in the second half of the year after a very volatile and tumultuous first half of the year. The Toronto Stock Exchange (TSE) 300, which measures the performance of Canada's top 300 companies in fourteen industrial sectors, increased by 4.9% for the year ending March 31, 2002.
The Heritage Fund's Canadian equity portfolio is held in various investment pools which are managed by internal and external managers. Over the year, the Fund's actual return from Canadian equities was 4.2% or 70 basis points below the benchmark TSE 300. Over four years, the Fund's return from Canadian equities was 2.3% or 20 basis points less than the benchmark TSE 300. Canadian equities underperformed its benchmark as positive performance from the passive and small capitalization products was offset by a premature move to telecommunication and technology stocks in a large capitalization equity
pool.
As at March 31, 2002, investments in Canadian equities rose to $2.6 billion or 20.7% of the Heritage Fund investment portfolio, up from $1.6 billion or 13.8% a year earlier.
United States
Equity Investments
The United States equity market ended the fiscal year on a positive note. The Standard & Poor's 500 Index, S&P 500, which measures the performance of the top 500 American companies, increased by 1.6% over the year in Canadian dollars.
The Fund's actual rate of return over the year from US equities was 1.4% or 20 basis points less than the S&P 500. US equities slightly underperformed its benchmark on a one-year basis as the growth segment of the portfolio negatively impacted results.
As at March 31, 2002, investments in U.S. equities rose to $2.0 billion or 15.8% of the Heritage Fund investment portfolio, up from $1.2 billion or 9.9% a year earlier.
Non-North American
Equity Investments
The non-North American equity market declined over the year. The Morgan Stanley Composite Index for Europe, Australasia and the Far East, MSCI EAFE, measures the performance of approximately 1000 companies on 21 stock exchanges around the world. The index returned a negative 7.3% over the year in Canadian dollars.
The Fund's actual return from non-North American equities was negative 5.8% or 150 basis points better than the MSCI EAFE Index. The Non-North American equity component of the Fund outperformed its benchmark due to strong results from the European segment of the portfolio.
As at March 31, 2002, investments in non-North American equities rose to $2.0 billion or 15.8% of the Heritage Fund investment portfolio, up from
$1.1 billion or 9.2% a year earlier.
Real Estate
Investments
The real estate market in Canada continued in a positive trend this year. The Russell Canadian Property Index, which measures the performance of institutionally held real estate investments situated across Canada, returned 9.8% for the year ended March 31, 2002.
The Fund's real estate investments are held in the internally managed Private Real Estate Pool. 47% of the Pool's real estate is retail, 47% office, 5% industrial and the remaining 1% is residential. The Fund's real estate portfolio earned 7.3% this year and 9.0% over 4 years.
As at March 31, 2002, investments in real estate grew to $594 million or 4.7%, up from $388 million or 3.2% a year earlier.
The combined rate of return is determined by adding the proportionate market value returns of each portfolio and adjusting for the timing of cash flows from the Transition Portfolio to the Endowment Portfolio.
Administrative expenses include investment management, cash management, custodial and other expenses. External management and custodial fees are deducted directly from the income of externally managed investment pools. Internal administrative expenses are deducted from the internally managed pooled funds and also directly from the Fund.
In the 2001-02 fiscal year, administrative expenses charged directly to the Fund were $1.5 million, the same as the previous year. The Fund's total administrative expense for the year ending 2001-02, including amounts deducted from the investment income of the pooled funds, amounted to
$11.5 million or .092% of the Fund’s net assets at fair value compared to $8.1 million or .067% of net assets the previous year.
The management of the Fund is cost effective. The average investment expense paid by other institutional investors is 0.25% of total market value or the equivalent of $31.0 million, a savings of approximately $18.5 million to the Province.
The increase in administrative expense is related to the transfers from the Transition Portfolio to the Endowment Portfolio. The Endowment Portfolio is more expensive to administer because it is predominantly invested in equities, a large portion are foreign equities which are externally managed.
ACCRUED INTEREST
Interest income that has been earned but not paid in cash.
ACTIVE STRATEGIES
The strategies have two forms - security selection or market timing. Security selection is the buying and selling of securities to earn a return above a market index such as the TSE 300 Index for Canadian Stocks. Market timing is based on shifting asset class weights to earn a return above that available from maintaining the asset class exposure of the policy asset mix.
ASSET MIX
The percentage of an investment fund's assets allocated to major asset classes (for example 60% equities, 5% real estate and 35% fixed income).
BENCHMARK
A standard against which others are measured. For the purposes of this report, benchmarks are established income indices used to measure the health of the Fund's investment income.
BOND/DEBENTURE
A financial instrument showing a debt where the issuer promises to pay interest and repay the principal by the maturity date.
BOOK VALUE
See Cost Value
CAPITAL GAIN
The market value received on sale of an asset beyond its book value or purchase price. If the asset is bought for $50 and sold for $75, the realized capital gain (profit) is $25.
COST VALUE
The value for which an asset was acquired.
DEPOSITS
Liquid, short term investments. A cash equivalent.
DERIVATIVE CONTRACT
Financial contracts, the value of which is derived from the value of underlying assets, indices, interest rates or currency rates.
DURATION
Modified duration is the weighted average term to maturity of the security's cash flows (i.e. interest and principal) and is the measure of price volatility; the greater the modified duration of a bond, the greater its percentage price volatility.
EMERGING MARKET
An economy in the early stages of development whose markets have sufficient size and liquidity and are receptive to foreign investment. Examples include China, Greece and Brazil.
EQUITY
Stocks; the ownership interest in a company.
EXTERNAL MANAGER
A third-party firm contracted to provide investment management services.
FAIR VALUE
Fair value is the amount of consideration agreed upon in an arm's length transaction between knowledgeable, willing parties who are under no compulsion to act. Fair value is similar to market value.
FIXED INCOME SECURITIES
Interest bearing investments such as bonds and debentures and money market investments such as treasury bills and discount notes (see "Bond" and "Money Market Security").
GENERAL REVENUE FUND (GRF)
The central operating account for the Province of Alberta. It is where most of the revenues received by the Province are deposited and from where most of the expenditures are made.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)
These are accounting guidelines formulated by the Canadian Institute of Chartered Accountants (CICA) Accounting Standards Committee (ASC), that govern how businesses report their financial statements to the public. They are the principles under which the financial statements of the Heritage Fund and other provincial funds are prepared. These principles help ensure fair presentation of the financial affairs of the Province.
INTEREST RATE SENSITIVE EQUITY
Equity whose return is expected to react to changes in interest rates.
LARGE CAP
Investment in larger capitalized firms. Within Canada, companies with a market capitalization of greater than 0.15% of the total Toronto Stock Exchange market capitalization.
NET INVESTMENT INCOME
On a cost basis, includes realized capital gains, interest, dividends, security lending income, derivative income and administrative expenses. On a fair value basis, include, in addition to the above, current period changes in unrealized gains and losses.
INVESTMENT PORTFOLIO
A pool of securities held as an investment. Holdings of a diverse group of assets by an individual company or fund.
LIQUIDITY
The ease with which an asset can be turned into cash and the certainty of the value it will obtain.
MARKET VALUE
See fair value
MARKET (VALUE) RATE OF RETURN
The market value rate of return measures income (interest and dividends) and capital appreciation or depreciation (realized and unrealized). The method used to calculate the return is the time weighted method.
Time-weighted rates of return are designed to eliminate the effect that the size and timing of cash flows has on the internal rate of return since the pattern of cash flows vary significantly among funds. The investment industry uses time-weighted rates of return when comparing the returns of one fund to another fund or to an index.
MARKETABLE SECURITY
An investment for which there is usually a ready market.
MID-TERM INVESTMENT
A fixed income instrument (bonds, debentures, treasury bills or discount notes) that matures in one to five years from the date of acquisition.
MONEY MARKET SECURITY
A fixed income security that matures within one year from the date of acquisition.
NET INCOME
The amount of earnings remaining after deducting expenses.
NOMINAL RATE OF RETURN
A measure of return that does not exclude the effect of inflation (see Real Rate of Return).
PAR VALUE
A value set as the face or principal amount of a security, typically expressed as multiples of $100 or $1000. Bondholders receive par value for their bonds at maturity.
PASSIVE STRATEGIES
These strategies involve investing to replicate the performance of a given market index such as the TSE 300 Index for Canadian stocks, or managing asset class exposure to match the performance of an established policy asset mix .
REAL VALUE OR REAL RATE OF RETURN
A measure of value or return after accounting for inflation. It is equal to the nominal value or return less an amount for inflation.
REALIZED AND UNREALIZED
Terms generally used to describe capital gains or losses. A gain or loss is realized when the asset is sold; prior to sale the gain or loss is unrealized and it is only a potential gain or loss.
SECURITY
Any investment instrument such as a bond, common stock, deed of trust on property, or any evidence of indebtedness or equity.
SHORT-TERM INVESTMENT
An investment with a maturity date of less than one year.
SMALL CAP
Investment in smaller capitalized firms. Within Canada, companies with a market capitalization of less than 0.15% of the total Toronto Stock Exchange market capitalization.
TERM-TO-MATURITY
The number of years left until a bond matures.
VOLATILITY
In financial matters, volatility of returns is the measurement used to define risk. The greater the volatility, the higher the risk.
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Statements and Investments)
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