Alberta Heritage Savings Trust Fund First Quarter Update 2001-02 Quarterly Report

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Index

• Introduction
• The Endowment Portfolio
• The Transition Portfolio
• Financial Statements June 30, 2001 (unaudited)
  • Balance Sheet
  • Statement of Operations
  • Statement of Changes in Financial Position
  • Notes to the Financial Statements
  • Schedule of Endowment Portfolio Investments
  • Schedule of Transition Portfolio Investments

Introduction

• On June 30, 2001, the fair value of the Heritage Fund was $12.0 billion, down from $12.1 billion at March 31, 2001. On a cost basis the value of the Fund remained unchanged at $12.3 billion.
• During the first quarter of the fiscal year 2001-02, the net income of the Heritage Fund was $158 million, a decrease of $55 million over the same period last year. Heritage Fund investments are accounted for on the cost basis. Unrealized capital gains and losses are not included in investment income of the fund.
• The net income of the Heritage Fund, less any amount retained for inflation-proofing in the Fund on the advice of the government, is transferred to the Province’s main operating fund, the General Revenue Fund (GRF).
• During the quarter, $900 million was transferred within the Fund from the Transition Portfolio to the Endowment Portfolio.
• By March 31, 2003 all assets of the Transition Portfolio will have been transferred to the Endowment Portfolio. During the quarter, the Endowment Portfolio outperformed the benchmark by 30 basis points and over a four-year period it outperformed the benchmark by 40 basis points.

• In the Heritage Fund business plan, the Fund’s forecasted net income is $582 million for the year ending March 31, 2002. On a consolidated basis, the forecasted net income is $551 million which excludes income from holdings of Alberta government securities and Provincial Corporation debentures.

• The combined Heritage Fund returned a positive 0.4% over the quarter and negative 1.2% over a one-year period on a market value basis. In the Heritage Fund business plan, the return of the Fund is measured against the cost of the Province’s total debt. On a market value basis, the Province’s total debt cost (Canadian and U.S. dollar debt) was negative 0.9% for the quarter and positive 8.3% for a one-year period.

• Administrative expenses include investment management, cash management, custodial and other expenses. External management and custodial fees are deducted directly from the income of the externally managed pooled funds. Internal administrative expenses are deducted from the internally managed pooled funds and directly from the Endowment Portfolio and the Transition Portfolio.

The increase in administrative expenses 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 of which are foreign equities which are externally managed.

The Endowment Portfolio

• Objective: to optimize long-term financial returns.
• During the first quarter, the Endowment Portfolio recorded net income of $92 million, $61 million less than the same period last year. Net income for the past three months includes net realized capital losses of $2 million compared to net realized capital gains of $117 million for the same period last year.
• During the first quarter, $900 million was transferred from the Transition Portfolio to the Endowment Portfolio. The Alberta Heritage Savings Trust Fund’s business plan provides that all assets in the Transition Portfolio be transferred to the Endowment Portfolio by March 31, 2003. Commencing in 2001-02, the Lieutenant Governor in Council has approved the annual transfer of assets with a book value of not less than $1.2 billion and not more than $3.6 billion.
• During the three months ended June 30, 2001, the cost of investments held in the Endowment Portfolio increased by the following amounts:

• At June 30, 2001, the fair value of the investments held in the Endowment Portfolio was $8.2 billion.

• During the first quarter, the fair value of the Endowment Portfolio’s net assets increased by $823 million represented by:

• The Canadian and US equity markets performed better than the non-North American equity markets during the quarter. Canadian equities as measured by the TSE 300 Index posted a positive return of 2.1% in the quarter. US equities as measured by the S & P 500 Index posted a positive return of 2.0%. Non-North American markets as measured by the MSCI EAFE Index recorded a negative return of 4.6%. In the bond market, the Scotia Capital Universe Bond Index recorded a negative return of 0.7% for the quarter.
• On a one-year basis, the bond market dominated returns. The SC Universe Bond Index returned 6.2% for the year. The equity markets performed poorly. The TSE 300 Index returned a negative 23.1% for the year. The S & P 500 Index returned negative 12.8% and the MSCI EAFE Index returned negative 21.8% for the one-year period.
• The Endowment Portfolio’s return for the first quarter was a positive 0.4% which was better than the benchmark return of 0.1%. On a one-year basis, the Endowment Portfolio performed better than the benchmark, returning a negative 7.1% compared to the benchmark return of negative 8.1%.
• Canadian equities outperformed the TSE 300 Index in the first quarter returning a positive 2.8% compared to the TSE 300 Index of 2.1%. International equities out-performed the benchmark, returning a negative 3.4% versus a negative 4.6% for the MSCI EAFE Index. The out-performance by Canadian and International managers was due to an under-weight position in technology stocks. US equities under-performed the benchmark returning a positive 1.4% compared to the S & P 500 return of 2.0% due primarily to the stock selection by a growth manager.

The Transition Portfolio

• Objective: to earn income to support the government’s fiscal plan.
• At June 30, 2001, the Transition Portfolio had investments with a fair value of $3.8 billion (including project loans totaling $97.4 million at cost).

• During the first quarter, investment income for the Transition Portfolio totaled $66 million, $6 million more than the same period last year. Net income for the past three months includes net realized capital gains of $6 million compared to net realized capital losses of $46 million for the same period last year.
• During the three month period ended June 30, 2001, $12 million of Alberta provincial corporation debentures were repaid or redeemed, bringing the book value of holdings down to $239 million.
• A performance benchmark for the Transition Portfolio is not provided for the current year since all of the assets held in the portfolio will be transferred to the Endowment Portfolio by March 31, 2003.

• The net assets of the Transition Portfolio, on a fair value basis, decreased by $934 million during the quarter, represented by:

Alberta Heritage Savings Trust Fund
Financial Statements
June 30, 2001 (unaudited)

• Balance Sheet
• Statement of Operations
• Statement of Changes in Financial Position
• Notes to the Financial Statements
• Schedule of Endowment Portfolio Investments
• Schedule of Transition Portfolio Investments

Balance Sheet

Statement of Operations

Statement of Changes in Financial Position

Notes to the Financial Statements
June 30, 2001 (unaudited)

NOTE 1 AUTHORITY AND MISSION

The Alberta Heritage Savings Trust Fund (the Fund) operates under the authority of the Alberta Heritage Savings Trust Fund Act (the Act), Chapter A-27.01, Revised Statutes of Alberta 1980, as amended.

The preamble to the Act describes the mission of the Fund as follows:

Investments of the Fund are held in an Endowment Portfolio and a Transition Portfolio. The Endowment Portfolio has the objective of optimizing long-term financial returns. The Transition Portfolio has the objective of providing income support to the Government’s consolidated fiscal plan over the short term to medium term. The Fund’s business plan provides that all assets in the Transition Portfolio will be transferred to the Endowment Portfolio by March 31, 2003.

NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND REPORTING PRACTICES

These financial statements are prepared in accordance with generally accepted accounting principles.

The accounting policies of significance to the Fund are as follows:

(a) Portfolio investments

Fixed-income securities, mortgages, equities, and real estate investments held directly by the Fund or by pooled investment funds are recorded at cost. Cost includes the amount of applicable amortization of discount or premium using the straight-line method over the life of the investments.

Investments in loans are recorded at cost less any unearned revenue and allowance for credit loss. Where there is no longer reasonable assurance of timely collection of the full amount of principal and interest of a loan, a specific provision for credit loss is made and the carrying amount of the loan is reduced to its estimated realizable amount.

Investments are recorded as of the trade date.

The cost of disposals is determined on the average cost basis.

Where there has been a loss in value of an investment in fixed-income securities, mortgages, equities and real estate that is other than a temporary decline, the investment is written down to recognize the loss. The written down value is deemed to be the new cost.

(b) Investment Income

Investment income is recorded on the accrual basis where there is reasonable assurance as to its measurement and collectability. When a loan becomes impaired, recognition of interest income in accordance with the terms of the original loan agreement ceases. Any subsequent payments received on an impaired loan are applied to reduce the loan’s book value.

Gains and losses arising as a result of disposals of investments are included in the determination of investment income. Income and expense from derivative contracts are included in investment income.

(c) Foreign Currency

Foreign currency transactions are translated into Canadian dollars using average rates of exchange, except for hedged foreign currency transactions which are translated at rates of exchange established by the terms of the forward exchange contracts. Exchange differences on unhedged transactions are included in the determination of investment income.

(d) Investment Valuation

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 values of investments held either directly by the Fund or by pooled investment funds are determined as follows:

(i) Public fixed-income securities and equities are valued at the period-end closing sale price, or the average of the latest bid and ask prices quoted by an independent securities valuation company.

(ii) Mortgages, provincial corporation debentures and private fixed-income securities are valued based on the net present value of future cash flows. These cash flows are discounted using appropriate interest rate premiums over similar Government of Canada benchmark bonds trading in the market.

(iii) The fair value of private equities is estimated by management.

(iv) Real estate investments are reported at their most recent appraised value, net of any liabilities against the real property. Real estate properties are appraised annually by qualified external real estate appraisers.

(v) Fair value of loans are not reported due to there being no organized financial market for the instruments and it is not practical within constraints of timeliness or cost to estimate the fair values with sufficient reliability.

(vi) The fair value of deposits, receivables, accrued interest and payables are estimated to approximate their book values.

(vii) The fair value of investments and any other assets and liabilities denominated in a foreign currency are translated at the period-end exchange rate.

(e) Valuation of Derivative Contracts

Derivative contracts include equity and bond index swaps, interest rate swaps, forward foreign exchange contracts, equity index futures contracts and cross-currency interest rate swaps. As disclosed in Note 4, the value of derivative contracts is included in the fair value of pooled investment funds. The estimated amount receivable or payable from derivative contracts at the reporting date is determined by the following methods:

(i) Equity and bond index swaps are valued based on changes in the appropriate market based index net of accrued floating rate interest.

(ii) Interest rate swaps are valued based on discounted cash flows using current market yields.

(iii) Forward foreign exchange contracts and equity index futures contracts are based on quoted market prices.

(iv) The value of cross-currency interest rate swaps is included with the value of the underlying security. Cross-currency fixed to fixed interest rate swaps are valued at quoted prices based on discounted cash flows using current market yields. Cross-currency fixed to floating interest rate swaps are valued at the principal amount plus accrued interest.

NOTE 3 RISK MANAGEMENT

Income and financial returns of the Fund are exposed to credit risk and price risk. Credit risk relates to the possibility that a loss may occur from the failure of another party to perform according to the terms of a contract. Price risk is comprised of currency risk, interest rate risk and market risk. Currency risk relates to the possibility that the investments will change in value due to future fluctuations in foreign exchange rates. Interest rate risk relates to the possibility that the investments will change in value due to future fluctuations in market interest rates. Market risk relates to the possibility that the investments will change in value due to future fluctuations in market prices.

The Standing Committee on the Alberta Heritage Savings Trust Fund reviews and approves the business plan of the Fund. In order to earn an optimal financial return at an acceptable level of risk, the 2001-2002 business plan limits investments of the Transition Portfolio to include only fixed-income securities other than securities transferred from the previous structure and proposes the following asset mix policy for the Endowment Portfolio:

Fixed-income instruments 25% to 45%
Equities 75% to 55%

Risk is reduced through asset class diversification, diversification within each asset class, quality and duration constraints on fixed-income instruments, and restrictions on amounts exposed to countries designated as emerging markets. Controls are in place respecting the use of derivatives (see Note 4). Forward foreign exchange contracts may be used to manage currency exposure in connection with securities purchased in foreign currency (see Note 4).

NOTE 4 DERIVATIVE CONTRACTS

Derivative contracts are financial contracts, the value of which is derived from the value of underlying assets, indices, interest rates or currency rates. The Fund uses derivative contracts held indirectly through pooled investment funds to enhance return, manage exposure to interest rate risk and foreign currency risk and for asset mix management purposes. The notional value of a derivative contract represents the amount to which a rate or price is applied in order to calculate the exchange of cash flows.

(i) A swap is a contractual agreement between two counter-parties to exchange a series of cash flows based on a notional amount. An equity or bond index swap involves the exchange of a floating interest rate cash flow for one based on the performance of a market index. For interest rate swaps, parties generally exchange fixed and floating rate interest cash flows based on a notional amount. Cross-currency interest rate swaps are contractual obligations in which the principal amounts of Canadian fixed-income securities denominated in foreign currency are exchanged for Canadian currency amounts both initially and at maturity. Over the term of the cross-currency swap, counter-parties exchange fixed to fixed and fixed to floating interest rate cash flows in the swapped currencies. There are underlying securities supporting all swaps. Leveraging is not allowed.

(ii) Foreign exchange contracts are contractual agreements to exchange specified currencies at an agreed upon exchange rate and on an agreed settlement date in the future.

(iii) A stock index futures contract is an agreement to receive or pay cash based on changes in the level of the specified stock index.

All derivative contracts mature within one year except for bond index swaps, cross-currency swaps and interest rate swaps with a notional value of $294,183,000 (March 31, 2001: $294,850,000) that mature between 1 and 3 years and $194,669,000 (March 31, 2001: $208,033,000) that mature over 3 years.

NOTE 5 FUND EQUITY

By no later than 2003, all assets of the Transition Fund will be transferred to the Endowment Fund. For the year ended March 31, 2002, the Lieutenant Governor in Council approved the transfer of assets with a book value of not less than $1.2 billion and not more than $3.6 billion.

Section 8 (2) of the Alberta Heritage Savings Trust Fund Act (the Act) states that the net income of the Heritage Fund less any amount retained in the Fund to maintain its value shall be transferred to the General Revenue Fund annually in a manner determined by the Provincial Treasurer. Section 11(5) of the Act states that for fiscal years subsequent to 1999 and until the accumulated debt is eliminated in accordance with the Fiscal Responsibility Act, the Provincial Treasurer is not required to retain any income in the Heritage Fund to maintain its value, but may retain such amounts as the Provincial Treasurer considers advisable.

NOTE 6 NET INCOME

Investment income is comprised of interest, dividends, amortization of discount and premiums, swap income, security lending income and realized gains and losses, net of write-downs, on investments. The Fund’s share of income earned from externally and internally managed investment pools is net of administrative expenses incurred by the pools. (see Note 7).

Investment income from the Endowment portfolio for the three months ended June 30, 2001 includes a net loss from disposal of investments totalling $1,637,000 (June 30, 2000 net gain: $117,262,000). Investment income from the Transition portfolio includes a net gain of $5,873,000 (June 30, 2000 net loss: $45,968,000).

NOTE 7 ADMINISTRATIVE EXPENSES

Administrative expense includes investment management, cash management, safekeeping costs and other expenses charged on a cost-recovery basis directly from Alberta Revenue. The Fund’s total administrative expense for the period, including amounts deducted directly from investment income of pooled funds is as follows:

NOTE 8 COMPARATIVE FIGURES

Certain comparative figures have been reclassified to conform to June 30, 2001 presentation.

NOTE 9 APPROVAL OF FINANCIAL STATEMENTS

These financial statements were approved by the Deputy Minister of Revenue.

The majority of the Endowment portfolio investments are held in pooled investment funds established and administered by the Alberta Revenue. Pooled investment funds have a market based unit value that is used to allocate income to participants and to value purchases and sales of pool units. As at June 30, 2001, the Fund’s percentage ownership, at market, in pooled investment funds is as follows:

(a) The Consolidated Cash Investment Trust Fund is managed with the objective of providing competitive interest income to depositors while maintaining appropriate security and liquidity of depositors’ capital. The portfolio is comprised of high-quality short-term and mid-term fixed-income securities with a maximum term-to-maturity of five years. As at June 30, 2001, securities held by the Fund have an average effective market yield of 4.77% per annum (March 31, 2001: 5.09% per annum).

(b) As at June 30, 2001, directly held fixed income securities have an average effective market yield of 5.5% per annum (March 31, 2001: 5.5% per annum) and the following term structure: under 1 year: 80%; 1 to 5 years: 20%.

(c) The Canadian Dollar Public Bond Pool is managed with the objective of providing above average returns compared to the total return of the Scotia Capital Universe Bond Index over a four-year period while maintaining adequate security and liquidity of participants’ capital. The excess return is achieved through management of portfolio duration and sector rotation. The portfolio is comprised of high quality Canadian fixed-income instruments and debt related derivatives. As at June 30, 2001, securities held by the Pool have an average effective market yield of 6.12% per annum (March 31, 2001: 5.75% per annum) and the following term structure based on principal amount: under 1 year: 4%; 1 to 5 years: 35%; 5 to 10 years: 32%; 10 to 20 years: 13%; over 20 years: 16%.

(d) The Private Mortgage Pool is managed with the objective of providing investment returns higher than attainable from the Scotia Capital Universe Bond Index over a four-year period or longer. The portfolio is comprised primarily of high quality commercial mortgage loans (95.9%) and provincial bond residuals (4.1%). To limit investment risk, mortgage loans are restricted to first mortgage loans, diversified by property usage and geographic location, and include a small portion of NHA insured loans. As at June 30, 2001, securities held by the Pool have an average effective market yield of 7.33% per annum (March 31, 2001: 7.14% per annum) and the following term structure based on principal amount: under 1 year: 13%; 1 to 5 years: 17%; 5 to 10 years: 25%; 10 to 20 years: 27%; and over 20 years: 18%.

(e) The Domestic Passive Equity Pooled Fund is managed on a passive approach with the objective of providing investment returns comparable to the Toronto Stock Exchange (TSE) 300 Index. A portion of the portfolio is comprised of both publicly traded Canadian equities and structured investments replicating the TSE 100 Index and the TSE 60 Index. The other portion of the portfolio fully replicates the TSE 300. The Pool’s investment in units of the Floating Rate Note Pool (FRNP) are used as the underlying securities to support the index swaps of the pool. FRNP is managed with the objective of generating floating rate income needed for the swap obligations in respect of structured investments in foreign equities, domestic equities and domestic bonds. Through the use of interest rate swaps, FRNP provides investment opportunities in high quality floating-rate instruments with remaining term-to-maturity of ten years or less.

(f) The Canadian Pooled Equity Fund is managed with the objective of providing competitive returns comparable to the total return of the Toronto Stock Exchange 300 Index while maintaining maximum preservation of participants’ capital. The portfolio is comprised of publicly traded equities in Canadian corporations. Risk is reduced by prudent security selection and sector rotation.

(g) The External Managers Fund is comprised of numerous portfolios which are managed by numerous external managers with expertise in Canadian small and large stock market capitalization companies, United States, and International equity markets. The international equity market consists of non-North American investments in Europe, Australia, the Far East, Pacific Basin and Emerging Markets. The objective of the Fund is to provide investment returns higher than the total return of the applicable Morgan Stanley, Standard and Poor’s and Toronto Stock Exchange indices over a four-year period. The portfolio is comprised of publicly traded equity securities on Canadian and approved foreign markets. Risk is reduced through manager style and market diversification.

(h) The Private Equity Pool (98) is managed with the objective of providing investment returns higher than attainable from the TSE 300 Index over a five to ten year period. The portfolio is comprised of investments in institutionally sponsored private equity pools. Risk is reduced by avoiding direct investments in private companies and by limiting holdings in any single pool. The Private Equity Pool is in the process of orderly liquidation.

(i) The Private Real Estate Pool is managed with the objective of providing investment returns comparable to the Russell Canadian Property Index over a four-year period or longer. Real estate is held through intermediate companies which have issued to the Pool, common shares and participating debentures secured by a charge on real estate. Risk is reduced by investing in properties that provide diversification by geographic location, by property type and by tenancy. As real estate returns are positively correlated to inflation and negatively correlated to returns from fixed income securities and equities, the Pool provides diversification from the securities market with opportunities for high return.

(j) Where the fair value is less than cost, in management’s best judgement, and based on market trends, the fair value will likely recover overtime.

Schedule 2:  Schedule of Transition Portfolio Investments

(a) See Schedule 1, Note (a).

(b) As at June 30, 2001, fixed-income securities held have an average effective market yield of 4.86% per annum for securities maturing within a year (March 31, 2001: 5.01% per annum), and 5.56% per annum for securities maturing between 1 and 35 years (March 31, 2001: 5.10% per annum). As at June 30, 2001, fixed-income securities have the following term structure based on principal amount: under 1 year: 46%; 1 to 5 years: 47%; and over 5 years: 7%.

(c) As at June 30, 2001, Provincial corporation debentures have an average effective market yield of 7.79% per annum (March 31, 2001: 7.84% per annum). The maturity profile based on expected repayments is as follows: under 1 year: $135,693,000; 1 to 5 years: $24,016,000; and over 5 years: $78,917,000.

(d) Under the terms of the loans to Ridley Grain, 11% Participating First Mortgage Bonds due July 31, 2015, interest is compounded semi-annually and payable annually to the extent of available cash flow and any shortfall is to be deferred and capitalized. The principal of $91,245,000 and unpaid interest is repayable on or before July 31, 2015. Unpaid interest at June 30, 2001 amounted to $55,125,291 (March 31, 2001: $55,125,291).

Grain throughput volumes are the main determinant of profitability of the grain terminal and its ability to service its loan from the province, and therefore the value is sensitive to changes in grain throughput volumes. Grain throughputs are difficult to forecast because they are dependent in part upon port allocation decisions of the Canadian Wheat Board and other factors such as crop size and composition. Accordingly, due to the uncertainty of the grain throughput volumes, income from the participating bonds is recognized when it is measurable and collectable.

(e) The principal amount of the Vencap loan, amounting to $52,588,000, is due on July 2046 and bears no interest. Investment in the loan is recorded at cost. Cost includes the present value of the anticipated loan repayment amounting to $1 million at December 31, 1995 plus accumulated amortization on the discount.

(f) During the period, $900,000,000 was transferred from the Transition Portfolio to the Endowment Portfolio in accordance with the investment provisions of the Alberta Heritage Savings Trust Fund Act.