June 24, 2003
Edmonton, Alberta
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Table of Contents -
Part 1
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to Part 2
(Financial Statements,
Investments and Glossary)
Fiscal 2002-03 marked the 27th year of the Alberta Heritage Savings Trust Fund. The Fund is a source of pride to all Albertans. Over the past 27 years, the Fund has generated approximately $25 billion dollars in investment income. The Fund’s income is transferred to the Province’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.
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, public and private equities, real estate, derivative products and absolute return strategies.
An atmosphere of uncertainty prevailed in public equity markets throughout 2002-03. Few investors escaped the effects of significant declines in stock values. Tensions in the Middle East, fears of a slowing world economy, unwinding of excess capacity in the technology sector and concerns over corporate governance all contributed to a general loss of investor confidence in the stock market. The decline in the value of the Fund’s equity holdings was partially offset by solid performance from the Fund’s bond, mortgage and real estate portfolios.
As of March 31, 2003, the Heritage Fund closed out the year with a fair value of $11.1 billion, a decrease of $1.3 billion from the previous year. On a fair value basis, the Fund recorded a negative rate of return of 11.0% over the year and a positive annualized return of 0.3% over four years.
On a cost basis, after writedowns of equity investments, the value of the Heritage Fund at March 31, 2003 was $11.4 billion compared to $12.3 billion one year earlier. The Fund’s investment loss for the year was $894 million; however, over the previous four years the Fund had contributed over $3 billion of income to pay for priority programs for Albertans. A return to positive income is forecast for 2003-04.
The key to achieving long-term, sustainable performance is to maintain a prudent, diversified portfolio, long-term focus, and investment discipline. As a result, the policy asset mix for 2003-06 increases investments in real estate, private equities and absolute return strategies and reduces modestly the Fund’s exposure to public equities. The performance of the fund is assessed over the long term since volatility in markets can produce significant fluctuations in performance from year to year. Management is cautiously optimistic that stock markets will rebound over the next year.
Albertans feel strongly about the Alberta Heritage Savings Trust Fund. In the fall 2002 survey,
“Looking Forward: Planning for the Future With the Alberta Heritage Savings Trust
Fund”, the majority of the 77,000 respondents favored a strong, healthy Heritage Fund that continues as an endowment. Albertans look forward to the future with the Heritage Fund further strengthened to ensure the Fund continues to benefit Albertans, just like it has over the last 27 years.
[original signed]
Honourable Greg Melchin, CA
Minister of Revenue
- 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 came into effect that sets out a revised investment framework for the Fund.
- 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.
- 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.
PURPOSE
The business plan for the Heritage Fund describes the mission, goals, investment objectives, 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, the Treasury Board and the Legislature’s Standing Committee on the Alberta Heritage Savings Trust Fund.
MISSION
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.”
GOALS
The three goals of the Fund, as outlined in the 2002-05 business plan, remain as follows:
- Earn income to support the Government’s consolidated fiscal plan.
- Make investments to maximize long-term financial returns. The Heritage Fund is expected to generate an annualized real rate of return of 5.0% at an acceptable level of risk over a four-year period.
- Improve Albertans’ understanding and the transparency of the Heritage Fund.
INVESTMENT OBJECTIVE
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 since equities have historically provided investors with higher total returns (dividends and capital gains) than interest bearing securities. The Heritage Fund follows a similar strategy to achieve higher financial returns. However, as witnessed in recent years, this can result in volatility in income.
PERFORMANCE MEASURES
The Heritage Fund business plan outlines various performance measures and benchmarks which are reviewed annually to determine ongoing suitability.
The 2002-05 business plan incorporated the following major changes:
- Increased investments in private equities, absolute return strategies and real estate.
- Reduced investments in public equities to accommodate the increase in private equities, real estate and absolute return strategies.
The following table summarizes the 2002-05 business plan performance measures, including the long-term investment policy weights and benchmark return indices by asset class.
YEAR IN REVIEW
The first and second quarters of 2002-03 saw great uncertainty regarding the future path of the world economy. World equity markets continued to experience significant declines in stock values. The information technology sector led the decline in value of share prices. The decline in the equity markets was attributed to a number of factors including the slowing world economy, tensions in the Middle East, corporate governance concerns, unwinding of excess capacity in the technology sector and the general loss of investor confidence. Investor confidence stabilized in the third quarter as the outlook for corporate earnings improved and reports of accounting irregularities subsided. In the fourth quarter, the beginning of the US led war with Iraq resulted in greater uncertainty in the stock market and a corresponding decline in share prices.
At March 31, 2003, the fair value of the Heritage Fund stood at $11.1 billion, down $1.3 billion from $12.4 billion at the beginning of the year.
INVESTMENT INCOME
The Fund recorded a net loss of $894 million during fiscal year 2002-03. Over the year, income of $286 million from investments in bonds, notes, short term paper, $39 million from real estate investments and $5 million from absolute return strategies was offset by losses of $1,224 million from investments in equity markets. Realized capital losses from declining world stock markets, primarily in the information technology and telecommunication services sectors, contributed to the net loss for the year.
INVESTMENT VALUATION
Investments and investment income are recorded on the financial statements of the Heritage Fund at cost in accordance with government accounting policies. The fair value of the Fund and its investments are provided for information purposes. Management uses fair value to assess the investment performance of the fund against market-based benchmarks.
The Fund’s policy is to write down the cost of those securities where the decline in value below cost is not considered temporary. On a quarterly basis, management reviews the Fund’s investment portfolio to identify those securities where the fair value has declined significantly below cost. The Fund’s
net loss of $894 million for the year includes write downs of $669 million, primarily against information technology stocks.
CHANGE IN NET ASSETS
The Heritage 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 loss on a fair value basis for fiscal year 2002-03 is $1,339 million.
INVESTMENT
ASSET MIX
The investment strategy is to invest in a diversified portfolio to optimize long-term returns at an acceptable level of risk. The policy asset allocation in the Fund’s 2002-05 business plan was as follows:
For the 2002-03 fiscal year, the policy asset mix for fixed income securities remains the same as the previous year at 35%. The policy mix for public equity investments decreases from 58% to 50% while real estate investments were targeted to increase from 7% to 10%, private equities and absolute return strategies increased to 2.0% and 3.0% respectively.
The actual investment mix changed over the past year. Fixed income securities declined from 43.0% to 35.8%. Public equity investments increased from from 51.7% to 52.9%. Actual public equities exceeded the target policy by 2.9% as a result of fewer than expected opportunities for investments in private equities, real estate and absolute return strategies. Nevertheless, real estate investments increased from 4.7% to 7.9 % of the Fund’s total investment portfolio. A new investment asset class called Absolute Return Strategies (see Glossary) was initiated in September 2002 and comprises 2.6% of the Fund’s investment portfolio. Private equity investments increased from 0.6% to 0.8%.
TRANSFERS TO THE GENERAL REVENUE FUND
The Fund’s net income is transferred to the Province’s main operating fund, the General Revenue Fund (GRF), and used for Albertans’ priorities like health care, education, roads, tax reductions and debt repayment. Changes in unrealized gains and losses are not included in amounts transferred to the General Revenue Fund. As a result of the Fund’s net loss of $894 million for the year, no transfers were made to the General Revenue Fund. The net loss reduces the equity of the Heritage Fund.
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 totaling $18 million for the year ending March 31, 2003. On a consolidated basis the Heritage Fund loss was $912 million.
HERITAGE FUND RATE OF RETURN
The Heritage Fund posted an overall negative rate of return of 11.0% this year. Negative returns from Canadian, US, and non-North American public equity investments were partially offset by positive returns from the fixed income investments, real estate and absolute return strategies.
Over the past four-year period, the fund generated an annualized return of 0.3%.
The performance of Heritage Fund investments is measured against various market-based indices. Value added by investment management is accomplished through asset mix decisions and security selection. The following sections describe the performance of the Fund’s major asset classes in relation to their benchmarks.
FIXED INCOME INVESTMENTS
The Canadian bond market performed well this year reflecting the deep bear market in equities, concerns about the US economic recovery and problems in the Middle East. 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 9.2% while the short term SC 91-Day T-Bill Index increased by 2.7%.
The Fund’s actual rate of return over the year from Canadian bonds was 9.5%, 30 basis points better than the benchmark SC Universe Bond Index. The outperformance was primarily due to overweight in high quality corporate bonds relative to government bonds and the strong performance of private mortgages. The Fund’s return from short-term securities was 3.0% or 30 basis points better than the benchmark SC 91-Day T-Bill Index. Over the year, investments in bonds, notes, short term paper, provincial corporation debentures and loans declined from 43.0% to 35.8% of total investments. Fixed income securities now total $4.0 billion down from $5.4 billion the previous year.
The Fund’s Canadian fixed-income portfolio is comprised of diversified holdings in corporate, federal, provincial and municipal bonds, notes and short-term paper.
CANADIAN EQUITY INVESTMENTS
The Canadian stock market struggled through a very volatile year as investors worried about a lackluster economic recovery, geopolitical risks and highly publicized corporate scandals in the US. The S&P/TSX Composite Index which measures the performance of Canada’s top companies in ten industrial sectors, decreased by 17.6% for the year ending March 31, 2003.
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 negative 16.6%. The fund outperformed the S&P/TSX benchmark by 100 bps due to a higher allocation of small capitalization securities. Over four years, the fund’s return from Canadian equities was 50 basis points less than the benchmark S&P/TSX due to an overweight position in growth oriented securities.
At March 31, 2003, investments in Canadian public equities totaled $2.4 billion or 21.4% of the Heritage Fund investment portfolio compared to $2.5 billion or 20.1% a year earlier.
UNITED STATES EQUITY INVESTMENTS
The United States equity market closed out the fiscal year in a bear market due to a combination of corporate scandals, a weak economy and poor profits. Aggressive action to improve corporate governance and interest rate cuts by the US Federal Reserve restored investor confidence in the fall. But the stock recovery was short lived due to tensions in the Middle East. The Standard & Poor’s 500 Index (S&P 500) which measures the performance of the top 500 American companies, decreased by 30.7% over the year in Canadian dollars.
The Fund’s actual rate of return over the year from US equities was negative 30.6%. The negative impact of the strengthening Canadian dollar was partially offset through currency hedges. Over four years, the Fund’s US equity portfolio returned a negative 9.2%. The fund outperformed the S&P 500 benchmark by 10 bps on both the short term and long term from an overweight position in small cap securities.
At March 31, 2003, investments in US equities totaled 15.8% or $1.8 billion of the Heritage Fund investment portfolio compared to 15.8% or $2.0 billion a year earlier.
NON-NORTH
AMERICAN EQUITY INVESTMENTS
The non-North American equity market declined for the 3rd consecutive year. The Morgan Stanley Capital International Index for Europe, Australasia and the Far East, MSCI EAFE Index, measures the performance of approximately 1000 companies on 21 stock exchanges around the world. The index decreased by 29.3% over the year in Canadian Dollars.
The Fund’s actual return from non-North American equities was negative 29.1%. Over four years the Fund’s non-North American equity portfolio returned a negative 8.2%, 260 basis points better than the benchmark MSCI EAFE due to superior stock selection and country allocation in Asia-Pacific region investments.
At March 31, 2003, investments in non-North American equities totaled 15.7% or $1.7 billion of the Heritage Fund investment portfolio compared to 15.8% or $2.0 billion a year earlier.
REAL ESTATE INVESTMENTS
The real estate market in Canada continued in a positive trend this quarter.
The Fund’s real estate investments are held in the internally managed Private Real Estate Pool. Nearly half of the real estate portfolio is invested in retail, half in office and a small portion in industrial and residential. The Fund’s real estate portfolio earned 9.8% this year and 8.1% over 4 years. Over the long term, the portfolio underperformed the benchmark by 220 bps due to the underperformance of Alberta retail properties and below average performance from Ontario retail and Alberta office properties.
At March 31, 2003, investments in real estate totaled 7.9% or $870 million of the Heritage Fund investment portfolio compared to 4.7% or $594 million a year earlier.
Administrative
Expenses
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 2002-03 year, the administrative expenses charged directly to the Fund were $1.8 million compared to $1.5 million in 2001-02. The Fund’s total administrative expense for the year ending 2002-03, including amounts deducted from the investment income of the pooled funds, amounted to $15.9 million or 0.144% of the Funds net assets at fair value compared to $11.5 million or 0.092% of net assets the previous year. According to the 2001 CEM (Cost Effectiveness Measurement) report, the average fund had investment management and administration expenses of 0.31% of total market value or the equivalent of approximately $34.3 million.
The increase in administrative expense is primarily related to an increase in US and non-North American equity investments which are externally managed and more expensive to administer.
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%.
Go to Part 2 (Financial
Statements, Investments and Glossary)
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