The Business Plan was
reviewed and approved by Treasury Board on February 18, 2005, and
by the Legislature’s Standing Committee on the Alberta Heritage
Savings Trust Fund on March 14, 2005.
introduction
This
is the ninth business plan for the Alberta Heritage Savings Trust
Fund (Heritage Fund), which amends the previous business plans and
incorporates updated financial information and income forecasts.
The plan sets out specific investment objectives, goals and strategies
to achieve the Heritage Fund's objectives as expressed in the legislation.
mission
The
mission of the Heritage 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.1
1
Preamble to the Alberta Heritage Savings Trust Fund Act.
BACKGROUND AND FISCAL
CONTEXT
- The Heritage Fund
was created in 1976 to save a portion of non-renewable resource
revenue. The Heritage Fund grew from a portion of Alberta's oil
and gas revenue being deposited into the Fund from inception until
1987. As well, prior to 1982, the Heritage Fund retained its income.
- On January 1, 1997,
the Heritage Fund was restructured in response to a public review
and, after a transition period, is now an endowment fund. The
restructuring included a new governance structure as well as the
establishment of new investment objectives and performance measures.
- Public consultation
on the future mandate of the Heritage Fund was conducted in the
form of a survey mailed to all Alberta households in 2002. The
survey confirmed the importance of the Heritage Fund as an endowment,
underscoring the need to preserve its real value over the long
term.
- Assets and income
of the Heritage Fund are fully consolidated with the assets and
revenue of the Province. Income earned during a fiscal year is
transferred to the General Revenue Fund (GRF), except for any
portion retained for inflation proofing.
- The Alberta Heritage
Savings Trust Fund Act includes a provision to retain a portion
of the Heritage Fund's income in the Fund to protect its real
value. Until the Province's accumulated debt is eliminated, the
Province has discretion in retaining income to protect the real
value of the Heritage Fund. It is anticipated that sufficient
assets will have been set aside to retire the Province's accumulated
debt by March 31, 2005. As a result, inflation proofing will commence
in 2005-06.
- The Heritage Fund
is embarking on an exciting new era. Subject to legislative approval
of Bill 1, the Access to the Future Act, additional assets
will be allocated to the Access to the Future endowment within
the Heritage Fund, which is targeted to reach a maximum of $3
billion. An amount equal to 4½ percent of the account will
be allocated annually to Advanced Education's proposed Access
to the Future Fund, as described in Bill 1, to enhance advanced
education opportunities for Albertans. An initial allocation of
$250 million is forecast to be made to the Heritage Fund for this
purpose in 2005-06.
HERITAGE
FUND STRUCTURE AND INVESTMENT OBJECTIVE
The Alberta
Heritage Savings Trust Fund Act created an endowment with the
objective of maximizing long-term financial returns. The Act requires
the Minister of Finance, when making investments, to adhere to investment
and lending policies, standards and procedures that a reasonable
and prudent person would apply in respect of a portfolio of investments
to avoid undue risk of loss and obtain a reasonable return that
will enable the endowment to meet its objectives.
GOAL,
INVESTMENT STRATEGIES, OUTCOMES AND PERFORMANCE MEASURES
GOAL
1: Preserve the real value of assets
What
it means
The Alberta
Heritage Savings Trust Fund Act provides for the maintenance
of the Fund's real value by requiring the Heritage Fund to be inflation-proofed
once the accumulated debt of the Province is eliminated. Investments
made within the Endowment Portfolio must be made with the objective
of maximizing long-term financial returns. Equities have typically
provided investors with higher historical total returns (current
income and capital appreciation) than fixed income investments,
and therefore constitute a significant proportion of the portfolio.
GOAL
2: Achieve budgeted cumulative income forecasts during a 5-year
planning horizon.
The government
reports its financial statements on a consolidated basis and therefore
Heritage Fund income is included in consolidated revenue of the
province. Consequently, the level and variability of Heritage Fund
income is important to the government's fiscal plan. However, the
benefit of long-term capital appreciation is also desired.
The Heritage Fund is
invested in a diversified portfolio that includes interest-bearing
securities, Canadian equities, international equities, private equities,
absolute return strategies and real estate. The Fund is invested
to generate long-term returns to assist in supporting the Province's
income and spending needs. It is widely accepted that a prudent
mix of interest-bearing securities, equities, real estate and alternate
asset classes best achieves the objective of optimizing financial
returns as it provides enhanced expected returns and diversifies
risk. While income may fluctuate from year to year, over a five-year
period it is reasonable to expect income targets to be met.
The following
strategies, expected outcomes and performance measures pertain to
both Goals 1 and 2.
Strategies
• Implement the
policy asset mix below:
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- Increase investments
in absolute return strategies and private equity.
Increasing exposure to non-traditional asset classes (absolute
return strategies and private equity) can create a portfolio with
improved risk/return trade-offs even after the additional investment
costs associated with these assets are taken into account. An
increased exposure to non-traditional asset classes is in line
with the policies of other North American endowment funds.
- Reduce Canadian
fixed income and public equity investments.
These investments will be gradually reduced to accommodate the
increase in absolute return strategies.
- Review and,
if deemed appropriate, add investments in timber to potentially
enhance overall portfolio return and diversification.
During the fiscal year, timber will be reviewed as a potential
asset class for inclusion in the portfolio.
- Vary the
allocation of assets to enhance returns.
Based on the outlook for financial markets, Alberta Investment
Management may vary the allocation of liquid assets to enhance
returns.
- Reduce the
Heritage Fund's investment in project loans.
Remaining project loans have a total value at cost of $93 million
or 0.8% of Heritage Fund fair value. The largest of these project
loans is a $91 million loan to Ridley Grain Ltd.
- Retain a portion
of income so that the Heritage Fund grows with inflation over
time.
- Remove remaining
foreign property restrictions.
Expected Outcomes
- Income forecasts
are achieved on a cumulative basis over five years.
- Real value of assets
is preserved over a 20-year horizon.
- The Heritage Fund
policy asset mix is expected to generate a real rate of return
of 4.5% at an acceptable level of risk over a moving five-year
period.
- Active management
will add further value to the total rate of return.
Performance Measures
- The market value rate
of return of the policy benchmark will be compared against the
Consumer Price Index (CPI) plus 4.5% to determine whether the
investment policy is achieving the returns expected based on long-term
capital market assumptions.
- The actual market
value rate of return will be compared against the policy benchmark
return to determine the impact of fund management on performance
using the following benchmarks for each asset class. Alberta Investment
Management will seek to add 50 bps (0.50%) of value per year (after
fees are deducted) over a five- year investment horizon.
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2 See Appendix
A for a description of these benchmarks.
3 See Appendix C for a description of this asset class.
The above benchmarks
are unchanged from the previous business plan except that the real
estate benchmark is to be changed from CPI + 5% to the Investment
Property Databank Large Institutional Property Index.
RISKS
TO GOALS, INVESTMENT STRATEGIES, OUTCOMES AND PERFORMANCE MEASURES
Investment
returns and income will vary significantly from year to year for
the following reasons:
- The well-established
capital market principle that increased expected returns are accompanied
by increased risk.
- An investment policy
to maximize long-term returns implies a weighting towards investments
in equities. Equities have historically provided investors with
higher total returns (dividends and capital gains) than fixed
income investments; however, dividend rates in general are lower
than interest rates. An equity portfolio will provide lower current
income while the magnitude and timing of realizing capital gains
is uncertain.
- Given a well-implemented
private equities program, private equities can provide investment
returns above those of public equities. However, by their nature,
private equity investments are highly illiquid and are associated
with an investment horizon of five to ten years to realize investment
gains. Some private equity investments are subject to potentially
large or total investment losses.
- Absolute returns strategies
have gained prominence in recent years with an expectation of
stable returns. However, this market is very fragmented, with
many different strategies and investment fees above those of traditional
managers. In some cases, there have been large losses sustained
in the industry by otherwise well informed and highly professional
investors. Manager selection and oversight are therefore critical
to successful implementation.
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ACCOUNTABILITY
TO ALBERTANS
GOAL
3: Ensure the transparency of the Heritage Fund’s objectives
and results for Albertans.
What
it means
Results from the Looking
Forward survey confirm Albertans want a strong, healthy Heritage
Fund that is used primarily for savings. Ongoing communication through
published reports and news releases will ensure Albertans remain
aware of the performance of the Heritage Fund.
Strategies
- Release quarterly
and annual reports on a timely basis in simple, understandable
language.
- Release summary reports
of the Heritage Fund’s investment activities and results
for Albertans on a timely basis.
- Publish the Heritage
Fund Business Plan annually.
- The Legislature’s
Standing Committee will hold annual public accountability meetings
around Alberta to report on the Heritage Fund’s results
and to answer questions on the Fund’s performance.
Expected
Outcome
- Improved understanding
by Albertans of the management, operations, investment philosophy
and performance of the Heritage Fund.
Performance
Measures
- Timeliness
of reports and public accountability meetings.
- Knowledge
of Albertans regarding information provided about the Heritage
Fund.
- Annual report
will be released by June 30 of each year.
- Quarterly
reports will be released within two months after the conclusion
of the quarter.
- Albertans
are satisfied with their knowledge of the Heritage Fund, with
50% able to estimate the Fund’s value.
MANAGEMENT
AND ACCOUNTABILITY
- The mission and investment
objectives for the Heritage Fund have been established in legislation
and are summarized above.
- A Standing Committee
of the Legislature has been created by legislation and has the
following responsibilities:
- To review and
approve annually the business plan for the Heritage Fund;
- To receive and
review quarterly reports on the operation and results of the
Heritage Fund;
- To approve the
annual report of the Heritage Fund;
- To review after
each fiscal year end the performance of the Heritage Fund
and report to the Legislature as to whether the mission of
the Heritage Fund is being fulfilled; and
- To hold public
meetings with Albertans on the investment activities and results
of the Heritage Fund.
- The Minister of Finance
is responsible for the operation of the Fund.
- The Endowment Fund
Policy Committee reviews and recommends the business plan, quarterly
and annual reports, and the investment policies for the Heritage
Fund to the Minister of Finance. The Committee includes a majority
of private sector members with relevant financial and business
expertise.
- Alberta Investment
Management, the investment operations group of Alberta Finance,
makes ongoing investment decisions.
- The Auditor General
is the auditor of the Heritage Fund.
- There are restrictions
on the kind of investments that can be made. Heritage Fund assets
are to be invested prudently and cannot be used for economic development
or social investment purposes.
INCOME
AND EXPENSES
- Capital gains and
losses on traditional investments are not recognized as income
until the investment is sold or, given a significant loss, written
down. Therefore, gains and losses that are included in reported
rates of return may not be immediately reflected in realized income.
In contrast, income and expenses on equity index swaps are accrued
as earned, resulting in gains and losses being realized in income
as they occur.
The income projections
include:
- Interest income;
- Dividend income
- Capital gains or losses
only when they are realized, such as when an investment is sold
or written down; and
- Income and expense
on index swaps and interest rate swaps accrued as earned.
- The income projections
do not include unrealized capital gains.
- Following are current
projections of Heritage Fund income based on the assumptions noted.
Actual results will vary from projected income depending on the
extent to which actual interest rates and equity market returns
vary from the assumptions used.
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RISKS
TO THE INVESTMENT INCOME FORECAST
- If equity
returns are lower than assumed, accounting investment income will
be lower depending on the extent of the decrease in equity returns
and the amount of turnover in the equity portion of the Heritage
Fund.
- If interest rates
increase, the market price of bonds held by the Heritage Fund
would typically decline. Accounting investment income will decrease
depending on the extent of the interest rate increase and the
amount of turnover in the fixed income portion of the Heritage
Fund.
EXPENSE
FORECAST
The preceding
projections for the Heritage Fund are gross of estimated direct
investment expenses. Estimated investment expenses are as follows:
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The administrative
expenses include both direct and indirect administrative expenses,
which include staff time, supplies and services, investment service
costs and advisory services.
The increase in costs
is due to increased staff and systems costs, increased size of the
fund, and increased allocation to
non-traditional asset classes (absolute return strategies and private
equity) which are more costly to manage.
As of December 31, 2004,
approximately 68 per cent of the Heritage Fund's assets were internally
managed.
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APPENDICES
APPENDIX
A: Description of Benchmark Indices for the Heritage Fund
Scotia
Capital 91-day T-Bills Index (SC T-Bills Index)
Reflects the performance of the Canadian money market as measured
by investments in 91-day Treasury Bills.
Scotia Capital
Universe Bond Index (SC Universe Index)
Covers marketable investment-grade Canadian bonds with terms to
maturity of more than one year. The purpose of this index is to
reflect performance of the broad Canadian bond market in a manner
similar to the way the S&P/TSX represents the Canadian equity
market.
S&P/TSX Composite
Index (S&P/TSX)
An index maintained by the S&P/TSX Canadian Index Policy Committee
that measures the total return on the largest companies that trade
on the Toronto Stock Exchange. (Formerly the TSE 300)
Standard &
Poor's 500 Index (S&P 500 Index)
Covers 500 industrial, utility, transportation and financial companies
of the US markets. It is a capitalization-weighted index calculated
on a total return basis with dividends reinvested.
Standard &
Poor's 1500 Index (S&P 1500 Index)
The S&P 1500 index is a compilation of the S&P 500 large-cap,
S&P 400 mid-cap and the S&P 600 small-cap indices. This
combination addresses the needs of investors wanting broader exposure,
beyond the S&P 500. The S&P 1500 covers approximately 90%
of investable U.S. equities.
Morgan Stanley
Capital International Europe, Australasia, Far East Index (MSCI
EAFE Index)
An index of over 1,000 securities listed on the stock exchanges
of countries in Europe, Australasia and the Far East. The index
is calculated on a total return basis, which includes re-investment
of gross dividends before deduction of withholding taxes.
Consumer Price
Index (CPI)
Base year 1992. Provides a broad measure of the cost of living in
Canada. Tracks the retail price of a representative shopping basket
of about 600 goods and services from an average household's expenditure
of food, housing, transportation, furniture, clothing and recreation.
All data figures that use CPI are lagged by 1 month.
IPD Large Institutional
All Property Index
An index maintained by the Institute of Canadian Real Estate Investment
Managers / International Property Databank that measures the total
return from six large Canadian funds, which have real estate portfolios
valued greater than $1.5 billion. The index is also prepared on
a Held Property basis.
APPENDIX
B: Business Plan Performance
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APPENDIX
C: GLOSSARY
Absolute
Return Strategy
Absolute Return Strategies encompass a wide variety of investments
with the objective of realizing positive returns regardless of the
overall market direction. A common feature of many of these strategies
is buying undervalued securities and selling short overvalued securities.
Some of the major types of strategies include long/short equity,
fixed income arbitrage, merger arbitrage, macroeconomic strategies,
convertible arbitrage, distressed securities and short selling.
Active
Management
Attempts to achieve portfolio returns greater than a specific index
while controlling risk, either by forecasting broad market trends
or by identifying particular mispriced sectors of a market or securities
in a market.
Asset Allocation
The investment process by which the investment manager chooses or
allocates funds among broad Asset Classes such as stocks and bonds.
Asset-Backed
Securities
These are debt instruments collateralized by a pool of assets such
as automobile loans or equipment leases.
Asset (or Investment)
Class
Refers to a broad category of investments with similar characteristics
(the typical asset classes are cash, stocks, bonds and real estate).
Benchmark Index
A Benchmark Index is a statistical yardstick tracking the ups and
downs of a particular market by monitoring a representative group
of securities over time. For example, the Scotia Capital Universe
Bond Index is a benchmark index that is designed to reflect the
changes in the Canadian bond market.
Bond
A bond is a financial instrument representing a debt where the issuer
(corporation or government) promises to pay to the holder a specific
rate of interest over the life of the bond. On the bond's maturity
date, the principal is repaid in full to the holder.
Capital Gain
(or Capital Loss)
The market value received on the sale of an asset, which is higher
(lower) than its purchase price (also called cost or book value).
If an asset is bought for $50 and sold for $75, the realized capital
gain or profit is $25.
Diversification
Diversification is a process of allocation of investment assets
within an Asset Class and among asset classes. In general, the greater
the number of holdings within an asset class and among asset classes,
the greater the diversification, which reduces risk.
Dividends
Earnings distributed to shareholders of a company, proportionate
to their ownership interest.
Duration (or
Modified Duration)
Modified duration is a measure of price volatility and is the weighted
average term to maturity of the security's cash flows (i.e., interest
and principal), with weights proportional to the present value of
the cash flows. Bonds with a longer duration are more price-sensitive
to interest rate changes than bonds with short durations.
Equities
Equities are synonymously called stocks or shares and represent
an ownership interest in a company (could be either a public or
private firm). The shareholder normally has voting rights and may
receive dividends based on their proportionate ownership.
Inflation
Increases in the general price level of goods and services. Inflation
is one of the major risks to investors over the long-term as savings
may actually buy less in the future.
Interest-Bearing
Securities
An investment that is required to pay a fixed interest rate at periodic
intervals such as bonds, mortgages and debentures.
Investment Grade
An investment grade bond is rated a minimum of BBB (or equivalent)
by a rating agency, with AAA being the highest grade. Bonds rated
below BBB are generally classified as being speculative grade and
carry higher levels of credit risk than investment grade bonds (i.e.,
they have a higher probability of default on interest or principal
payments).
Long-term
A long-term investment horizon in the context of the Heritage Fund
means a period of time that would include two business cycles, which
would generally mean about 10 years.
Market Value
Rate of Return
An annual percentage, which measures the total proceeds, returned
to the investor per dollar invested. Total proceeds for market value
rates of return = “money in the bank” plus paper profits
or losses (paper profits or losses are also called Unrealized Capital
Gains or Losses). “Money in the bank” means cash interest
and dividends and realized capital gains or losses from selling
the investment.
Median Return
The median return of a group of investment managers reflects the
return associated with the manager ranked at the 50th percentile
(the 50th percentile is that point where half the managers had a
higher return, and half the managers had a lower return).
Money Market
Instruments
Debt instruments such as Treasury Bills or corporate paper with
a maturity of less than one year.
Mortgage-Backed
Securities (MBS)
An MBS is a debt instrument that has an ownership claim in a pool
of mortgages or an obligation that is secured by such a pool.
Mortgage Investment
A mortgage investment is a debt instrument collateralized by real
assets (e.g., a building) and requiring periodic payments consisting
of interest and principal.
Nominal Rate
of Return
A measure of the earnings performance of a fund measured in current
dollars.
Passive Management
Buying or investing in a portfolio that represents a market index
without attempting to search out mispriced sectors or securities.
Portfolio
A collection of investments owned by an investor.
Private Equity
An equity investment in a private (not publicly traded) company.
Real Rate of
Return
The nominal rate of return minus the rate of inflation.
Realized/Unrealized
Terms generally used to describe Capital Gains or Losses. A gain
or loss is generally realized when an asset is sold; prior to sale
the gain or loss is unrealized and it is only a potential or “paper”
gain or loss.
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