IMCO's CEO Bert Clark Reflects on the Canadian Model and More

I recently had the pleasure of speaking at Top1000 Funds’Fiduciary Investors Symposium Toronto 2024. This year’s theme — the Canadian model—brought together leaders from Canadian pension funds to discuss the evolution of the model and its future. We also covered the trends institutional investors are watching most closely, and where we see the biggest risks and the biggest opportunities.

Here is some of the ground we covered at the event, and additional thoughts the conversation sparked for me:

Twenty-five years ago, pioneering work was done to develop the so-called “Canadian model.” What do you think are the lasting impacts of that work, and what has changed since then?

In my view, the three most impactful elements of the “Canadian model” are strong independent governance, including both professional boards and staff; cost efficiencies, by making the right trade offs between internal and external expenses; and a willingness to innovate.

Good governance has in no way gone out of style. It is still the bedrock of strong public fund management. It still means ensuring boards are qualified and independent. It still means professional staff are required, with the market competitive compensation that implies. And it still means there can be no political interference.

Over the last 25 years, there have been significant developments, particularly in relation to cost efficiency.

Take for example, internalization of front office activities. In 2000, the universe of potential private investments was relatively small. Certain asset classes – like private credit – were still nascent. And today’s mega funds were managing less than $25-billion in assets. There simply weren’t that many private assets available and not much competition to buy them. It was feasible to build a global program and compete with funds like Brookfield and Blackstone with 100% internal teams, to drive down costs.

Today, the global opportunity set for private assets has exploded. Funds like Brookfield and Blackstone are now managing $1-trillion and there are other enormous funds, like Apollo, KKR and Carlyle, that dominate asset classes. There are also more niche players in certain market segments.

It now often makes more sense to have an explicit strategy of partnering (as opposed to competing) with best-in-class general partners (GPs) who have the scale or niche expertise required to originate and add value in large global markets.

There have also been big changes when it comes to operations. Today it is possible to leverage software as a service to build better risk, portfolio management, trading, asset mix, HRIS and other capabilities than you could ever build internally. There are big cost savings through outsourcing operations as opposed to internalization.

The spirit of innovation continues. While Canadian funds may not be breaking new ground, they continue to innovate by borrowing practices from others, and making them new for public funds.

For example, Canadian funds have replicated the treasury functions of large financial institutions – managing cash, liquidity, inflows, outflows, leverage, risk management, trading and so on, more efficiently. Banks and insurance companies have been doing these things forever. And Canadian pensions have adopted some of their best practices and applied them to pension investment.

Or take for example, the establishment of operating companies in areas like renewable energy and credit. We have a utility scale battery company in the UK. Others have mid-market lending companies. Platforms in these sectors is new to Canadian pensions. But the idea of platforms is not—many pensions bought real estate companies years ago. The point is, innovation—meaning the willingness to try new things—is alive and well in the Canadian pension space.

Your 5-year strategy is focused on Investment Excellence. How do you pursue Investment Excellence?

At IMCO, we have 8 clients with very different liabilities. Investment excellence means meeting their investment objectives with the least risk. To do that, we follow 3 straightforward strategies:

1. We build diversified portfolios, which for our larger clients, tend to have a growth-asset orientation.
2. We help clients avoid the two most common investment pitfalls: having insufficient liquidity and making outsized asset class or market segment bets; and
3. We seek to outperform only where we have a credible advantage.

For most of our larger clients, they cannot meet their investment objectives without either a lot of leverage or a tilt to growth assets. We tend to recommend a tilt to growth assets like equities, credit, infrastructure and real estate because we believe we have advantages investing in private growth-oriented assets and its challenging from a liquidity risk perspective to combine these with a lot of leverage.

We also are very careful to avoid the two biggest investment pitfalls:

The first big pitfall is having a shortage of liquidity. Lack of liquidity kills financial institutions. It is what killed Lehman and it is what killed Silicon Valley Bank. Managing liquidity is very important, and it was one of the first capabilities we built. We err on the side of conservatism. With a diversified portfolio, you can afford to have some investments not work. If you have too little liquidity, your best case scenario is that at some point you will have permanent loss of capital. In a worse case scenario, you will need help getting through a market event.

The second pitfall is making big bets. There are regular seismic events which impact asset classes or large market segments and lead to prolonged underperformance. After peaking in 1989, it took Japanese equities over 30 years to recover from its subsequent fall. The Nasdaq took 14 years to recover from its decline following its peak in 2000. The point is these things happen, they happen regularly, and they are devastating if you have made a big bet on one asset class.

Finally, we only look to outperform where we have an advantage because outperforming is just the icing on the cake. So called net value add is not what pays pensions or insurance claims.  If all goes well, it may represent 5-10% of returns.

We have the humility and self-awareness to recognize that we don’t have advantages in all asset classes, geographies and market segments. Therefore, we are prepared to not invest in certain things or to accept market returns in those things.

We do think we have some advantages. We believe our size allows us to partner with best-in-class partners. Our flexible mandate allows us to invest in things don’t fall squarely into traditional asset classes, like structured credit transactions.

Having investing advantages doesn’t mean we are better than everyone else doing these things. In fact, it can often just mean we have a higher tolerance for certain risks than the markets, which allows us to generate incremental returns in places where we are more risk tolerant. For example, being paid incremental returns in private credit is something that makes sense given we have a good handle on our overall liquidity requirements.

Are you still a believer in private assets?

One of our key focus areas is investing in private assets. Our larger clients target investing 50% of their funds in private assets.

We believe that over the long-term, investing in private assets can generate better returns than their public markets equivalents. There are levers you can pull in private ownership to enable value creation that are not possible in public market settings, where stability of dividends, strategy and financial structures is prioritized.

Still, there are a few things to be mindful of when investing in private assets:

First, private assets are only worth pursuing if you can reduce the fees paid to GPs. Otherwise, all the benefits will be consumed by the fees. This is one more reason smaller funds need to consider consolidation. They cannot access things like private markets on an efficient basis.

Second, if you invest material amounts in private assets, you need to have a keen eye on your liquidity. Today, that illiquidity is very evident: office buildings are not trading, and private equity funds are not having liquidity events to distribute funds to limited partners.

Third, the private-public debate is a false binary choice. There is a role for both. Public equities provide important exposure to market-driving companies and trends. We saw this in 2023, as artificial intelligence took off and companies like Amazon and Nvidia delivered strong returns. Lack of exposure to such trends and companies is a big bet we would not recommend.

Real estate has been challenged in recent years. What does the future hold for this asset class?

Real estate isn’t a monolithic asset class. There have been big differences in market segment performance, which is why our team is focused on building a much more diversified portfolio, with the aim of growing our multi-residential, life sciences and industrial (logistics) exposure, and right-sizing our exposure to retail and office. Today, each market segment is often driven by its own dynamics as well as interest rates and the overall economy.

Despite the big challenges the overall asset class has faced, such as higher interest rates and construction costs, there are a few bright spots:

Given the real supply shortages, we view multi-residential real estate positively in the coming years. We are working with our partners to develop and acquire quality multi-residential in key markets.

Life sciences is benefitting from significant demographic tailwinds that are driving demand by both large pharma and small-to-mid sized life science companies for modern lab facilities within key research clusters. We have established apartnershipwith Tishman Speyer and Breakthrough Properties to advance this strategy and have large scale projects underway at both Harvard and Oxford.

We are also excited about data centres. The rapid progress of AI has given rise to a huge need for data centres. We areparticipatingin the development of new data centres alongside partners like Digital Bridge and are looking at additional opportunities to develop data centres in key locations.

We continue to view logistics positively, even as demand has normalized since the phenomenal build out of this segment during Covid. We believe the demand for logistics space will continue to be strong as vacancy remains low (in the 5% range) across most markets.

Regarding retail, we are hopeful the worst is behind us. Since the pandemic, consumers have returned to malls, with traffic nearing pre-pandemic levels. We are still in the process of re-positioning our portfolio through dispositions and exploring redeveloping some retail properties to include other uses such as housing intensification.

We are being patient when it comes to office. In many cities, office real estate values have been hurt by higher construction costs and the shift to hybrid work. Unfortunately, with vacancy rates in some cities is in the mid-teens range, so it is going to take years of positive net absorption rates to reach pre-Covid occupancy levels.

Ultimately, we aim to have a balanced exposure to all market segments to deliver consistent, stable returns going forward.

What are the big trends investors need to think about today?

Over the past 40 years, many things investors took for granted havechanged.

The biggest change has been inflation and interest rates.

Inflation was not really a serious concern in developed markets for decades. In the last 3 years, we have had higher sustained inflation than at any other time in the last 30 years. The prospect of both bouts of inflation and ongoing higher inflation is more real today than it was for decades. Investors with inflation-linked liabilities need to be much more careful about managing this risk.

We also seem to have entered a period of frequent and powerful government intervention in the markets and the economy. The Federal Reserve grew its balance sheet by trillions and ran negative real interest rates during the period between the Great Financial Crisis (GFC) and Covid. It then raised rates more and faster than at any time in 40 years. Meanwhile, US government debt levels have exploded, as deficits have become larger since the GFC. This fiscal intervention has made the Government and the Federal Reserve among the biggest drivers of near-term macro and market dynamics, and in turn, has made it harder for investors to predict near term macro and market events.

And finally, geopolitics is back. The golden era of growing trade and subdued state conflict has passed. We have returned to something that is, sadly, more normal, with serious tension between the world’s largest powers and multiple armed state conflicts underway. This heightened geopolitical activity increases the risk of investing in some markets more than others.

How do you think about geopolitics as an investor?

There was a golden era just before and after the turn of the millennium where all the developed and emerging markets in the world seemed investable. China joined the WTO. Trade was growing quicker than GDP. Wars and death from armed conflict were down. And ESG was something investor were less focused on.

In those years, it made sense to invest in high growth economies to ride the wave of economic growth and trade—even if those economies weren’t yet democratic or capitalist.

And here we are today. There is war in the Ukraine and Gaza. There is ongoing and still-escalating tension between China and the US. This has led investors to become much more vigilant about the geopolitical dynamics surrounding countries in which they invest.

For us, these recent developments reinforce a natural bias we have towards developed markets. This is where we can more easily leverage our comparative advantages: investing with and alongside world class partners, often in private assets. We are better positioned to do these things in places like Canada, the US, Australia and Europe.

Another big trend is AI. How should investors think about AI?

We have all heard the statistics, such as AI will impact about 60% of jobs. Bill Gates said,“The development of AI is as fundamental as the creation of the microprocessor, the personal computer, the internet and the mobile telephone.”

The impact of AI will be big, although nobody really knows exactly what its impact will be on jobs or the economy, or the investment implications.

I believeAIwill replace some jobs, enhance others but overall, be a net positive for society, like previous big technological developments such as the internet, the internal combustion engine and electricity.

But, it is very difficult to identify the specific companies that will become the long-term dominant players when any new technology emerges. Netscape was the dominant search engine when the internet first took off. Nokia was the dominant cell phone company when mobile telephones took off. Chesapeake was the dominant shale gas company when fracking took off. These companies stumbled and some of them disappeared and were replaced by other companies who went on to dominate those sectors.

We are trying to invest incompaniesand sectors that are going to benefit from the trend more generally. In private markets, we are investing in data centres and fibre optic infrastructure to benefit from the large demand for computing power, data storage and data transmission associated with more widespread use of AI. And we are investing in renewable power generation to power data centres.

We also believe that one of the big advantages of our broad public market exposure is that it provides easy access to new trends like AI, without having to pick the long-term winners. It may be hard to identify the next Nvidia (if their market dominance does indeed continue). But if you have broad public market exposure you will benefit from the trend’s impact.

What do you make of the interest governments have in encouraging domestic investment?

Canada has a well-recognized productivity problem. We are not investing at the pace required to drive income per person up, especially given current population growth.

Against this backdrop, it is understandable that the government wants to engage with the largest pools of capital in the country to explore solutions to this challenge. The solution isn’t having pension funds invest more in the existing opportunity set. Rather, the solution is to work with us and other investors toexpandthe opportunity set.

I believe the most obvious place we could do that is infrastructure. Ports, airports, roads, energy transmission, energy generation—these are the types of assets we are buying in other jurisdictions. They match our return objectives, tolerance for illiquidity and investment time horizon. If done right, these can be real win-wins from a public policy perspective.

I’m hopeful the conversations underway will identify ways to spur more investment by us and others in Canada. We are certainly going to roll up our sleeves to help where we can make it work.

Where do you see the biggest risks?  The biggest opportunities?

I believe that big, unforeseeable events happen, and they happen fairly frequently, and they are hard to accurately predict in advance. If they could, oil would not have reached $147 in 2008—a level is has never subsequently reached and the examples I referred to earlier—involving the Nikkei and Nasdaq—wouldn’t have occurred.

Our strategy is to try to keep exposures to any asset class or market segment at a size that won’t lead to regret if something goes wrong. The biggest risk to me, at any time, is making a “really big bet.” Things go wrong, and when they do, they really hurt if you have invested too much.

In terms of opportunities, I am a long-term optimist. I believe that growth assets like equities will generate healthy returns over the long-term. $100 invested in the S&P 500 in 1928 would be worth almost $800,000 today, whereas $100 invested in 10-year US Treasuries in 1928 would only be worth around $10,000 today. The biggest advantage an investor can have is time—meaning modest and stable outflows and a tolerance for near-term volatility. Time allows investors to invest in growth-oriented assets like equities and earn a long-term premium over lower risk assets. Thankfully, our biggest clients generally have this advantage. The keys to successfully leveraging this investment advantage are managing liquidity to avoid being a forced seller of growth-oriented assets to meet short-term liquidity needs; avoiding “big bets”; and maintaining psychological discipline through periods of volatility.