UTAM favours equities, private credit

The University of Toronto Asset Management Corporation (UTAM) manages the institution’s C$8.8 billion ($6.5 billion) pension and endowment assets. Its performance is benchmarked against a traditional 60/40 reference portfolio where key characteristics are passive management in public markets, simplicity and low cost.

Although the reference portfolio comprises only equity and fixed income, UTAM has the flexibility to invest in other assets, such as private equity and hedge funds. These assets are classified under the most appropriate reference portfolio asset class.

Within this framework, UTAM’s new president and chief investment officer, Daren Smith, guides a new six-person, expert investment committee. He has honed a sophisticated, outsourced strategy informed by his prior roles at the fund, which he joined in 2008.

“We are trying to outperform the reference portfolio but we don’t make any significant macro bets away from it,” Smith says in an interview from UTAM’s Toronto offices.

With 60 per cent of the portfolio in equities and the strong returns of recent years expected to taper, Smith’s focus is working with the best managers ahead of a tougher climate.

“We are not set up to take significant bets where we would underweight equities based on the view that [these] markets are overvalued,” he explains. “We are about finding best-in-class managers that can outperform over a market cycle and in a downturn, hopefully, preserve more capital than the benchmark.”

Passive US equities, active international

For now, he favours passive US allocations and active international strategies. US shares represent 20 per cent of the benchmark allocation, an area where Smith says outperforming the S&P 500 benchmark with traditional managers is tough.

“We looked at traditional long-only managers in US equity, found the ones we thought were best in class, looked at the fee schedules and didn’t have the conviction that active traditional managers would outperform,” he recalls. [It’s why] a large proportion of our US equity is passive.”

Would equity long-short hedge funds perform any better?

“We’ve evaluated whether these funds can outperform the long-only benchmark,” Smith responds. “The reality, in our view, is that it is extremely difficult for a typical equity long-short manager to outperform a long-only benchmark. They may have a higher Sharpe Ratio and less volatility, but when you look at the returns, we find most of the value tends to be on the long side, and then we find most of that value is gross of fees. Net of fees, a significant proportion of that value is eroded.”

Not much private equity

What about private equity? He explains that any investment in private equity requires conviction that the allocation would outperform not only passive markets but also the next best alternatives, which are more liquid – such as a traditional long-only or hedge fund manager – to compensate for locking up assets for a long time.

“The hurdle for private equity is not the usual benchmark returns,” he explains. It’s an analysis that leads him to conclude: “Plain vanilla US private equity is not attractive and the expected returns don’t appropriately compensate investors for locking up capital for such a long period of time. It’s not an area we are actively focusing on at this time.”

In international private equity, applying the same analysis has led UTAM to favour long-only and extension strategies – an allocation that is 15 per cent of the benchmark.

“We’ve been able to find managers that are traditional long-only or extension managers who have significantly outperformed the relevant public-market benchmark. This is the hurdle an international private-equity manager would need to meet, and so far we have little international private-equity exposure.”

UTAM hedges 50 per cent of its currency exposure from US and international equity allocations, in a strategy that leaves the fund with a 32.5 per cent foreign currency exposure. Smith explains that the fund has been overweight US dollar exposure for the last four years, but now that the US dollar is strengthening, UTAM is sticking much closer to the benchmark currency exposure.

“In the past, it was a slam dunk to be overweight the US dollar because the dollar was undervalued and had a risk-reduction benefit for a Canadian investor. It is rare to have something in a portfolio that both reduces risks and is expected to add value.”

Opportunistic in private credit

As equity markets challenge investors, so does private credit. UTAM’s opportunistic credit portfolio comprises strategies including direct lending in Europe, Asia and the US, credit long-short hedge funds, an allocation to mortgages, and a mandate with a special situations Asian manager focused on non-core bank assets and non-performing loans.

“We try to go after different opportunities created by dislocations in the market. In many cases, this has been where banks have retrenched or pulled out of the market,” Smith says. “The objective of this portfolio is to deliver 8 per cent plus net returns with as little risk as possible. If we have to take more risk than we are comfortable with to get to 8 per cent, we will drop the 8 per cent objective.”

The direct lending space has become “less compelling” and UTAM is not re-upping with most of its direct-lending managers, he says.

Uncorrelated returns come from an absolute return portfolio set up in 2011, in an allocation that targets returns of cash plus 4 per cent with low volatility and no market beta. UTAM allocates to nine managers, 70 per cent of which run equity market neutral/low net strategies, with the remainder in global macro.

“Only a small sub set of hedge fund strategies are appropriate for this mandate, because there is traditional beta in most hedge fund strategies. We would argue your typical equity long-short hedge fund manager would have a beta north of 0.3 or 0.4 to the market,” he says.

Smith notes that at “a point in time”, the absolute return portfolio may have a long market exposure, due to global macro strategies, where managers take directional views. Yet over “a market cycle”, he doesn’t want managers “to have a static bias one way or another”.

Responsible investing

Smith says the portfolio has met all its objectives, outperforming the cash return objective and a customised index.

UTAM has 40 core managers, selected and managed by an internal team of seven. He has expanded environmental social and governance (ESG) integration at the fund and just produced a first Responsible Investing Report. This promises another lens through which to rate managers.

“We’ve developed a whole set of questions and processes to evaluate existing and potential managers from an ESG perspective,” he explains. “We want to know that the manager is aware of ESG risks that are relevant for their strategy and has taken these into account in underwriting. What we ultimately hope is that this makes us better at selecting and monitoring managers.”