The $51.6 billion Canadian fund, HOOPP, returned 8.55 per cent for the 2013 financial year, exactly half the return of 2012. But it finished the year in a better position than the year before, demonstrating that returns are only half the story. Amanda White spoke to Jim Keohane about the funds liability-driven investment style.

 

The Healthcare of Ontario Pension Plan (HOOPP) finished 2013 with a funding status 10 per cent higher than in 2012, putting the defined benefit plan in a great position of 114 per cent funded.

A couple of years ago HOOPP moved to a liability-driven investing approach, and now divides its portfolio into two distinct parts: a liability hedging portfolio, where all the physical assets are invested, and a return-seeking portfolio, implemented entirely through derivatives.

In the past year the liability hedge portfolio lost $1.4 billion, which compares to a gain in that portfolio of $2.2 billion the year before. This year’s loss was due to the interest rate increases across the yield curve resulting in market-to-market losses on the fixed income portfolios.

The rise in interest rates also had the effect of the discount rate, used to calculate the present value of HOOPP’s pension obligation moving to 6.25 per cent, from 6 per cent the year before.

This meant that the total pension obligations were lowered by about $1.5 billion, which was offset by the change in the hedge portfolio of -$1.438 billion.

“Some of our peers may get better returns than us, we are ok with that, we have more bonds than them. Our objective is not to beat our peers but to increase our funding rates. We look at the return on our liabilities, which was 10 per cent, not the return on our assets,” the fund’s chief executive, Jim Keohane says.

The fund manages assets actively in house, making active decisions to move along the yield curve, and using futures, swaps and options to get returns.

Within the liability hedging portfolio the asset allocation is split into real return bonds (12.5 per cent), real estate (12.5 per cent), nominal long bonds (70 per cent), and private equity (5 per cent).

The return-seeking portfolio, which gets equity, credit and beta exposures through derivatives is all managed internally including absolute return strategies, making it more like the proprietary desk of an investment bank than a pension fund.

If the notional value of the derivatives was added up the exposure is something like $200 billion, but that’s not really representational because it is long/short.

“In risk terms the exposure is quite small, because they are all relative value strategies,” Keohane says.

In 2013 value was added in both portfolios, and in the liability hedge it reduced its bond holdings relative to the policy benchmark. Where the strategic position is around 70 per cent in bonds, there was a tactical active decision to reduce it to around 60 per cent.

In addition the holdings were re-positioned out of the mid-term bonds into cash and short-term and long-term bonds.

“We are adjusting our fixed income exposures constantly, shifting with the yield curve,” he says. “The risk premium is very skinny and it is hard to find things.”

HOOPP has been overweight credit and equities since 2008 and is now neutral to short on both fronts.

The house view is that US equities are about 5 per cent overvalued, and Canadian equities about 2 per cent overvalued. While this is not extreme, with 10 per cent overvaluation considered extreme, Keohane says it is a cause for concern.

“Equities have been trading at a 10-15 per cent discount, and were at a 40 per cent discount in 2008, but the market is pricing in good news now. The same is true in corporate credit, spreads are as tight as they were in 2007 so you’re not being paid as much to take risk, so we are dialling that down.”

Instead HOOPP is overweight short-term bonds, and within real estate also sees some opportunities.

Given the fund’s envious funding position, now at 114 per cent, the investment strategy is to proceed with caution.

“We are in good shape from a funding point of view, we don’t need to take a lot of risk. We’re cautious.”

The fund has, however, been doing a lot of work on factor analysis, and  has built its own risk tools with a view to moving towards a risk based approach to asset allocation rather than rules-based capital allocation approach.

“We have built the tools to look at the contribution of risk to the portfolio, and we are now looking at the language in our policy documents to move that in.”

Interestingly the risk analysis has revealed that the portfolio doesn’t have as much credit risk as the team thought, so there is room to allocate more.

The biggest contributors to risk are a decline in long-term interest rates, an unexpected rise in inflation, and equity market risk.

“Liability-driven investing is the best way to manage those,” he says.

 

Blackrock has a favourable view on equities, relative to bonds, but within fixed income it advocates an unconstrained approach. Amanda White spoke to chief investment strategist, Russ Koesterich.

 

Equities look cheap relative to bonds or cash, says chief investment strategist for Blackrock and iShares chief global investment strategist, Russ Koesterich, with the manager recommending an overweight position in equities.

While equities are stressed they are cheaper than bonds or cash on a relative basis.

“At the highest level we would be overweight equities,” he says.

Within equities the manager is overweight Europe, cutting back on its US exposure.

“Europe is politically more stable and the risks are reflected in the price, which is a good deal cheaper than US.”

Koesterich, who is a founding member of the Blackrock Investment Institute which delivers Blackrock’s insights on global investment issues, says the discount in European equities relative to the US is sufficiently cheap, and when combined with the catalysts for growth in Europe, it look attractive.

He cites the possibility of an additional stimulus by the European Central Bank at the end of the year, and a more favourable monetary environment.

“The US market is fully valued. I don’t see it as particularly expensive but it’s not a bargain. Most of the gains in the US have been through multiple expansion, through stock market expansion, and it’s become expensive.”

Quantitative easing has supported this and also impacted the long-end of the treasury curve.

The impact of this is that investors are looking to source yield in alternative places.

Within fixed income, Koesterich says it is still hard to find any bargains, although there are pockets of opportunities including the US municipal market and hard currency and emerging market debt.

Blackrock is an advocate of unconstrained fixed income, which gives the manager greater flexibility to make larger latitudinal shifts in duration.

“Adjusting against duration is an advantage of a non-benchmark portfolio,” he says.

Given the continued volatility in fixed income Blackrock argues for an unconstrained fixed income portfolio, particularly given traditional benchmarks are typically concentrated in government-related debt.

And while the future is difficult to predict, the manager says there are three factors that will shape the direction of the bond market: interest rates should move higher over the year; rates at the “belly” of the yield curve will rise more dramatically than long-term rates; and volatility among and within fixed income sectors should be high.

As chief investment strategies of the world’s largest manager, Keosterich has a big job, which is made easier by the fact the firm has a lot of scope, and he can draw on experts from every asset class.

There are often cases when Blackrock’s views are the same as other managers, but the purpose is not to be different.

“We don’t set out to have a different view but to do what is best for clients,” he says.

In terms of portfolio construction, he advises investors should always keep in mind what “they are afraid of”.

“Putting portfolios together should be driven by the idiosyncrasies of what an investor is trying to achieve,” he says.

He believes there is often too much focus on returns with risk often omitted.

“Risk is important to think about, and if investors are basing risk on the past 18 months they may be underestimating risk.”

Investors must first decide what risk they are hedging or defending against – whether it be equity market slowdowns or interest rates – and change their investments accordingly.

 

“It used to be easier to make money,” Oaktree Capital Management founder and chairman, Howard Marks muses as he discusses meeting the demands and goals of his clients in 2014.

Marks is an avid communicator, and has been writing memos to clients for 24 years. The result is his book “The Most Important Thing”, which Warren Buffett’s review on the front cover summarises as “…that rarity, a useful book”.

His January memo is a 4,000-word musing on the role of luck. In it he discusses many things including “alpha” which he defines as superior personal skill.

“It used to be easier to make money. If you look at the history of inefficiency, there were markets that people didn’t have access to, there was infrastructure that was lacking and investments that were unknown. Now everyone knows everything about everything,” he says.

There was a time, not so long ago, that high yield bonds, the asset class where Marks started his career, were considered “improper”. He rues the

fact there are “no structural inefficiencies anymore.”

“I call this process ‘efficient-isation’, and it’s the norm.”

However what does still exist is cyclical inefficiencies and he’s only too aware that “people do panic at the lows and sell, or at least fail to buy”.

“It requires a certain degree of malfunction for the market to allow an investor to find a bargain, buy it on the cheap and enjoy an excess return. But it takes a greater degree of malfunction for everyone else to fail to notice that investors’ success, fail to emulate his methods, and thus allow the bargain to persist. Usually a free-lunch counter should be expected to be picked clean,” he says in the memo.

Given this “efficient-isation” Marks believes fund managers should focus on managing the expectations of clients.

howard marks 400x200

“Investment is still very much about alpha, but it’s harder to find and there is less of it,” he says. “So expectations need to be managed.”

Marks has worked with Bruce Karsh, who sits alongside him as number 296 on the Forbes 400 list of richest people in America, for 27 years, and he believes this longevity and stability speaks volumes for the firm’s success. His other co-founders have been with him longer.

“We have lived together through three major credit cycles,” Marks says, and he believes that working closely with a team for a long period of time creates a joint philosophy and lessons learnt which facilitates a strong environment.

“It’s constructive, not competitive, and we have a conducive compensation system that stresses teamwork,” Marks says, adding a key ingredient for success is retaining star performers.

A Wharton and University of Chicago graduate, Marks’ time in the markets has taught him to be contrarian, something you can’t learn in a class room.

“It’s the human side of investing that you can’t know when you’re at school,” he says. “It’s the importance of being contrarian, keeping your emotions in control and applying second level thinking.

“Investing is not physics: you can’t apply laws and assume it’ll work the same every time. With golf you can play 100 times and learn more about how to play a given hole each time you play. But with investing the course plays back and so do the other players.”

Quoting George Soros’ reflexivity – that the actions of people in an environment alter it – Marks says that investing in large part consists of predicting outcomes, and success comes from predicting more correctly than others.

“It’s relative to the universe. The first level thinker says ‘the company is good, buy it’ but the second level thinker says ‘the company is good but as good as people think so it’s overpriced: sell it’.”

An example of this is the firm’s success throughout the financial crisis, when it put to work more than $6 billion in the last quarter of 2008 following the bankruptcy of Lehman Brothers.

“It almost didn’t matter what you bought. But it’s not just intellectual, you also have to have to keep emotion under control,” he says.

 

Oaktree Capital Management, which invests in less efficient markets including credit, distressed debt, real estate and emerging market equities and manages $83 billion in assets, went public in April 2012.

Marks says, he was looking for an alternative to public listing, and as a result the company sold stock privately in 2007 and joined Goldman Sachs’ market for unregistered equities. But that route failed to create the liquidity needed to facilitate general transition, so an IPO followed five years later.

He denies that being a public company has changed the focus of the firm, asserting there is still the same sense of responsibility to do a good job for clients.

“People ask about a conflict of interests, but I think it’s not conflict but congruence. If you put the clients, first the business will be successful and you will make money for the shareholders,” he says. “It is not right to do just anything for the sole purpose of boosting assets under management. It has to work for the clients.”

He says a great firm has to stand for something other than AUM, and for his firm that is the Oaktree investment philosophy: the primacy of risk control, emphasis on consistency, the importance of market inefficiency, the benefits of specialisation, macro-forecasting not being critical to investing, and disavowal of market timing.

“We study the markets as they are today and take our cues from valuation and investor behaviour,” he says.

Marks’ outlook is that asset prices are elevated by central banks, and that when quantitative easing unwinds interest rates will rise. His mantra today is “move forward but with caution”.

“I think long bond rates will rise moderately, with the 10-year moving perhaps to 4 per cent. I don’t think it will go to 7 per cent, maybe to 4 per cent. Short rates are low also but they will rise more.”

The firm has 18 strategies, with high yield bonds and distressed debt the “tent poles”. Real estate is growing in importance, and an asset class Marks really likes.

The firm has raised $6 billion in the past two years for strategies that didn’t exist two years ago.

“We’re raising small funds, investing carefully and trimming expectations,” he says. “Today the key lies in caution, not aggressiveness.”

 

This paper by MSCI creates a framework in order to answer the question: given a portfolio of managers, how does the active risk of each manager relate to the active risk of the portfolio?

Asset owners often measure manager risk (the active risk of each manager) and have difficulty relating it to the contribution each manager makes to the multi-manager portfolio. MSCI says it is important that the analysis of the multi-manager portfolio be coherent with the analysis of each manager in isolation.

In order to achieve this, the paper defines and calculates manager risk contribution as the product of manager weight, manager risk and the correlation of the manager’s active return with the active return of the entire portfolio.

 

To access the paper click here

Manager_Risk_Contribution_-_Attributing_Risk_by_Manager

 

 

Using detailed data from IPD, this paper looks at the holdings and performance of 256 UK commercial real estate funds from 2002-2011. It concludes the more active funds, those further from benchmark holdings, outperform but are not accompanied by higher risk.

 

To access the paper click here

How active is your real estate fund manager

The $15 billion Australian super fund for hospitality workers, HOSTPLUS, has a 10 per cent allocation to infrastructure and is aggressively increasing its allocation to real assets. David Rowley spoke to chief investment officer, Sam Sicilia, about what the fund seeks from real assets.

 

A quarter of the $15 billion in assets held by the Australian defined contribution pension fund, HOSTPLUS, is held in unlisted property and unlisted infrastructure, and the fund is keeping a keen eye out for more.

While other funds might hold back on the temptation to buy a share in an airport or an office block, due to cash-flow fears, there is less restraint for HOSTPLUS, where the majority of members are between 20 and 40 years from retirement.

Including private equity, the fund currently has about 40 per cent in illiquid assets; but with its demographics, it could, in theory, raise that figure to more than 70 per cent, according to chief investment officer Sam Sicilia.

“When an airport is available for sale, that is the only time you can buy it,” he says. “You do not get a second bite. Even if you have reached your hypothetical limit to airports in allocation terms, it is OK to go over that limit to secure that asset, because it is unlikely to be there if ever you are underweight.”

To stay alert to opportunities, the fund has employed in-house experts during the past 18 months, including Jordan Kraiten as head of infrastructure and Spiros Deftereos as head of property.

A milestone in the fund’s step to build up its allocation to real assets was its decision in July/August 2010 to divest itself of sovereign bonds.

This was in part due to concerns about the health of these assets; but it was also due to the realisation that infrastructure and property produced the sort of returns you would expect from government bonds.

While switching out of bonds hurt in 2011, because the unexpected fall in interest rates from around 2 to 1 per cent pushed bond returns through the roof, it has paid off handsomely ever since, Sicilia says.

“There will probably never be a large allocation to sovereign bonds in this fund again because of our member demographics,” he says.

Prior to the global financial crisis, sovereign bonds largely abided by the laws of economics but from 2008 onwards they were behaving erratically.

“It was much riskier to be in the bond space, when the world departed from fundamentals, than being in equity markets – that is not what we learnt in finance school,” he says.

Of HOSTPLUS’ 15 per cent allocation to property, 9 per cent is defensive and acts in a way most investors would hope a sovereign bond would act.

Casselden Place, a prime piece of office space in the centre of Melbourne, Australia is typical of this approach. This property has space let to large corporates or government departments on 10-year leases and these have strong credit qualities.

“The rent they pay is like the coupons of a bond and the risk you are taking is essentially sovereign risk,” Sicilia says. “That is not a growth asset; rather it is predominantly a defensive asset that behaves like a bond.”

 

Process

The confidence HOSTPLUS displays regarding real assets comes from experience in property and infrastructure – the latter of which it first started investing in, in the early 2000s.

Once upon a time the fund invested through managers – “you would give a cheque to a fund manager and say, ‘the best of luck’” – but now it invests only in unlisted property and unlisted infrastructure, rather than listed forms of these asset classes; and along its path to sophistication it has worked out the defensive and growth parts of its property and infrastructure portfolios.

It has also become clear about the return profiles, the yield and the liquidity of each – so much so that the fund can move quickly when it sees something it likes. Sicilia says it is a three-part process.

“When the next asset in infrastructure or property appears before us, we can make a very quick determination as to whether it is appealing and worth some initial due diligence to take it to the board to see whether it is appealing to the board,” he says. “Only then we will do full diligence, which is quite expensive.”

This confidence around purchasing also extends to the growing expertise of IFM (the manager it has a share in), the fund’s consultant JANA Investment Advisers and its internal investment team.

 

Government deals

For the future, Sicilia foresees a time when funds like HOSTPLUS will broker infrastructure deals directly with government and believes it is inevitable governments will tap such funds for risk-free funding of greenfield sites – an idea that has so far faced opposition from the Australian Treasury.

Otherwise, he says superannuation funds are unlikely to invest in projects such as toll roads or bridges where there is risk of future revenue disappointing or construction risk.

“Why would we invest in that, when it is safer to invest in an operating infrastructure asset or the building down the road,” he says.

He describes such an arrangement with the government as “underwriting sub-optimal investment opportunities”. In this model, a 10-year government bond would be raised for a specific project, the return would be underwritten by the government bond rate and would be guaranteed for the term of the investment. Previously, the response from Treasury to the proposal was that it was not their role to underwrite a rate of return for infrastructure investors, though the noises the current government are making hint at change.

Sicilia believes time is on his side.

“The parcel of money in superannuation is growing and creating such a big opportunity set to deploy it for the benefit of the country, across the whole economy, that these ideas will ultimately see the light of day,” he says.