OMERS Strategic Investments (OSI) is more than the international co-investment arm of Ontario Municipal Employees Retirement System (OMERS), it is the vehicle which the system uses to shape and implement several key parts of its strategic plan.

OSI is one of five investment groups that fit under the OMERS Worldwide brand. The other four groups have specific capital allocation and investment management functions – capital markets, private equity, infrastructure and property – but OSI has multiple functions.

While it does invest, across various vehicles and strategies, the overriding purpose of OSI is to implement the strategy of the organisation as a whole.

Chief executive of OSI, Jacques Demers, says this can include bringing opportunities to the investment arms but also forging relationships, conducting research and exploring co-investment.

“The actual investments, the sourcing of deals and opportunities, are undertaken by those investment entities. What we do [is] to support and enhance what they’re doing,” he says.

“So what OSI is doing is intended to assist them with operating investment plans, so when they’re ready, OMERS is ready.

“We are kind of like the R&D, skunkworks, strategic-relationship unit. We could feed back to be thematics in investment entities.”

 

Global Strategic Investment Alliance (GSIA)
OSI in itself also deploys capital, and Demers says most of that is unrelated to the other four investment arms, but in some cases it reinforces the fund’s relationships in certain areas.

The best way to exactly describe the function of OSI is to look at the recently closed Global Strategic Investment Alliance (GSIA) alongside the initial alliance members, Pension Fund Association and a consortium led by Mitsubishi Corporation, both from Japan.

The GSIA closed with $7.5 billion, of which $5 billion was committed from OMERS, to invest in large infrastructure investments. The role of OSI, which builds investment platforms and develops direct relationships globally, was to source the co-investment partners, and all GSIA investments will be originated and managed by the infrastructure-investment arm of OMERS, Borealis Infrastructure

This investment satisfies the OSI objectives, which are to establish a global footprint, raise capital for OMERS investment entities and supplement the fund’s corporate strategy by creating global investment platforms that would not otherwise exist. The idea is the platforms could ultimately be transferred to the investment entities, established as a standalone platform, or sold to third party investors.

“The whole point of GSIA is to achieve our objectives securing preferred infrastructure while advancing our presence; developing relationships and creating platforms,” he says.

At the moment about two thirds of the capital in GSIA is from OMERS, and Demers would like to see that get to about 25 per cent.

“Our target would be to have about six to eight members, to manage it effectively,” he says.

The idea is that each institution invests about $1.25 billion, but the concept of a feeder fund has been suggested, where up to 10 investors all contribute $100 to $125 million to that $1.25 billion aggregate.

The fund will be kept open to 2014, with some institutions pre-approved, and the aim is to raise $20 billion.

“We have about 100 outreach relationships now worldwide and about 20 to 25 globally, where we could pick up the phone to co-invest very easily,” he says. “At the end of the day we’re a pension plan – this is not a fee-driven exercise.”

 

Energy, capital and airports
Demers says OMERS is looking at how to develop those relationships and is considering secondments, exchanging employees with its collaborative players.

The GSIA is one of four platforms, or major investments, that the strategic arm has been involved in. The others include OMERS Energy, OMERS Ventures, and ADC & HAS Airports.

Demers says OMERS Energy, based in Calgary, is a mid-sized oil and gas operator and has grown from $300 million to $1 billion in three years. OMERS is the main investor but there are two other Canadian investors, and Demers says there is growing interest from institutional investors around the globe.

OMERS Ventures, which was launched last year with John Ruffolo at the helm, is part of OSI, and is a venture-capital investor that started from scratch and will invest across the life cycle of venture capital opportunities.

The fourth platform is ADC & HAS Airports, the Houston-based airport operator that is focused on markets less familiar to OMERS’ native Canadian market.

“Airports are strategic investments. For example, through our investing in Costa Rica we have developed a relationship with the government there and that will have flow on to other potentially attractive private-market investments,” he says. “We can act as an early scouting unit for emerging markets. So when OMERS private-investment arms go in, we’ve done some work.”

 

Light team
Demers says OMERS is shaping and implementing a strategic plan which includes moving to 100 per cent in-house investment management, a split of 53:47 between public and private markets and a return target of 7 to 11 per cent.

Part of the interpretation of that agenda, Demers says, is to advance the presence globally, and the fund now has offices in New York, London, Calgary and Toronto.

“We have developed relationships in Canada with pension plans, governments and public policy makers, and industry organisations around investments like infrastructure. Now we have to develop those kinds of relationships in other markets,” he says.

“OMERS leverages our intellectual capital and the all-in cost is less than 1 per cent of invested capital. Our feedback from other funds is that is very attractive,” he says.

OSI has a notional 5 per cent allocation of the total fund and it is now sitting at 1.6 per cent.

The strategic team has about 14 people, with OMERS Ventures another 13.

“It’s a light team because they’re strategic initiatives, but we do have support from other teams across the enterprise and can resource as appropriate.”

A few weeks ago I had a meeting with Ranji Nagaswami, chief investment advisor to New York City mayor, Michael Bloomberg. She’s the first mayoral chief investment adviser in NYC to oversee pensions and investments, an area that is usually the domain of the comptroller. She is an experienced and dynamic enthusiast with ideas galore on how to improve the city’s pension system. Which is a good thing. There’s a lot to be done.

New York City Employee Retirement Scheme (NYCRS), which will be profiled with an interview with its chief investment officer Larry Schloss on conexust1f.flywheelstaging.com in the coming weeks, is a governance mess, and there’s no surprise this has been impacting returns.

The $120-billion fund is made up of five separate funds for city employees. It has 58 trustees and five consultants for an asset allocation across the five funds that has about 90 per cent overlap. The boards still do beauty parades.

Short-termism is rife at the fund, driven by a structural element that sees the chief investment officer elected by the comptroller, a publicly elected official with a four-year term.

Furthermore, if you work at the fund you are required to live in one of the five boroughs of New York City, but the average investment employee salary is only $100,000.

(Apparently, according to a Bloomberg report, Nagaswami lives in Greenwich, Connecticut, so the city administration secured a waiver enabling her to work for the city. Her salary is $175,000).

 

Getting to the core

Wall Street is literally a stone’s throw from the 1 Centre St office of the City Comptroller’s Bureau of Asset Management, which manages the NYCRS investments, but geography is all they have in common.

Nagaswami, who before joining NYCRS spent more than 20 years at UBS Asset Management and Alliance Bernstein, was reluctant to speak with me on the record. Fortunately, and perhaps not so coincidentally, she has written a piece on the battle facing US public pension schemes in the spring issue of Rotman International Journal of Pension Management.

In this she outlines her observations and concerns, and many of the governance challenges have been acknowledged by mayor Bloomberg and the comptroller, John Liu, as well as some union members.

But widespread reform across investment strategy, decision-making, trustee governance and actuarial-assumption rates is needed to turn the fund around in the direction of best practice.

In the article Nagaswami outlines three clear challenges for NYCRS.

First, the investment-planning process should start with an understanding of the risks in the current portfolio as well as the short and long-term market and return environment. A new and multi-step investment road map should be designed to construct a long-term balanced policy portfolio. And the governance of the plans must be overhauled.

She wants to create a new starting point, redraw the investment road map, including a new attitude to the role of fixed income, and broadening the approach to policy portfolio construction, as well as getting the governance right.

Secondly, she says what is most needed in NYC is further professionalisation of investment staff and the board trustees to attract and retain the best talent at competitive market compensation rates while improving the board’s oversight.

She argues for consolidation of the existing five separate investment committees to improve efficiency and reduce unnecessary duplication.

And finally, she says, the fund needs de-politicisation to ensure that the structure is not influenced by the election cycle or shifting political agendas.

In the past few weeks Nagaswami, and the pension beneficiaries in NYC, have had a win that could jet her plan into action.

The city’s independent actuary has recommended a reduction of the actuarial rate from 8 to 7 per cent.

Perhaps Nagaswami, who also sits on the Yale University investment committee, is big and bold enough to generate change at the city.

The Callan Investment Institute explores portfolio construction using risk factors in its latest paper. The research finds that while building purely factor-based portfolios is challenging and largely impractical for most asset owners, using factors to understand traditionally constructed portfolios can be very useful.

The paper, from the research arm of Callan Associates, looks at ways that key elements of factor-based methodologies can be integrated in multiple ways into traditional asset-allocation structures to enhance portfolio construction, illuminate sources of risk and inform manager structure.

Click on the title to read Risk Factors as Building Blocks for Portfolio Diversification.

For the past five years David Neal has been integrating the vision of “one team, one portfolio” into the culture of the investment team at the $77-billion Future Fund. This has now been set in stone – well, porcelain – with coffee cups bearing the moniker used by staff throughout the organisation.

The slogan is not a frivolous mantra but a reality among the investment team, and an overriding philosophy driving the culture and the investment decision-making at the Future Fund.

The investment team is driven by nine principles that all feed into the complex, multi-layered and reciprocal process. And its internal team is deliberately small, and strategic, with assets managed by external managers.

David Neal, the fund’s chief investment officer since inception and an engineer by training, puts a lot of emphasis on documenting the process via a diagram that shows the multiple inputs into decision-making.

 

Size and culture matters

“When you are managing a large amount of money, there’s a tendency to just grow and grow because it’s always easy to justify an extra person. Being clear about how our beliefs, comparative advantages and required culture influence the right team size and process is therefore critical,”
says Neal.

The fact decisions are made by an interactive team, means that size is clearly something he takes very seriously. Not just size per se, but the impact it has on the fund’s culture. Adding extra functions and people comes at a cost, he says.

“Our right size is not much bigger than it is now,” he says. “It is not just about size and cost, but the point at which the culture could degrade more rapidly with extra people.”

The fund is trying to remain as small as possible internally while allowing its asset size to grow as large as possible.

And while the investment process is supported by investment models, there is a recognition of their limitations, and the emphasis on qualitative inputs into the portfolio construction. The teams get together frequently to discuss ideas and everyone feeds into decision-making. The managing director and chief investment officer have right of veto, but Neal rarely uses that right.

Communication discussion forums, including macro and market forums, and senior-investment and full-investment team meetings feed into the decision-making process, highlighting the benefits of a small team in such a process.

The Future Fund sits in a peer group that includes the $158-billion Canadian Pension Plan Investment Board (CPPIB) and $15-billion NZ Super, both of which approach the management of assets in a single total portfolio. However, the difference in the approach taken by these two funds highlights a view taken by Neal, that the right size is a function of the business strategy driving the fund.

The CPPIB, for example, hires more than 600 employees and manages all assets in house. This differs to NZ Super and the Future Fund, whose teams focus on strategy and outsource asset management.

“We look at our own comparative value add in each area, what does it mean for process, and what team structure do you need. What we require is strategic thinkers, as most of the money management is outsourced.”

“We look at our own comparative value add in each area, what does it mean for process, and what team structure do you need. What we require is strategic thinkers, as most of the money management is outsourced.”

 

Total management costs

Last financial year the fund paid about $444 million in total management costs, which includes all fund-management fees, core custody and portfolio administration, and the costs of the board and the agency. About $153 million of that was investment-manager base fees, with a further $218 million in performance fees paid to managers, highlighting an important bias in the investment thinking towards rewarding alpha.The internal investment staff were collectively paid $21 million, and have a performance bonus which is aligned to both the three-year rolling return of the investment and annual plans. (It pays its chair $182,530 and board members
receive $91,280).

 

The mechanics of decision-making

There is a global trend among large funds to bring asset management in house, ostensibly as a cost-saving exercise. But not only is the Future Fund required by law to keep an external manager between its agency and the money, Neal doesn’t necessarily believe it would be more effective to fulfilling the fund’s strategic aim.

“I’m sure we could put a business case together to manage money in house,” he says. “CPPIB is a very high quality organisation and they are working very hard to add value. If success is defined as beating the benchmark in each sector then added together to beat a portfolio benchmark, then this is rational. But for us, every person added makes it harder to create an efficient total portfolio targeted on our ultimate real return objective. It would be difficult to have seamless ideas and true competition for capital across sectors with 600 people, you feed teams like that with transactions. We have very different objectives.”

It makes sense for Neal to document the investment decision-making process in a detailed linear model, complicated by important feedback loops. The foundation inputs of beliefs and the mandate interpretation feed into portfolio construction from the top down. That also gets fed with scenario planning and macro environment analysis such as strategic themes and sector risk and opportunity analysis. Qualitative and quantitative risk-and-return assessment are also inputs.

What is clear at the Future Fund is that the culture and the process are interdependent.

“The process requires that we are checking on the strength of our culture,” he says. “And it is what I spend most of my time doing. The culture reinforces the process and vice versa.”

 

One team, one-portfolio

One of the key differences Neal highlights is the Future Fund’s one-portfolio approach. What this means is that everyone in the organisation has input into the portfolio as a whole, and in this way it is much more akin to the approach of NZ Super, which also has a small strategically based team.

It is no coincidence that the inaugural general manager of the Future Fund, Paul Costello, formerly worked at NZ Super.

The Future Fund does have a target allocation, or medium-term allocation, which in the 2010/11 annual report was 39 per cent in equities, 15 per cent in tangibles, 16 per cent in debt, 20 per cent in alternatives and 10 per cent in cash.

However, the actual allocation can vary a great deal from this target, which is different again to the long-term strategic asset allocation, which is not even really seen as a benchmark, more of a guide to the typical nature of the portfolio over time. This raises questions of how the performance of the team can be assessed if there is no benchmark to measure their active decisions against.
“We should be confident and competent enough to be evaluated without the use of a benchmark, we don’t need to curl up in bed sucking the corner of a benchmark,” Neal says.

Instead there is a concentration on meeting long-term goals via a commitment to teamwork and the nine investment principles, and a focus on the cultural values of integrity, innovation and “joined-upness”.

Long-term Strategic Asset Allocation Target asset allocation
(as of June 30, 2012)

 

 

Current asset allocation
(as of March 31, 2012)

 


The team functions by focusing on collaboration, looking for better ways to ways to communicate, which includes “being candid without getting personal”.

The fund has had some recent high-profile leadership changes but Neal takes this in his stride.

“With the CEO and chair changes, we have had a strong alignment. With all of the flavours of the board we’ve had, our overall investment beliefs, principles and strategy implementation, have consistently been bought into. There really hasn’t been a change. Personally, I don’t worry about it,” he says.

 

Continuous communication, continual development

While there is a one-portfolio approach, the investment team is still structured into the specialist sector teams of listed equities, private equity, property, infrastructure, debt and alternatives, strategy and environmental, social and corporate governance (ESG).

There is a focus on continuous communication and continual development so the entire team is brought along for the ride, whatever that might be. And while the “annual” portfolio reviews are conducted almost monthly the team, particularly the strategy team, is cognisant of focusing on the long-term – even as the short-term noise gets louder.

Neal says there is a lot of peer review in the investment team, stressing that the joined-up process only works if the specialists inform other specialists and vice versa.

He says the sector teams do their own analysis, guided by the strategy teamwork, and then filter up their ideas through their own research.

Those ideas arrive at a review committee, either a manager-review committee or an asset-review committee, consisting of about nine senior people.

That committee pulls apart the idea, tests its consistency with the strategic direction and whether in itself it is an opportunity. Passing that test, it then goes to the investment committee, which includes the sector heads, the managing director, the chief investment officer and head of strategy, whose job it is to build the portfolio and approve the investments.

 

Responding to change

While it seems like a reasonably bureaucratic process, Neal says it doesn’t necessarily take a long time to make a decision.

“We are open to the fact that things change, and so the portfolio and views change. It would be a very unusual world in which forward-looking risk and returns don’t change. But the things that populate the portfolio – the building blocks – don’t necessarily need to change when markets change quickly.”

The close relationship that the fund has with managers is also a lever to move the portfolio rapidly if it is appropriate.

“We have a close relationship with managers and I hope if the world changes, we have them already in place to be opportunistic either in the existing mandate or a new one. The committee owns that decision, the strategic decision, so we can do that rapidly at short notice,” he says.

Neal points to an example when the US credit rating was downgraded, and the fund took the view that the market had not sufficiently priced the likelihood that the US government was running out of fiscal stimulus bullets.

“We gathered the investment committee quickly, within a day of the strategy team forming the view, and made a decision to decrease our equity weight a few percent. We weren’t trying to make money from short-term trades, but it was a medium-term-outlook decision,” Neal says.

The investment committee has been granted decision-making approval within a range of plus or minus 3 per cent around the big headline allocations and within a sector have full discretion if the decision is to use an approved manger.

“For example, when the bank-loans market sold off in the credit crisis, we appointed a range of credit managers to build a substantial exposure for us. As the crisis developed, we had the discretion to move quickly and efficiently by expanding the mandates of those existing managers, for example, into securitised debt as it looked cheap.”

Neal describes the way that manager relationships are handled as “very deep and frequent”. Where the fund had 15 managers in June 2008, it now has 87.
“They’re important eyes and ears on the market, and they contribute to where the strategy should evolve. We have a bias to use an existing manager.”

“They’re important eyes and ears on the market, and they contribute to where the strategy should evolve. We have a bias to use an existing manager.”

The fund rarely uses consulting services, and Neal says the services they purchase are more about research and narrowing the field.

“It is a pretty small part of the overall approach.”

Neal says there is a trend to increase allocations to infrastructure, property and private equity, but it takes time to build and at some point will slow.

“It is taking us much longer to buy than we thought,” he says. “Three years ago we thought we’d be further along the line.”

The debt component of the fund also sets the portfolio apart, demonstrating that there is diversification as well as diversity. There is an overweight to high yield, which gives diversity to the corporate risk alongside its listed-equity and private-equity allocations.

This is a perfect example of the benefits of the one-portfolio approach. While the overall equity-like risk allocation has not altered, there is a recognition of the multi-dimensional nature of risk, and so where the risk is coming from, or being allocated to, has altered.

Future Fund principles of investment philosophy
Principle 1: Our portfolio management is focused on the specific objectives and risk definitions of the fund

Principle 2: We manage a single, total portfolio

Principle 3: We act as a single team, running an integrated process

Principle 4: We manage our portfolio dynamically

Principle 5: We aim to construct a diversified portfolio that is, as far as possible, robust to an uncertain future

Principle 6: We seek a relatively small number of relatively large relationships

Principle 7: We value flexibility and nimble decision-making

Principle 8: We manage for a net of costs return

Principle 9: While growing our investment team as large as necessary, we aim to keep it as small as possible

 

The seriousness with which the Danish pension fund ATP takes hedging paid off last year, with the fund recording its best ever return. A combination of the hedging activity and a deliberate move to substantially reduce its risk meant the fund weathered the European storm despite the fall-off in interest rates.

The 579-billion-Danish kroner ($98.4-billion) fund is managed in two distinct portfolios, a hedging portfolio and an investment or return-seeking portfolio.

The investment portfolio is divided into a beta and alpha portfolio, with about 97 per cent of the risk in the beta portfolio managed according to five underlying risk factors.

But it is the hedging portfolio that remains the main focus and indeed the main driver of the fund’s ability to pay its beneficiaries. The role of the hedging portfolio is to hedge, as precisely as possible, the interest-rate exposure of the fund’s pension liabilities, which last year was adversely effected by the fall in interest rates.

Chief investment officer of ATP, Henrik Jepsen says 2011 really demonstrated the importance of hedging against risks.

“There was a very substantial fall in interest rates in 2011, which meant being hedged was extremely important,” he says. “We made a total return of 26 per cent and the bulk of that came from hedging activity.”

Last year the total pre-tax return was $21.18 billion, with the hedging portfolio contributing about $18.3 billion, enabling it to pay its pension promise as well as add $679 million to its bonus reserves after tax.

The investment portfolio also contributed in a reliable way, with the fund realising returns regardless of what financial markets were doing.
“Effective risk diversification proved its value in our investment portfolio again in 2011,” Jepsen says. “And noticeably we made positive returns in all four quarters of the year despite the big differences in conditions – quarter one was optimistic, quarter two more wobbly, quarter three saw an extreme flight to quality and quarter four rebounded somewhat.”

Last year four of the five risk classes within the investment portfolio contributed to returns, with equities the obvious anomaly. The investment portfolio gave a return of $3.2 billion.


Hedging in Denmark

However, while the fund outperformed, particularly given wider market volatility, changes in the guarantee benefits – due to declines in interest rates – negatively affected hedging activities by $17.5 billion. The changes in the guaranteed benefit were higher than the return on the hedge (after tax) because Danish interest rates fell more than German interest rates as Denmark experienced flight to quality during the autumn, he says.

This meant that overall the results for 2011 came in at $441.6 million – lower than the performance target of the hedging and investment activity for that year.

In the context of the five-year performance target, however, the fund was above its target.

ATP has changed the way it quantifies the market value of its future pensions. Until 2011 the Danish swap rate was used to calculate pension liabilities but that changed last year.

“We have now changed the discount rate so it is a mix of Danish and German interest rates, which reflect the way we actually can hedge the liabilities and will result in a more stable hedging result. It means the hedging portfolio and value of liabilities will move more in sync.”


Dynamic risk allocation

Another example of how seriously risk is taken is that the $52.5-billion investment portfolio is driven by dynamic risk allocations.

At the end of March this year, the beta portfolio had an asset allocation (and risk allocation) as follows: commodities 3 per cent (11 per cent risk allocation), inflation 16 per cent (24 per cent), equity 15 per cent (42 per cent), credit 15 per cent (8 per cent) and interest rates 52 per cent (15 per cent).

The investment portfolio’s risk allocations have been stable for the past five years and, while there isn’t a benchmark per se, the fund has a long-term risk allocation, which includes 35 per cent in equities, 20 per cent in government bonds, 10 per cent in credit, 25 per cent in inflation-linked assets and 10 per cent in commodities.

“The long-term risk allocation was determined on the basis of a qualitative and quantitative study including data for the last century,” Jepsen says. While the fund can diverge from this risk allocation, he says it must always be within the limits of effective diversification.

In addition to diversification paying off, Jepsen says the fund had a focus on tail risk protection and reduced the absolute portfolio risk markedly during the second quarter.

“We are now using about half of our risk budget,” he says. “We kept the same relative-risk allocation, but did the risk reduction in a balanced way. We don’t bet on markets but have a risk-based decision model.”


Certain and small

Jepsen says the fund sold a lot of exposure in all five risk classes including equities, index-linked bonds and its oil exposure.

And, given the volatility in Europe, Jepsen says the focus will remain on defence, rather than offence, in the fund reaching its performance target.

“We lack visibility about the deleveraging process and the debt crisis so it is hard to be offensive. It is not any easier this year, as we see a lot of different equilibria depending on how the euro situation turns out. The biggest mistake to make would be to move to risker assets because safer assets are yielding so low,” he says. “We have stayed liquid and taken risk off the table.”

While the fund doesn’t use asset-class descriptions, by way of demonstrating the fund’s current risk tolerance Jepsen says if, conceptually, the fund was invested in equities, then about 20 per cent of the money would be in equities right now.

He says ATP has consistently taken a risk approach to the volatility in markets. Among other things the fund sold almost all its exposure to peripheral governments long before the crisis evolved.

“We look at tail risks rather than the most likely expected outcome,” he says. “We are not putting money on what we think will happen but rather making sure that the portfolio will perform well no matter the economic outcome.”

Jepsen is not afraid of losing short-term opportunities.

“It is much more important to avoid a black hole than miss a small rally,” he says.

Given the size of the fund, its investment team is quite small.

In the investment department, it only employs 20 people to manage strategy and implementation of fixed income, hedging, Danish equities and tail-risk management.

The specialised investment areas such as real estate, private equity, venture and alpha have been put into wholly owned subsidiaries owned by the fund, but not based at the headquarters.

“It means there is a smaller organisation here and management can focus on the broader issues,” he says.

Jepsen is responsible for the broader team, including the actuarial team, which together numbers about 80.

In recently released research, Dominic O’Kane, affiliated professor of finance at EDHEC Business School, challenges the assumptions about the operation of the eurozone sovereign-linked credit default swaps (CDS) market.

The European Parliament decided to permanently ban so-called “naked” CDS in October 2011 on the back of claims that their speculative use caused or accelerated the rapid decline in 2010-11 bond prices of eurozone periphery countries.

O’Kane performed theoretical and empirical analysis of the relationship between the price of eurozone sovereign-linked CDS and the same sovereign bond market during the debt crisis of 2009 -2011. Read the paper here: The Link between Eurozone Sovereign Debt and CDS Prices.