The extensive use of derivatives has been a big contributor to the C$35.7 billion ($37.4 billion) HOOPP reaching fully funded status. Jim Keohane, chief investment officer, explains how the fund manages its assets and liabilities through liability-hedging and return-seeking portfolios and the role derivatives play in dialling risk up, or down.
The moved to liability-driven investing a few years ago means HOOPP has two portfolios – the liability-hedging portfolio and the return-seeking portfolio. This structure allows the fund to extensively use derivatives in its portfolio, in fact Jim Keohane, chief investment officer says most of the portfolio exposure is through derivatives while most of the physical investments are in long-term sovereign bonds.
“Our move into derivatives started 10 to 12 years ago as a way to get around a foreign content rule, and we found there are a lot of things you can do with derivatives,” he says.
The fund almost stumbled into using credit default swaps, as at the time it thought Canadian credit was overpriced.
“The effect was it allowed us to reduce risk by diversifying credit and we improved return by decreasing risk.”
The fund recently released some good headline figures, announcing it was fully funded, and had returned 13.68 per cent for 2010. And it only has 35 investment professionals, keeping investment management costs down.
Risk is a big focus of the way the fund manages its assets, and the use of derivatives allows the investment staff to either take risk, or reduce risk.
“Derivatives consistently get a bad rap in the press, they’re just a tool. You can do woodwork with hand tools or use a radial-arm saw – which is very precise – and if I’m not trained I can cut my thumb off. But if you are properly trained they are more efficient in time and cost,” Keohane says.
He argues derivatives allow the fund to be more precise about the risk taken, for example in a US corporate bond investment there is credit risk, duration risk and foreign exchange risk, and through the use of derivatives any or all of those risks can be reduced or enhanced.
Within the risk management framework, HOOPP has identified that in its liability hedging portfolio – which has a 4.5 per cent return expectation – the liabilities are sensitive to interest rates and demographic factors. This is a minimum risk portfolio which is long only, with interest rate sensitive and inflation sensitive assets, including 30-year bonds, interest rate swaps, interest rate futures, real return bonds, real estate and private equity.
It also has a return-seeking portfolio which consists of a beta risk overlay, beta risk hedges and an alpha strategy. Within the beta risk overlay the fund uses S&P Futures, international futures, credit overlay CDX index and long-term options on the S&P 500. And the alpha strategies are equity-based strategies, interest rate strategies, funding strategy and cross-market arbitrage.
“It’s a two-step risk process. The liability hedge portfolio is a risk reduction portfolio. Interest rates, inflation and equity are the three major risks, and interest rates are almost as big as equities. For example a 100 basis points decrease in long rates would cost us $5 billion,” Keohane says.
The fund has a clear strategy to focus only on the areas of investment it does well, with Keohane pointing out it has a large balance sheet to allow collateral for shorting.
“We are making beta work for us and we focus where we strategic advantage over time,” he says.
The fund has a ‘vanilla’ portfolio, for example it does not invest in infrastructure, but acts more like an investment bank than a traditional pension fund investment division.
“We break down the barriers that exist within most funds, they’re siloed according to asset classes. We have one large public markets group, and we can figure out where next arbitrage might be globally. We can run hedge fund strategies internally and offer competitive pay. People have a lot of scope in their jobs, we hire those with bigger visions, searching for the next great ideas.”
Keohane believes there are a lot of investment myths out there that people blindly follow, one of those is that no one is good at big macro calls.
“We do what we are good at, which is identifying over- and undervalued securities, not being directional. For example we can determine the position of one bank relative to another but not whether banks generally will go up or down,” he says.
“We do certain things really well but don’t try to do everything. Running beta strategies with derivatives means you can run a large amount of money at a low cost.”
In 2010 the operating expenses of the fund were $129.2 million, down 1.6 per cent from $131.3 million in 2009, with the decrease primarily related to strategic initiatives and the elimination of external investment manager fees. HOOP’s investment operating cost work to just under 26 basis points and yet 80 cents of every dollar comes from investment returns.
The results speak for themselves. The fund is now fully funded with the effect that the contribution rates and benefits will be stable until at least the end of 2012.
The asset allocation December 31, 2010
Fixed income 53.3 %
Cash and ST securities 1.6
Canadian equities 10.1
US equities 10.3
Non-North American equities 8.5
Real estate 11
Private equity and special sit 5.2