Thursday, March 21, 2013

HOOPP Does it Again, Gains 17.1% in 2012

Janet McFarland of the Globe and Mail reports, HOOPP sees best return in more than a decade:
The Healthcare of Ontario Pension Plan posted a 17-per-cent return on its investments last year and is running a significant surplus, far outstripping most Canadian pension plans in its financial performance.

The $47-billion pension fund, which represents 274,000 Ontarians working in the healthcare sector, said it was 104 per cent funded at the end of 2012, which means it has assets significantly greater than required on a solvency basis. By comparison, the average Canadian pension plan was just 69 per cent funded at the end of 2012 after years of low interest rates and growing funding obligations, according to a report by consulting firm Aon Hewitt.

HOOPP chief executive officer Jim Keohane said HOOPP’s 17.1-per-cent return on investments was its best result in more than a decade.

“This was a year when all of our investment strategies worked,” he said. “We were firing on all cylinders, with positive returns from every type of investment.”

Canadian pension plans earned an average of 9.4 per cent on their investments last year, according to a survey by RBC Investor Services Ltd. The giant Caisse de dépôt et placement du Québec, for example, earned 9.6 per cent on its investments last year, while the Ontario Municipal Employees Retirement System reported 10-per-cent returns and The Canada Pension Plan Investment Board, which has a March 31 year end instead of a Dec. 31 year end, reported nine-month returns of 5.5 per cent as of Dec. 31.

HOOPP attributes much of its funding success to its liability driven investment (LDI) strategy, which sees the pension fund closely match its assets with its liabilities to try to ensure the plan will remain well funded even when markets are highly volatile. To accomplish the goal, HOOPP invests heavily in bonds with long maturities to ensure their investments match the long-term nature of pension funding liabilities. It has reduced the proportion of stocks it holds, and seeks additional returns through complex derivatives strategies.

HOOPP says its 10-year average rate of return is now over 10 per cent, giving it one of the best long-term investment records for pension plans worldwide.
The Financial Post also reports that the significant performance propelled fully funded HOOPP to record $47.4 billion in assets.

Any way you slice it, HOOPP's significant performance in 2012 is nothing short of spectacular. It comes off another great year where they led their peers, gaining 12.2% in 2011. As you will see below through my conversation with Jim Keohane, what makes HOOPP one of the best plans in the world and this performance so incredible is how tightly they manage risk, successfully implementing an LDI strategy, and how they have the right culture to take intelligent investment opportunities that others never take because it doesn't fit in their investment parameters.

First, let's go over HOOPP's results and press release which is posted on their website:
The Healthcare of Ontario Pension Plan (HOOPP) has posted returns for 2012 of 17.1 per cent, which boosted the pension plan for Ontario healthcare workers to a record $47.4 billion in assets, compared to $40.3 billion at the end of 2011. This strong double-digit return increased HOOPP’s 10-year average rate of return to more than 10 per cent, one of the best long-term records among pension plans worldwide.

At the end of 2012, HOOPP was 104 per cent funded – this fully funded status means the Plan has sufficient assets to pay for every promised member’s pension benefit, with no shortfall.

“HOOPP had a very strong year in 2012 – with our best investment results in more than a decade,” says HOOPP President & CEO Jim Keohane. “This was a year when all of our investment strategies worked. We were firing on all cylinders, with positive returns from every type of investment,” he said. HOOPP’s liability driven investment (LDI) strategy continues to contribute to HOOPP’s success, Keohane added.

The Plan paid out more than $1.4 billion in pension benefits in 2012, an increase of $151 million over 2011, he added.

Created in 1960, HOOPP is the pension plan of choice for Ontario’s hospital and community-based healthcare sector with over 440 participating healthcare organizations. HOOPP’s 274,000 members include nurses, medical technicians, food services staff and laundry workers, and many other people who work hard to provide valued Ontario healthcare services.

HOOPP’s full annual report, as well as a short video featuring remarks by Jim Keohane, will be posted March 21.
I encourage my readers to carefully for over the full annual report for 2012 as it presents details of HOOPP's performance. You will also read the President & CEO's message on page 10 and see the major drivers in the funded position on page 16 (click on image below):

As you can see the Liability Hedge Portfolio and the Return Seeking Portfolio did their job, hedging liabilities and delivering positive returns in all investment activities (please read the details on page 16).

In terms of active management, or “value added,” it came from a variety of sources within both the Liability Hedge and Return Seeking Portfolios – contributors included interest rates, corporate credit, real estate, absolute return strategies and asset allocation strategies (click on image below):

I had a chance to speak with Jim Keohane on Wednesday afternoon. Our discussion centered around the following questions which I sent to him:
1) What were the main drivers of these results? Corporate spreads tightening, stock market rally, illiquids like PE and RE, asset allocation/ sector rotation?

2) What do you attribute HOOPP's success to? (culture, LDI approach, etc.)

3) Do you think other pension plans can adopt your approach? Given low bond yields, is it too late to adopt an LDI approach, especially if the plans are grossly underfunded?

4) Are you changing your asset allocation right now and if so, why? What are the major risks that lie ahead?

5) Please talk about your benchmarks, value added over the policy portfolio and if there is anything there you are revising.

6) What was the cost of delivering these results? (30 basis points or less?)

7) What are your general thoughts on the retirement crisis and how we can deal with it through better policies?
Below, are some of my bullet points from our discussion covering the questions above and more:
  • All their investment strategies worked. They were "firing on all cylinders, with positive returns from every type of investment.” But the major contributor to the Return Seeking Portfolio was the long-term option strategy, adding more than 600 basis points to overall results (more on this below).
  • Jim was clear that HOOP's culture and LDI approach are the cornerstone of their success. They manage risk extremely tightly on all investment strategies and their culture is not based on "beating the benchmarks" but on adding value by taking intelligent risks where they present themselves.
  • He said that HOOPP is like a multi-strategy hedge fund which continuously focuses on relative value trades in capital markets but also invests in illiquid markets as opportunities arise, always focusing on the transaction and whether the premiums make sense.
  • In terms of those relative value trades in public markets, he told me that fixed income markets offer a lot more opportunity than equities. "There is a lot more segmentation in the fixed income markets. Equity markets are more efficient." 
  • They do a lot of arbitrage trades of cash vs derivatives in fixed income markets and run their internal absolute return strategies efficiently, always managing credit, interest rate and other risks tightly, knowing the downside risk of every trade
  • Importantly, HOOPP does not invest in any external hedge fund, preferring to go internally, lowering costs and managing  risk of their investment portfolios more closely.
  • In terms of illiquid asset classes, Jim told me he likes private equity and real estate. Real estate is part of their Liability Hedging Portfolio as it also provides an inflation hedge and was a major contributor of returns.
  •  Jim thinks risk premiums on infrastructure do not justify an allocation to this asset class at this time (read his comments on pensions taking on too much illiquidity risk). He sees infrastructure as more of an equity play with stable dividends. "These investments are levered, they provide stable, predictable cash flows but if something happens -- like regulations change or you need to sell -- you bear equity risk. Real estate is more liquid, you don't need approval by some regulators to sell and the cash flows are not subject to regulatory risk." HOOPP has invested in infrastructure in the past and will do so again if an excellent opportunity arises."Right now, we just don't see anything particularly attractive. This could change in the future."
  • In terms of implementing an LDI approach, Jim thinks it's never too late and pension funds that do not adopt one are going to be in bigger trouble in the future. Importantly, he told me the "risks of not owning bonds is huge" because there is an asymmetric tradeoff depending on whether interest rates rise of fall. In particular, the duration of most pension plan assets is shorter than the duration of their liabilities (for HOOPP, it is 12 vs 15), so if long bond yields fall by one percentage point, it will be destructive. "If we enter a Japan scenario, you will get killed not owning bonds." Conversely, if rates rise, your liabilities will go down more than your assets, so you will not be hurt as much.
  • In terms of asset allocation, they are reviewing their bond holdings but are in no rush to make a major move. Jim told me he gets to speak to the CEOs of major US banks and they tell him there is a lot of cash on hand because loan demand is very low, companies are flushed with cash and there are no major capital spending plans. He thinks the most likely outcome is that interest rates go sideways (range-bound like 2011-12) and that stocks keep grinding higher. He's positive on the US economy and still likes financials.
  • HOOPP beat its policy (benchmark) portfolio by 2.8%, which tells you it wasn't an easy threshold to beat and they added significantly in terms of active management over this portfolio.
  • In terms of benchmarks, he told me that they use appropriate market benchmarks for all investment strategies except private equity, which is under review. There they use a 7% absolute return benchmark but when determining compensation and bonuses, they will add to it if it is a really good year. This figure was based on their previous actuarial target rate of return (it is now 6%). "In good years, you shoot the lights out but in bad years, you significantly underperform. Very hard to find an appropriate benchmark for PE as we had years like 2008 where we underformed by less than other pension funds but they had value added because they beat some market benchmark which went down by a lot more."
  • As far as the retirement crisis, he sees this as a problem of demographics and low bond yields. He thinks countries should adopt a supplemental pension approach like in Denmark where ATP manages a supplemental program.
Finally, as we ended our conversation with a frank discussion on risk. I asked Jim if  HOOPP took undue risks to deliver these stellar results. He shared these insights with me:
  • "We cannot take undue risks in anything we do. We have to match assets with liabilities and the board is vigilant, monitoring our activities very closely."
  • "People think taking leverage is taking undue risk. This isn't the case as you can invest in a bond and add an S&P 500 overlay but that is not really leveraging. It's just smart investing."
  • "Look at our long-term option strategy, which was a major contributor to our overall results. We entered that trade, selling volatility on the S&P 500 when the S&P was at 1,000 a couple of years ago and immediately collected risk premium of 400 basis points and then added another 200 basis points by investing that premium in arbitrage trades. The S&P would have had to have fallen below 300 for us to lose money. The risk-return tradeoff of that strategy was just too compelling."
And then I asked Jim why didn't other pension funds enter that trade? He answered:
" my mind, only Warren Buffet entered that trade. The reason people don't do these trades is that it doesn't fit under benchmark activity or absolute return strategies. It doesn't fit anywhere. But people are not thinking about what is good for pensioners."

Great way to finish off our conversation. I thank Jim Keohane for taking the time to share these insights with me and congratulate him and the team at HOOPP for another outstanding year. HOOPP's members are very lucky to have them manage their pensions.

Finally, a pension expert who knows HOOPP very well shared this with me:
The big story is the huge win on the option strategy, quite unique in scale and risk/return tradeoff.

Beyond that, its good beta and more than typical focus on the liability profile which is really a governance success story as much as an investment one.

The private equity track record of 15 years is the real story in that area (including the portfolio success during leadership transition, and there is a great experienced guy whom has been hired to lead that area). The benchmark problem is an annual one, but the private equity prize is sustained risk adjusted performance. The track record is also actually disclosed, no one else in Canada does that and hence the short memories and focus on annual returns, without regard to risk.

Below, Jim Keohane's reflections on 2012. Also, please watch his BNN interview by clicking here. Begin on part 1 and go to parts 2 and 3 by clicking here and here. You can also search for his name on BNN's site. The episode link is available here.