Wednesday, August 8, 2018

HOOPP Ponders its Allocation of Risk?

Sarah Rundell of Top 1000 Funds reports, HOOPP ponders re-allocating risk:
With its assets under management forecast to double in the next five to seven years, Canada’s Healthcare of Ontario Pension Plan has begun exploring new assets for its C$77.8 billion ($59.8 billion) portfolio.

President and chief executive Jim Keohane says he is assessing whether HOOPP’s existing allocations can evolve to absorb forecast growth, or if he needs to add new and different strategies to re-allocate risk. Firm decisions are still a way off, but new allocations could include assets such as infrastructure, where HOOPP doesn’t currently invest, or reinsurance, which Keohane favours because its risk/return trade-off is similar to that of credit.

If HOOPP were to invest in infrastructure, it would sit within the fund’s matching portfolio, and be treated in a similar way to real estate. Assets could include local toll roads or water infrastructure, both areas where Ontario’s Government is busy currying more investment and where Keohane sees advantages because they don’t come with foreign exchange or sovereign risk.

Still, his enthusiasm for the asset class is lukewarm. He is unconvinced that infrastructure rewards investors enough for tying up their liquidity.

“Right now, the risk/return trade-off still looks pretty unattractive to me but that might change at some point in the future,” he says. “We would do something in infrastructure if the pricing was better.”

Celebrated strategy

Last year, HOOPP returned 10.8 per cent and its funded status swelled to 122 per cent. This has allowed the pension fund to increase member benefits and keep contribution levels from its 540 employers unchanged from 2004 levels – largesse most pension funds can only dream of.

Its robust health is owing to a celebrated investment strategy that Keohane, who joined the fund in 1999 and became chief executive in 2012, has done much to shape.

It rests on two portfolios: one comprises a liability hedge allocation with physical investments in nominal bonds, real-return bonds and real estate that has a high correlation to inflation; a second portfolio, designed to boost returns is made up of public and private equity, corporate credit, long-term option strategies and other return-seeking strategies that mostly use derivatives to gain exposure. HOOPP estimates that about 75 per cent of pension benefits it pays are derived from investment income.

The liability hedge portfolio is dynamically managed in accordance with interest rate and inflation risk. Witness how HOOPP reduced its bond weighting a couple of years ago when interest rates fell, lowering the interest rate sensitivity of the portfolio. The substantial rise in bond yields since has caused it to restore some of those bonds.

“There is a notion with [liability-driven investing] LDI that you buy a bunch of bonds and leave them, but this isn’t the case at all,” Keohane says. “We have brought our inflation sensitivity down and managed it more effectively.”

Recent strategy in the return portfolio has included positioning the equity allocation defensively with an options strategy that protects on the downside but also gives the fund some upside exposure.

“If we had a big sell-off in equities, we would try to increase our weighting to equity and credit, but we are being cautious at the moment,” he says.

Managing partnerships

New investments could be via partnerships with external managers or in funds, to begin with, before moving management in-house. HOOPP manages all its assets itself, apart from a portion of the private equity and real-estate portfolios.

In partnerships and co-investments, Keohane aligns interests with managers by making sure they have a significant amount of their own capital tied up in the transaction.

“We tend to be in groups where we have a dominant position; it means we have a bigger say in how things get done,” he adds.

HOOPP’s manager due diligence includes talking to the companies in which a potential investment manager has invested, and to other investors that have invested in the manager’s funds; it’s a process that can take up to a year.

“We like to hear from companies about how the manager helped them, what insights they’ve brought and the nature of the relationship they’ve had.”

At the end of 2017, HOOPP had $7 billion invested in private markets, in addition to $5.5 billion of committed capital.

Having internal management saves on fees, but Keohane manages costs in other ways, too. He says HOOPP has a deliberately narrow focus, investing only in assets that the fund “really needs to meet its obligations”, which excludes some allocations – like infrastructure.

While Canadian peers have opened offices internationally, HOOPP’s biggest move in recent years has been moving its Toronto headquarters a few blocks. But staying put doesn’t crimp access to the best deals.

“We are still seeing good access to deal flows and keeping costs down; it’s expensive running an international office,” Keohane says.

HOOPP’s 2017 operating expenses were $224 million, representing 0.29 per cent of net assets; that included management fees and performance fees related to investments in real estate and private equity.

Advocate for diversity

Going forward, Keohane says the pension fund will continue to use its muscle to influence board diversity. Canada’s resource sector is a particularly bad laggard.

“Board gender diversity is best among larger cap companies in Canada, but when you get into the resource sector it’s still quite poor,” he explains. “Corporate boards in the resources still have the idea that everyone needs to be a mining engineer, but boards with better diversity make better decisions.”
Good article which covers a lot of things.

It's important to note that HOOPP is the best pension plan in Canada and one of the best in the world. And by "best", I am referring to its funded status and the way it has successfully managed assets and liabilities over many years to reach a huge surplus which helps retired and active members of the plan.

HOOPP has always done things differently but its size is starting to be a real issue and that's why it needs to rethink the way it allocates risk between private and public markets and where exactly it will do this.

Jim Keohane is right, core infrastructure assets are extremely expensive, the  risk/ return tradeoff is unacttractive if you go the traditional route but in my opinion, if HOOPP hires an expert like Andrew Claerhout, OTPP's former head of infrastructure, or some other experts I know who specialize in direct investments, they can make a lot of money in this asset class.

And the beauty with infrastructure is it's scalable (you can put a lot of money to work relatively quickly) and it's a much better match for HOOPP's long-dated liabilities.

Moreover, if done properly, you can invest directly, avoiding paying any fees to fund managers like you typically do in private equity (except in co-investments where all of Canada's large pensions are focusing their attention on to scale into private equity while keeping costs (fees) down.

HOOPP is very cost conscious. Unlike OTPP, OMERS and CPPIB, it doesn't invest in external hedge funds, prefers to do absolute return strategies internally, but it has the luxury of being relatively small. As it grows, it will become harder and harder to allocate risk internally across public and private markets.

Still, it is doing innovative things with external partners when it makes sense, like the CLO retention vehicle it invested in last year, and it's not dogmatic about not paying fees to external managers when it finds the right alignment of interests and alpha it cannot reproduce internally.

In real estate, HOOPP took on construction (greenfield) risk  with its curent headquaters, One York street, a AAA class buidingwhich achieved LEED Platinum Certification and is the most energy efficient building in Canada.

You'll recall Jim Keohane spoke to me about real estate back in June when I covered why G7 investors are uniting on global initiatives:
Climate change risks are increasingly important to pensions which is why ESG investing has taken off in a big way.

On Wednesday afternoon, I had a scheduled call with HOOPP's CEO Jim Keohane to discuss the seventh annual LEAP Awards where HOOPP honoured the outstanding sustainability achievements and leadership of management teams and tenants in HOOPP’s real estate Canadian portfolio for excellence in energy performance, tenant leadership, stakeholder engagement and technology innovation.

Below, I give you the gist of our conversation:
  • Jim told me HOOPP wasn't invited to be part of this global initiative "probably because we don't have a substantial infrastructure portfolio" but that's fine because like other pensions, HOOPP practices responsible investing and integrates available ESG data and information alongside traditional fundamental analysis incorporating financial and economic information. 
  • In terms of real estate, Jim told me 40 percent of greenhouse gases come from buildings so it's a major contributor to climate change.
  • HOOPP focuses on best environmental standards and takes energy efficiency in its real estate holdings very seriously. Why? Simply put, it adds to the bottom line and makes great sense from a fiduciary and environmental standpoint.
  • He gave me the example of One York Street, a joint project of Menkes Developments and HOOPP, which is their headquarters now. He said it achieved LEED Platinum certification, earning 89 points, the highest score ever awarded to a Toronto building and is the most energy efficient building in Canada.
  • Interestingly, this energy efficiency is good for HOOPP because operating costs were slashed by 60 percent, allowing them to lock in quality tenants for longer at lower leases. Tenants like Sun Life enjoy lower leases but also lower their carbon footprint which is what shareholders want. 
  • Jim told me the building is incredible and the quality of the air is unlike any other building where the vents are on the ceiling and air is "drawn down and sucked right back up" which leads to "stale air and people getting sleepy in the afternoon" (no, it's not just fatigue, the air quality in your building is terrible). At One York, "the vents are on the floor and each area can dial it up or down." 
  • That's great for a new building which HOOPP built from scratch with its partner but what about older buildings in HOOPP"s real estate portfolio? Jim told me they're working with property managers to make them more efficient by focusing on three areas: 1) reducing energy consumption, 2) reducing water consumption and 3) reducing solid waste and recycling more.
  • That's what HOOPP's seventh annual LEAP Awards were all about last night. Property managers were invited to give their best ideas on making properties more sustainable and energy efficient. 
I thank Jim Keohane for taking some time to talk to me, it opened my eyes on how important it is to address climate risks in a real estate portfolio. Jim gave credit to Lisa Lafave, a senior portfolio manager, for starting this LEAP initiative and the whole real estate team led by Stephen Taylor. You can learn more on HOOPP's real estate portfolio here and see highlights of the LEAP Awards on HOOPP's twitter account here.

One thing Jim did convey to me is HOOPP doesn't practice divestments but prefers corporate engagement and he also told me their investments don't begin with ESG factors. Instead, they look at whether investments fulfill their pension obligations and then practice good environmental stewardship but the focus always remains on long-term returns.

Importantly, he gave me the example of the 1990s when pensions were divesting from tobacco, fossil fuels, and more sectors and they ended up being way overweight technology and it hurt them when the tech bubble imploded.

He also told me that alternative energies like solar and wind farms are going to grow (only make up 5 percent of global energy) but they rely heavily on government subsidies so there are risks.
That's not the only thing he told me. While HOOPP invests in emerging markets stocks, it's a lot more reticent to invest in emerging markets via private markets because of lack of rule of law in some countries.

This is probably why you will never see HOOPP opening up international offices in Asia and elsewhere because it doesn't need to and if there are good deals to invest in, it still has access to deal flow.

[Note: Earlier this week, Hayman Capital Management founder Kyle Bass said the US has the upper hand during trade negotiations with China and doesn't see the depreciation of China's currency as problematic. He also stated he doesn't feel bad for large US multinationals doing business in China because it's a well-known human rights abuser and it's a communist country with no proper legal recourse for foreign investors.]

Still, when you're the size of a Caisse, OTPP, CPPIB or PSP, it would be criminal not to explore opportunities in private markets in China and other emrging markets. And to do this properly, you defnitely need boots on the ground to establish long-lasting partnerships which are the key to investment success in these regions, even more so than developed countries.

Below, at a Canadian Club panel in late 2017, HOOPP President & CEO Jim Keohane was asked to outline the risk management and investment strategies that allowed the successful pension fund to withstand the 2008 financial crisis. With more than 321,000 members, a funded status of 122% and over $70B in assets, HOOPP is recognized as a global model for a successful defined-benefit pension plan.

HOOPP has done a great job managing assets and liabilities by keeping costs low, doing innovative strategies internally and externally when it makes sense. It also implemented conditional inflation protection years ago, a key element to its fully funded status.

As it grows, it will need to revisit its investment strategies and ponder its risk allocation more carefully but it's in a great starting position to do this very intelligently and I'm certain it will continue putting its members' interests first as it has done for many years.

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