OPTrust CEO Peter Lindley on Why Liquidity Matters More Than Diversification

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Sarah Mundell of top1000funds interviewed OPTrust CEO Peter Lindley on why liquidity is central to risk management:

As Silicon Valley Bank has just discovered – and UK pension funds were sharply reminded last year – every financial crisis is essentially a liquidity crisis. It’s why Peter Lindley, president and chief executive of $25 billion OPTrust, one of Canada’s largest defined benefit pension plans, puts liquidity management front and centre.

“Liquidity is everything and we are very liquidity aware and build it into our investment planning,” he says, speaking on the eve of OPTrust reporting a small net investment loss of -2.2 per cent in 2022 alongside being fully funded for the 14th consecutive year.

Moreover, liquidity is fundamental to resilience which, when assets suddenly correlate like in 2022, can be even more important than diversification.

“Resilience involves understanding all the risks in the portfolio, including liquidity. You can’t be resilient if you don’t have liquidity. Diversification is important, but even the most diversified portfolio can find unexpected correlations,” he says.

Pension funds need liquidity to pay benefits, invest in opportunities during market disruptions and on hand to meet capital calls. For pension funds that use leverage (borrowing to invest more using bonds as collateral) like OPTrust, liquidity is also needed to cover interest rate payments on borrowing as rates have cranked higher.

OPTrust’s so-called member-driven investment strategy (similar to LDI) incorporates liability hedging as well as strategies using derivatives to mitigate downside risk in the return allocation and boost liquidity by making more underlying cash available.

Mark to market

Rising interest rates are not entirely a bad thing for a pension plan because they allow investors to re-price their risk-free rate to a higher level, notes Lindley. However, he explains, the challenge from rising rates comes from the fact hedging liabilities in a bond portfolio involves having a mark to market on assets – but not a mark to market offsetting that from a liquidity perspective on the liability side.

“We are very aware of this risk and make sure we have a high degree of liquidity, especially when central banks are raising interest rates. Risk management doesn’t just involve managing investment risk. The funded status of the plan is the most important consideration, and this involves looking at the assets and liabilities together.”

OPTrust typically hedges between 30-40 per cent of its liabilities. This was reduced by around half at the end of 2020 when the pension fund cut back its liability hedging portfolio with long-term Canadian federal and provincial government bonds because of historically low interest rates reducing the efficacy of the hedge.

“We found that with very low interest rates, the hedging benefits of holding bonds was reduced.”

As interest rates started to increase through 2022, OPTrust has began to increase the liability hedging portfolio once again.

It leads him to reflect that one reason for the crisis in the UK LDI market last autumn was the high hedge levels of many UK pension funds, some of which hedge 100 per cent of their liabilities. “My suspicion is that UK funds had grown over reliant on falling interest rates and low volatility in the bond market, and no one was expecting a spike in either.”

Liquidity is all the more important given so much of the portfolio (50 per cent) is tied up in illiquid markets. An essential source of the returns that helped keep the plan fully funded in a difficult year.

Returns from infrastructure (21.1 per cent) and real estate (15 per cent) did better than private equity (4.8 per cent) where the lower return reflected the challenges in public equity and the fact private equity doesn’t have much protection from the impact of inflation as other private markets.

“That said,” he qualifies, “in many cases we target companies for our portfolio that are able to implement pricing strategies which allow them to pass along some or all of the increased costs of doing business in an inflationary environment. Private equity has provided excellent long-term returns for our portfolio, which we expect to continue in the future, and we expect infrastructure and real estate to provide additional diversification benefits, along with attractive risk-adjusted returns, in an inflationary environment.”

Nor does he expect private assets to be overly impacted by higher borrowing costs and the ability to tap low cost funding.

“There is a higher bar to access funding from various sources including banks, and that changes the economics. It will impact illiquid asset classes to an extent, but it will also result in higher returns.”

Climate change resilience

Resilience is also central to Lindley’s approach to climate change and once again trumps diversification which he says “can’t help”  navigate the combination of short-term challenges and long term opportunities encapsulated in climate change that are coming down the track.

One way the pension plan is building resilience is via a novel in-house team structure whereby the sustainability team are also able to invest, either directly or via third party managers.

Their dual mandate comprises assisting and providing insight to the investment teams by providing systemic analysis and expertise on an assets physical and transition risk, for example. On top of this they are also mandated to invest themselves which brings them much closer to the challenges on the ground.

“It gives them more credibility with colleagues because they are an investor, not just an advisor, and it is more engaging for them,” he says.

Other corners of OPTrust’s portfolio are also eye catching. Like a small allocation to digital assets with third party managers in an approach that aims to align interests and double due diligence in the unregulated, risky market.

The allocation particularly seeks opportunities adjacent to the digital world like custody and underlying technology and is tasked primarily with informing and educating the team as they begin to invest in another transition.

This is an excellent interview with OPTrust's CEO Peter Lindley.  

Recall, I recently went through OPTrust's 2022 Funded Status Report, A Clear Vision, which details the Plan's financial results and fully funded status.The plan lost 2.2% but remained fully funded which is what ultimately counts. 

I didn't recall reading anything about digital currencies but I'm quite certain it's a very small allocation (don't know why).

Anyway, this interview shows you in plain English how OPTrust manages liquidity risk.

As Peter states, 50% of the plan's assets are in illiquid private markets -- real estate, infrastructure and private equity -- which is why they need to manage their liquidity risk and make sure they have enough liquidity to pay their pension benefits.

Moreover, he explains how OPTrust typically hedges 30-40% of its liabilities through its liability-hedging portfolio but when rates dropped to record lows in 2020, this was cut in half and as rates rose quickly last year, it was restored to pre-pandemic levels.

Again, this is smart liquidity management and smart liability hedging.

Most importantly, you don't want to be stuck with no liquidity when you need it the most - ie. when there are major dislocations in markets you want to capitalize on.

As far a Private Equity, it only returned 4.8% last year but this is following a 50%+ return in 2021 where Sandra Bosela, Co-Group Head, Managing Director and Global Head of Private Equity at OPTrust Private Markets Group, and her team took advantage of buoyant activity to dispose of assets at a very nice premium.

In fact, 2021 was the best year for distributions at Private Equity groups across Canada's Maple Eight.

Why? Rates were low, money was cheap, stock markets were on fire led by technology shares, and investors were paying big premiums to own private equity and venture capital assets.

It was obviously unsustainable and now we are living through a quiet period in private equity and a deadly cold winter in venture capital.

I've seen these cycles many times, this one however will be particularly rough because of the depth and duration of the global economic recession headed our way.

That means Private Markets will not be delivering anywhere close to the returns they were delivering over the last 10 years.

The one asset class that has all institutional investors on edge lately is real estate:

We shall see how this plays out over the next 5 to 10 years.

Lastly, Alison Loat, Managing Director of Sustainable Investing and Innovation at OPTrust,and her team are doing a great job developing and helping teams implement OPTrust's enhanced climate strategy.

You can download OPTrust's enhanced climate change strategy here. 

Also, I interviewed Alison back in October to discuss the enhanced climate strategy and you can read her thoughts here. 

I think it is really important to review their latest climate scenario analysis report which they did with Ortec. 

Alison talked about the 2023 priorities and she told me they are going to do that report every other year and she added:

Just for your readers this is trying to integrate climate considerations into our overall asset liabilities program. We've been working with Ortec for a number of years. We were asked to share our experience with others and produced a paper. It does show there are material impacts on asset class returns, on interest rates, inflation, etc. As the science gets better, as the data gets better, we will be redoing this study (next year for example and every other year after).

Her small team also invests with third party managers but it's still a small allocation relqative ot the overall portfolio.

Below, a short clip on the collpase of UK pension funds last year and how LDI investing contributed to this collapse (also poor management and terrible regulations).

And soon after Chancellor Kwarteng announced the UK mini-budget in September 2022, the gilt markets nosedived. While public attention was focused on the currency and mortgage markets, pension fund managers were watching in horror as a little known financial instrument they had relied on for decades threatened to take down huge swathes of defined benefit pensions. David Chambers, Invesco 

Professor of Finance at CJBS and co-director of the Centre for Endowment Asset Management (CEAM) will explain what is liability driven investment (LDI), and how it works, as well as the risks involved with this type of investment. And we will look at the question : is the worst behind us? 

He will be joined by Derek Steeden, Portfolio Manager at Invesco. The answer is something that runs counter to some of the more sensationalist news headlines.

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