HOOPP Gains 10.4% in 2016
Despite a challenging start to 2016, the Healthcare of Ontario Pension Plan improved its investment return to 10.4 per cent by the end of the year. The number was up from 5.1 per cent in 2015.In a recent interview, Caroline Cakebread of the Canadian Investment Review asked HOOPP's CEO Jim Keohane five questions:
The fund’s net assets reached $70.4 billion, up from $63.9 billion in 2015. Its investment income for 2016 was also higher at $6.6 billion, compared to $3.1 billion the year before.
“In January last year, we had the worst . . . record in stock markets,” said Jim Keohane, president and chief executive officer at HOOPP, during the pension fund’s annual results presentation in Toronto on Thursday.
“During the year, we dealt with other issues, such as extremely low interest rates, we had the Brexit vote and the volatility that came around that and at the end of the year, we had the U.S. presidential election and the market reactions to that, which was quite unexpected, I would say. Despite that, we ended up having a very strong year.”
The pension plan’s 10-year annualized return stands at nine per cent.
In its report, HOOPP credited liability-driven investing for providing stability through challenging markets. The approach uses two investment portfolios: a liability hedge portfolio that seeks to mitigate risks associated with pension obligations and a return-seeking portfolio designed to earn incremental returns to help keep contribution rates stable and affordable.
In 2016, the liability hedge portfolio provided approximately 38 per cent of the pension fund’s investment income. Nominal and real-return bonds generated returns of 3.9 per cent and 6.8 per cent, respectively. The real estate portfolio was also a significant contributor during the year, with a 12.2 per cent currency-hedged return.
Within the return-seeking portfolio, which provided 62 per cent of the fund’s income, public equities returned 12.9 per cent, while private equity investments returned 15 per cent on a currency-hedged basis. Other return-seeking strategies, particularly those around absolute returns, also made significant contributions to the fund’s income.
“It was an unusual year in the sense that every strategy in every asset class actually contributed positive to the return of the fund, and it’s pretty rare when that happens, but it did happen last year,” said Keohane.
“Fixed income was a strong contributor. . . . Private equity and real estate both had a strong year,” he added.
HOOPP also maintained its funded status of 122 per cent on a smooth asset basis in 2016, a metric Keohane considers the most important in gauging the success of the pension fund. “It really measures your ability to meet the pension promise to the members . . . because it considers both assets and liabilities in that calculation,” he said. “During 2016, our surplus increased by $1.1 billion to $15.9 billion, which is an increase of two per cent over the year. On a regulatory filing basis, the fund is 122 per cent funded . . . so we’re in a very strong funded position.
“That funded position is valuable to members in a lot of ways. First, it’s a big risk mitigator because we’ve got that cushion. Inevitably, when a big downturn comes along, we’ll be able to absorb that and be fully funded and continue to meet our obligations to members. And it also gives the board the opportunity to consider benefit increases to members or price decreases to members and employers, so there are discussions ongoing on that right now.”
I recently sat down with Jim Keohane, president and CEO of the $63.9 billion Healthcare of Ontario Pension Plan to ask him five questions about how pension funds are investing and the risks he sees evolving in the marketplace.I had a chance to talk to Jim Keohane this morning to go over HOOPP's 2016 results. I'm glad Caroline Cakebread asked him these five questions above because it covers some of the questions I asked.
This is the first post in an ongoing series we’ve introduced to Canadian Investment Review that will see us posing five questions to Canada’s top pension investment leaders.
Our questions – and Jim Keohane’s responses – are below.
Is real estate a good substitute for fixed income for pension funds? Or are there additional risks?
We own real estate because of its inflation hedging characteristics – particularly for wage inflation. But there are a number of additional risks that come along with owning real estate that aren’t in fixed income – if you buy a 30-year Ontario bond you are pretty much assured of getting your money back in 30 years. But there’s a lot that can go wrong when you own a building. It has normal business risks – you have to run the buildings. You can’t dabble in it, you need scale.
There are risks and you need to know what they are and you need to get compensated though an adequate risk premium.
Real estate is not a substitute for fixed income — you can’t simply switch them. It has inherent risk and many investors don’t appreciate that. It’s hard to find deals that are attractively priced in the current market. We’ve found some deals of interest – but I see other transactions happening at very high prices.
It takes a fair amount of expertise to do it – and if you’re investing in real estate through a fund structure, it’s often not optimal for a long-term investor. Managers want to get paid – they may own long-term 30-year assets with a fund structure that winds up in five years in order for the manager to collect their fees.
We see a number of transactions happening at cap rates that offer no additional returns over long-term government bonds – so people are buying risky assets and not getting paid for it which is not rational risk taking. We witnessed similar irrational risk taking before the 1987 crash and in 2007. It’s a red flag.
What’s the number one risk that keeps you up at night?
It’s exactly that – people out there who hold risky assets and have no idea how much risk they hold. Pension funds, individuals – people are moving out the risk curve to get a yield who have no ability to absorb the risk. For example, people taking money out of an FDIC-insured fund are buying high yield exchange-traded funds – it’s a big leap up the risk curve and they’re treating it like it’s the same.
I also see a potential liquidity problem in the high yield ETF space. There have been significant inflows into them over the past few years as individual investors seek to earn a higher return on their investments. At the same time, regulatory reforms have significantly diminished the liquidity in the underlying corporate bond market. I see a potential liquidity problem happening when we get the next credit downturn and investors try to exit. Unlike equity ETFs, the underlying corporate bond market is a dealer market and it simply doesn’t have the liquidity to absorb a disorderly exit. When these things start to unwind, it will be uglier than you think.
We’ve heard much about the potential negative impact of Donald Trump’s ascendancy to the U.S. presidency – but does his promised rollback of Dodd-Frank have an upside for institutional investors?
Yes, there is a positive side – it will lead to better liquidity not just in the fixed income space but for big derivatives traders like us. It is almost impossible to execute large scale derivative transactions without a bank acting as an intermediary. For example, if HOOPP enters into an index option transaction, a bank will almost always be the counterparty on the trade and they may take a long period of time to unwind that trade in the marketplace. The Volker Rule, as part of Dodd-Frank, has made it much more difficult for large banks to engage in big trades like this because regulators are telling them that trades with a holding period of more than five days can no longer be considered market making and are interpreted as proprietary trades which violate the Volker Rule. Removing this regulatory uncertainty would be a positive development.
Corporate debt will also benefit – you have to carry significant inventory to be a market maker in that business. Reversing some of this will be helpful – it will boost liquidity and help us execute some transactions.
Another regulatory development that has been tough on investors are the Basel 3 rules that put a capital charge in bank balance sheets – basically, it tells banks to get out of the high balance sheet, low margin businesses, like the bond repo market. Bond repo is really important to the liquidity function of the market but banks are moving out of the space because the capital charge makes the economics unattractive. The bond repo market is an important mechanism for the Bank of Canada to inject liquidity into the Canadian market particularly during times of financial stress. On the whole, the regulatory pendulum has swung too far and it’s created additional risks in the market. Some relief from these rules would be a positive development.
How and why are pension funds using leverage today – and are there risks to doing so?
We have a levered balance sheet – but we didn’t set out to have one. Leverage at HOOPP allows us to minimize interest rate risk. We have a liability matching portfolio which contains real estate, fixed income and real return bonds. It’s the closest match for our liabilities. The trouble is, the returns from those aren’t enough to meet our obligation – so rather than owning physical equities we overlay derivatives on top. That makes it less risky than a traditional portfolio because we don’t have to sell the matching assets to get equity exposure.
Leverage allows us to take on equity market risk without creating the interest rate mismatch – we still own long-term bonds but we’ve taken on equity risk to enhance returns in a much less volatile way. In that context, even though our balance sheet has expanded, it actually reduces the overall risk in the fund.
Any advice for Ontario’s recently announced new pension regulator?
I think that all of us in the industry would agree that taking a big picture policy view is the best approach. It’s all about what is best in the public interest. The new regulator should have a mandate that allows them to consider what is in the public interest when making judgements.
I believe that most people are better off being in a defined benefit plan than a defined contribution plan. The world is changing – and we need a more flexible approach that makes it easier for employers to continue to offer DB plans. If DB plans closed are turned into DC plans or closed, members won’t be better off in the end. You need to look at the big picture and adapt the regulatory rules to accommodate a rapidly changing environment.
Before I get to my conversation with Jim, please take the time to read this press release, HOOPP tops $70.4 bllion in net assets with a 10.35% rate of return:
The Healthcare of Ontario Pension Plan (HOOPP) announced today that its Funded Status at the end of 2016 was 122%.
The Fund’s net assets reached a record $70.4 billion, up from $63.9 billion in 2015, following a rate of return on investments of 10.35% in 2016. As a result of the Plan’s stable funding position, contribution rates made by HOOPP members and their employers have remained at the same level since 2004 and the Board of Trustees has committed to maintaining these rates until 2018.
Investment income for the year was $6.6 billion compared to $3.1 billion in 2015, and the Fund’s 10.35% investment return exceeded its portfolio benchmark by 4.23% or $2.7 billion. The Fund’s 10-year annualized return stands at 9.08% and its 20-year annualized return is 9.12%.
“We are very pleased with our performance this year, particularly given a challenging first quarter and overall, a volatile market. But rather than comparing our annual results against those of peer plans or stock market benchmarks, we consider the true measure of our success to be our funded status as this demonstrates our ability to meet our current and future pension obligations,” said HOOPP President and CEO Jim Keohane.
“The important value of a defined benefit pension plan is certainty for our members, knowing they won’t outlive their retirement income. This is why our strategy puts funding first, an approach which balances the need to generate returns with the need to effectively manage risk,” added Keohane.
HOOPP’s liability driven investing (LDI) approach has served members well by providing stability through challenging markets. It is a holistic, long-term investment approach which considers the Plan’s assets in relation to pension obligations, in order to balance risk with returns.
For more information about HOOPP’s financial results please view the 2016 Annual Report, available on hoopp.com.
2016 Return Highlights
HOOPP’s liability driven investing approach utilizes two investment portfolios: a liability hedge portfolio that seeks to mitigate certain risks associated with our pension obligations, and a return seeking portfolio designed to earn incremental returns to help to keep contribution rates stable and affordable.
In 2016, the liability hedge portfolio provided approximately 38% of our investment income. Nominal bonds and real return bonds generated returns of 3.9% and 6.8% respectively. The real estate portfolio was a significant contributor during the year, with a 12.2% currency hedged return.
Within the return seeking portfolio, which provided 62% of the Fund’s income, public equities were the largest contributor to investment income, returning 12.9%, while private equity investments returned 15.0% on a currency hedged basis. Other return seeking strategies, particularly absolute return strategies, made significant contributions to the income of the Fund.
HOOPP’s asset allocation was also a big contributor to the Fund providing a 1% total return.
About the Healthcare of Ontario Pension PlanPlease take the time to go over HOOPP's 2016 Annual Report which is available here. I will be referring to this report as I go over my conversation with Jim.
Created in 1960, HOOPP is a multi-employer contributory defined benefit plan for Ontario’s hospital and community-based healthcare sector with over 510 participating employers. HOOPP’s membership includes nurses, medical technicians, food services staff and housekeeping staff, and many other people who work hard to provide valued Ontario healthcare services. In total, HOOPP has more than 321,000 active, deferred, and retired members.
As a defined benefit plan, HOOPP provides eligible members with a retirement income based on a formula that takes into account a member's earnings history and length of service in the Plan. HOOPP is governed by a Board of Trustees with representation from the Ontario Hospital Association (OHA) and four unions: the Ontario Nurses' Association (ONA), the Canadian Union of Public Employees (CUPE), the Ontario Public Service Employees' Union (OPSEU), and the Service Employees International Union (SEIU). The unique governance model provides representation from both management and workers in support of the long-term interests of the Plan.
First, there is no question this was another outstanding year for HOOPP, the best funded pension plan in Canada and along with Ontario Teachers' Pension Plan, one of the top pension plans in the world.
Most pension plans can only dream of achieving a funded status of 122%. Jim Keohane and Hugh O'Reilly of OPTrust have written an op-ed to explain why in their view funded status is a better measure of a pension fund's success.
Equally impressive is HOOPP's 10.35% investment return in 2016 exceeded its portfolio benchmark by 4.23% or $2.7 billion and the Fund’s 10-year annualized return stands at 9.08% and its 20-year annualized return is 9.12%.
Admittedly, whenever I see any pension trouncing its total benchmark by a whopping 427 basis points, I ask myself a simple question: Do the Fund's portfolio benchmarks adequately reflect the risks of the underlying portfolios, including credit, illiquidity risks and leverage?
Whenever you are looking at the results of any pension fund, you need to dig deeper to really understand which portfolio really contributed the most to overall results and why.
For example, when you read HOOPP's 2016 Annual Report, I bring to your attention the following passage on real return bonds and real estate (click on image):
Notice how HOOPP's RRB portfolio returned $538 million in 2016. Jim told me they sold a huge chunk of nominal bonds and bought real return bonds when Canadian 30-year breakevens sank to a low in mid-February. So that tactical asset allocation decision proved very useful and helped them easily beat their FTSE TMX Real Return Bond Index.
More impressive was the outperformance in Real Estate where HOOPP's real estate portfolio produced a return of 12.19% on a currency hedged basis, representing an outperformance of 6.79% relative to the Canadian Investment Property Databank (IPD) benchmark.
The REALpac/IPD Canada Quarterly Property Index, produced by MSCI, measures unlevered total returns of directly held standing property investments from one valuation to the next. You can learn more about this index here:
The index dates back to 1999, is an annual rolling index measuring unlevered total returns to directly held standing property investments from one open market valuation to the next. The index tracks performance of 2,343 property investments, with a total capital value of CAD $121.3 billion as at June 2014. The REALPAC/IPD Canada Quarterly Property Index is published quarterly and reports returns on a four quarter rolling basis.You can also see its breakdown in terms of real estate sub-sectors here:
Some important points. First, HOOPP fully hedges currency risk which proved to be very useful in 2016 with Brexit but less so in terms of the US and other currencies. Second, their benchmark is unlevered whereas there is leverage in real estate which needs to be accounted for and third, in terms of sub-sectors and geography, HOOPP's real estate portfolio is predominantly in Canadian real estate and in office space in Ontario which is soaring in terms of pricing (click on image):
Still, there is no doubt that HOOPP's real estate portfolio is outperforming and doing very well, and I don't want to make a big stink out of this outperformance but it's important to dig deep and understand the factors driving it.
In terms of private equity, HOOPP Capital Partners (HCP) invests in (i) private equity funds; (ii) privately-held businesses directly; and (iii) other private capital opportunities:
At the end of 2016, HCP had $5.3 billion invested, with a further $4.7 billion committed to private investments. The invested portfolio generated a currency-hedged return of 15.0% for the year compared to 17.7% in 2015 (the return on an unhedged basis was 13.1% compared to 28.7% in 2015), exceeding its benchmark by $445 million. The portfolio has increased by over $3 billion in the past few years and now includes credit and structured investments with lower risk/return attributes.Jim told me that co-investments make up the bulk of their direct private equity investments but they do a bit of independent direct deals. He told me that OMERS is trying to go more direct by sourcing their own deals but HOOPP prefers to invest in comingled private equity funds to gain access to larger co-investment deals where they pay little to no fees.
The fair market value of the invested portfolio represents 7.5% of the total Fund, meaning there is considerable scope for managed growth and for considering significant investment opportunities.
I told him this is the approach most of Canada's mighty PE investors take and that I don't buy for a second that OMERS or anyone else can effectively compete with the large private funds when it comes to sourcing the best deals. Jim agreed stating "that's why we pay fees in private equity, to gain access to distribution on the best deals and large co-investment opportunities."
Other strategies that performed well were corporate credit, long-term option strategy and other return-seeking strategies like asset allocation and absolute return strategies (click on images below):
Jim told me that HOOPP extensively uses repo strategy to lend securities in its large bond portfolio but to do this properly, you need "a substantial investment in systems which cost in the tens of millions" so there is a barrier to entry for smaller funds.
However, when done properly, this type of leverage is a lot more efficient than having your custodians repo your bond portfolio. "In our case, it's on our balance sheet whereas in other funds, it's hidden but still there because the custodians are lending out the securities."
[Note: Those of you who want to understand the use of repos to leverage a bond portfolio should pick up Keith Black's book on Managing a Hedge Fund and read chapter 10, The Building Blocks of Fixed-Income Investing.]
Jim told me they were defensively positioned going into 2016, underweight credit and stocks, going long nominal bonds and adjusted their asset allocation as rates came down and breakevens sank to new lows.
He said HOOPP is going to have a strategic retreat this Spring to reflect on how to manage the growth of the fund. "Some of the strategies we are doing internally are producing great results but are not scalable so we need to reflect on how to allocate risk as we grow."
On this, he reiterated that valuations are high across public and private markets. "Some real estate deals I've seen make no sense with cap rates at 3% when you can go buy a 30-year bond yielding 3% with no business risk associated with owning real estate."
However, he said HOOP is more comfortable with real estate than starting a new infrastructure team at this time and says they still see opportunities in real estate.
Here I respectively disagreed with Jim stating if done correctly using a platform like PSP does where you own 100% of the assets, there are better opportunities in infrastructure than real estate but I did agree that most people investing in infrastructure erroneously thinking it's a substitute for bonds don't know what they're doing and are bidding up prices like crazy (this is what happens when you hire investment banking types to run your infrastructure portfolio, they're looking to strike deals at any cost).
All in all, HOOPP had a great 2016 aided by public and private markets. It's undeniably one of the best pension plans in the world if we measure success by its funded status.
Here, let me point out one key difference between HOOPP and other more mature pensions (click on image):
As you can see, HOOPP has 2.2 active members for every retiree, so it's still a relatively young plan which benefits from positive cash flows. This is why the discount rate it uses to discount future liabilities is a bit higher than the one used at Ontario Teachers' or OMERS which are more mature plans with more retirees per active members (and in the case of OTPP, more centennials living a lot longer than the average population).
These are all important nuances to understand when comparing Canadian pension plans and unfortunately, the media doesn't cover them in detail.
What else did Jim share with me? He sees valuations stretched in public equities and higher rates could derail the bull market but the rally can go on longer than expected.
Here, I agree and will once again refer you to my comment on why Warren Buffett is baffled by 30-year bonds where I stated the following:
This brings me to an important point, the question Warren Buffett asked at the top of this comment, who in their right mind would buy a 30-year bond?
Well, in turns out a lot of pensions and insurance companies managing assets and liabilities are buying these long bonds. And if the US Treasury starts issuing 50 or 100-year bonds, I suspect many pensions will snap those up too, just like they did in Canada.
[Note: One president of a large Canadian pension plan told me they would buy 50-year US bonds, not the 100-year ones because their liability stream doesn't go out that far.]
In my outlook 2017 earlier this year, I warned my readers to ignore the reflation chimera and prepare for some fireworks later this year. I just don't buy that it's the beginning of the end for bonds, not by a long shot.
I also agree with François Trahan of Cornerstone Macro, investors better prepare for a bear market ahead, but I think his timing is a bit off as there is still plenty of liquidity to drive risk assets higher.
Interestingly, hedge fund titan David Tepper agrees with Buffett, he's still long stocks and still short bonds:
Billionaire hedge fund manager David Tepper told CNBC on Monday he remains bullish on the stock market rally.All these billionaires bashing bonds should read my comments more often because if Buffett feels like he got his head handed to him on Walmart, he will really be kicking himself next year for not buying the 30-year bond at these levels.
"Still long stocks. Still short bonds," Tepper told CNBC's Scott Wapner.
The founder of Appaloosa Management said: "Why are stocks and bonds acting differently? It's as if they're reacting to two different economies."
Since the election, bond prices have been falling, and bond yields have been rising. Stock prices, meanwhile, have been hitting new highs.
But more recently, as of mid-February, bond prices and stock prices have been moving higher together again.
Tepper also asked: "Could be there's too much monetary policy still around the globe? Reaction in markets suggests it's affecting the bond market more."
After Friday's late comeback, the Dow Jones industrial average was riding an 11-day win streak for the first time since 1992, with 11 record closes in a row for the first time since 1987.
Tepper's comments come on the same day as another billionaire investor, Warren Buffett, talked up stocks and bashed bonds.
U.S. stock prices are "on the cheap side" with interest rates at current levels, Buffett told CNBC's "Squawk Box" on Monday morning.
The Berkshire Hathaway chief also said: "It absolutely baffles me who buys a 30-year bond. I just don't understand it."
Given my views on the reflation chimera and US dollar crisis, I would be actively shorting emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE) and Financial (XLF) shares on any strength here (book your profits while you still can). The only sector I like and trade now, and it's very volatile, is biotech (XBI) and technology (XLK) is doing well, for now. If you want to sleep well, buy US long bonds (TLT) and thank me later this year.
On biotech, some of the stocks I told you are on my watch list when I went over top funds' Q4 activity are soaring since I wrote that comment (shares of La Jolla Pharmaceutical surged over 80% on Monday and shares of Kite Pharma are flying today, up 24%).
Simply put, I feel like the Rodney Dangerfield of pensions and investments, I get no respect and certainly don't get paid enough to share my wisdom but then again, I don't have Buffett, Soros, Tepper and Dalio's track record or their deep pockets.
As far as me being the "Rodney Dangerfield of pensions and investments", I say this somewhat jokingly but the truth is nobody else on the planet covers pensions and investments with the breadth and depth that I do. Nobody.
There are two things I hate more than covering long pension comments like annual reports: correcting my typos and begging institutional investors for money. I simply hate begging people for money so if you are an institutional investor, broker, hedge fund or private equity fund or retail investor and regularly read my comments, please subscribe or donate any amount on the top right-hand side using the PayPal options (institutions can easily afford $1000 a year subscription so please do subscribe).
Below, take the time to watch a clip where President & CEO Jim Keohane discusses Healthcare of Ontario Pension Plan’s overall pension plan performance in 2016 and explains how the Plan’s funded status, which stands at 122%, acts as a cushion for the Fund.
Jim told me the Fund's funded status of 122% is a great cushion in case another 2008 hits and also stated the Canada Revenue Agency "limits the amount they can increase the benefits," so this surplus will continue for the foreseeable future.
I also embedded other clips HOOPP posted on its YouTube channel which are very informative and well worth watching.
Lastly, in terms of compensation, HOOPP is a private plan and doesn't publicly disclose compensation but Jim told me it's in line with other large Canadian plans but not as much, which goes to show you the best pension in the world doesn't dole out the highest compensation.
I thank Jim for taking the time to talk to me earlier today and hope you all enjoyed reading this comment. Please remember to kindly contribute to this blog to show your support. Thank you.
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