OPTrust's CIO on the Importance of Resilience

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Amanda White of Top1000Funds interviewed OPTrust's CIO, James Davis, who shared insights on the importance of a resilience:
James Davis, CIO of the C$22 billion OPTrust started his career in October 1987 and within the first month experienced the “real world of investing” with the crash of 1987. But that experience is nothing compared to the conditions of today, he says.

“In more than 30 years in the industry there is nothing even comparable to the current environment we are operating in now.”

The difference, he says, is that in addition to the market volatility there is the extra challenge of limited visibility into the virus itself, the impact on the economy as well as the individual companies, and the associated policy changes.

 “Then add on to that the challenge of everyone working from home. This is an incredible environment and something unlike we have ever experienced. That being said we are holding up really well.”

But more than anything, OPTrust’s portfolio can be described as resilient due to its member-driven investment strategy which is designed to withstand all environments and meet the sole purpose of staying fully funded.

“From an investment perspective we are meeting this challenge head on,” Davis says. “The team is working very well together and we have a very long-term focus so we don’t get too stressed out when we have big drawdown days. We are in a pretty good place as an organisation. When we translate the MDI into investment decision making, our goal is not to earn outsized returns or outperform peers. The sole focus is to keep fully funded,” he says. “Our investment objective is to be able to pay pensions, and we do it by taking as little risk as possible.”

He says this has meant that the portfolio is very risk-centric.

“We stress tested the portfolio under thousands of different macro scenarios and chose the investment mix that reduced the probability that members would have to experience a contribution increase,” he says. “We see periods in those scenarios that show up very sharp drawdowns in equity markets and where correlations go to one. We try to take those things into account in the overall portfolio construction and it has allowed us to weather this environment very well.”

 OPTrust has been fully funded for the past 11 years and continues to be fully funded, with “an abundance of liquidity.”

Resilience

From a macro perspective Davis believes there is a paradigm shift underway and the response from governments and central banks dealing with the challenges of the crisis is a game changer.

“We have embarked on a new policy paradigm where innovation is being explored from an economic perspective. The challenges we might face going forward will be different than those from the past,” he adds. “The risk of a policy mistake is greater. The risk of inflation and stagflation is bigger now than two months ago. To assume the type of investment strategy we have had in the past will work is a mistake.”

With regard to resilience, Davis wants to position the fund for whatever is around the corner.

 “We don’t know what could cause inflation but it could happen so we need to be prepared,” he says. “In this case we are seeing things unfolding faster than I would have expected. Policy makers are throwing everything at this challenge, we wonder how they will feel about it once it has passed, will they retract some of the measures – that’s a big risk.”

In terms of the shifting global economic environment, Davis is also sharply focussed on the emerging social pressures associated with the crisis.

“Since the 1980s there has been rising income and wealth disparity causing big social risks and the environment is ripe for some big political changes as a result of that. How will policy makers respond? We are coming into the US election, imagine if we have equity markets at new highs and unemployment at 15 per cent, how will people feel about that and vote. We are trying to make sense of the risks associated with the policy perspective and make sure we are positioned accordingly,” he says. “We feel confident our portfolio is resilient. For everyone managing a pension plan, stagflation will be a hard position to manage. We are well funded but for others it could be devastating.”

Portfolio construction in four components

The OPTrust portfolio is divided into four separate components: return seeking; risk mitigating; liability hedging; and a funding portfolio.

Return seeking and liability hedging are the two largest components, with the latter aimed at mitigating interest rate sensitivity.

A lot of the emphasis of the portfolio construction is in the risk mitigation portfolio which Davis describes as “performing spectacularly” with a return of above 30 per cent year to date.

“This is a very diversified portfolio of assets we believe will help in deflationary times and somewhat in inflationary and stagflationary environments,” he says. It’s made up of real return bonds, TIPS, US Treasuries, and longer duration assets as well as trend following strategies, such as CTAs, that do well in a tail risk environment. It’s also got allocations to foreign currency including Yen, Swiss Francs as well as gold. But Davis is quick to point out this portfolio is not trying to time the market.

“We don’t try to manage it in a market timing sense. We see it as a critical part of the overall portfolio that allows for cost effective risk mitigation – we can cut off the left-hand tail without impacting longer-term expected returns,” he says. “In that sense we want to have some core exposure to each of those strategies.”

The team is working on some further systematic strategies that will add to the dynamic nature of this portion of the portfolio.

 “Strategies like trend following are systematic so will naturally move you when equity markets are under duress. We are building more systematic strategies,” he says. “We will adjust allocations to these when we think it is appropriate, there is an element of discretion around that. We are not trying to add returns, just cut off the left tail.”

Return seeking portfolio

The fund’s approach to return seeking is different to many other investors. In building the MDI program, diversification according to risk factor exposures was a priority, which meant reducing the exposure to listed equities.

“When I came on board about 80 per cent of the portfolio risk was from equity risk factor,” Davis, who was appointed CIO in 2016. says. “This is not uncommon but we made a deliberate decision to try to reduce that and it is around 40-50 per cent now.”

Equities, including both private and public exposures, now only make up about 20-25 per cent.

 “This was a deliberate decision, not made on valuations, but to right side our factor risk exposures,” he says.

In place of equities the fund invested in alternative risk premia, added to its overall hedge fund exposure and increased its allocation to direct investing in real estate and infrastructure. The fund has an internal direct team and has also built up the trend following capability inhouse, and it runs all the bonds, some credit and passive equities inhouse.

“Our asset class teams are thinking a lot about the changing global economy. In real estate we are always thinking about how the world is evolving and how people’s preferences are changing in the retail and office space. We had a relatively low allocation to retail, because we saw the trend that it wouldn’t be positive for shopping malls as an example. That’s not new for us. We have also been thinking about what this current environment means for challenges in real estate in years to come. Davis argues that it is not clear cut there will be less demand for commercial real estate and just because everyone is working from home now doesn’t mean they will continue to. “We have experienced it ourselves, people like to be social. After this people might need more space not less, it’s not clear cut there will be less demand for commercial real estate.”

Rebalancing

While Davis says the fund is disciplined around rebalancing he is also mindful there are opportunities in dislocated markets.

“The current environment necessitates a degree of discretion in rebalancing. Opportunities present themselves in this type of environment. We don’t want to be forced sellers or buyers, and want to take advantage of the ample liquidity we have. We tend to stand back and say we have rebalancing guidelines telling us what to do, and then we have a conversation about the opportunities.”

The CIO has taken advantage of the market turmoil to add to credit and equity exposures, but is really earmarking the ample liquidity it has for private market activity.

“Great opportunities are going to emerge there. We don’t have the visibility we’d like to have, there are not a lot of transactions going on in that space now. But we know when you come out of these types of environments that’s where the opportunities will show themselves. We can prepare ourselves to take advantage of those once they present themselves, we don’t fill buckets, it has to be where the best opportunities are.”

Climate change

Davis says a few months ago climate change was front and centre in all investment conversations. While he says that won’t change over the long run, right now the focus is dealing with the immediate challenge.

“This type of environment shows you how vulnerable the world is and the necessity of trying to take those types of risks into account. We are very long-term investors so we are interested in looking at the future and what types of risks we might be exposed to. Climate change continues to be important to us and a centre point of our overall investment strategy.”

Davis acknowledges there are a lot of risks and opportunities in the current environment and wants to take advantage of that.

“Humanity can use ingenuity to solve problems. We think there will be great opportunities investing in those areas that are trying to solve big major problems.”

OPTrust has created a small team focused on investments at the intersection of innovation and sustainability and has hired Alison Loat, formerly of FCLTGlobal, to look at that.

“We are already big investors in renewables and that will always be part of the investment strategy. Here we are looking at things beyond that, that have the potential through technology to significantly change the landscape. Our members want to retire into a safe world, that is how we view our overall mandate.”
In my last comment, I talked with Alison Loat and went over OPTrust's 2019 Responsible Investing Report.

As soon as I finished that comment I read this article on LinkedIn and decided to follow up with another standalone comment.

I know James Davis well, he's a very nice and super bright guy who is passionate about addressing climate change. The last time I saw him was a little over a year ago in Toronto.

James is busy these days dealing with these crazy markets so I didn't reach out to him as he covers a lot above. All CIOs are busy trying to figure out how to best diversify their portfolio and where to take risks across public and private markets.

Remember, pensions have a very long investment horizon, they need to think about the long run and take into consideration risks that will impact long-term performance.

Now, I already went through OPTrust's 2019 results here and they were solid, gaining 11.2% last year and more importantly, maintaining its fully funded status.

But this year is completely different, the pandemic has slammed public and private market asset classes, and all pensions will experience serious challenges and in all likelihood, a very lousy year depending on how bad things get this year (I remain bearish).

When looking at any fund, especially a pension fund, it's important to understand their asset mix. Here are a few observations which I discussed when looking at OPTrust's 2019 results:
  • OPTrust allocates more into Private Equity (12.9%) than Public Equity (11.3%)
  • There is a significant allocation to "market neutral and multi-asset strategies" (20%)
  • The weightings in Real Estate (14.3%) and Infrastructure (11.1%) are also significant
  • Taken together the weighting in Private Markets and Hedge Fund Strategies make up roughly 56% of total assets, which is significant, and Fixed Income makes up 37% to hedge liabilities.
  • In other words, there isn't much public market beta in OPTrust's portfolio, at least not when I look at the overall asset mix.
  • While public equity exposure delivered a net return of 23.2% last year, the private equity portfolio generated a net return of 24.7% in 2019.
  • The real estate portfolio generated a net return of 5.2% last year while the infrastructure portfolio generated a net return of 12.8% in 2019.
  • Credit strategies earned net returns of 13.4% while market neutral strategies generated a net return of 2.2% in 2019.
  • The Risk Mitigation Portfolio holds US Treasuries, safe-haven currencies and gold and earned a net return of 5.4% last year.
  • The Funding Portfolio includes exposures such as bond repurchase agreements, implied funding from our derivative positions, and liquidity reserves. The -16.9% weight of the Funding Portfolio reflects OPTrust’s overall balance sheet leverage.
So, OPTrust only has 11% of its assets in public equities, 37% in fixed income assets and 20% in external market neutral and multistrategy hedge funds.

That alone tells you they absorbed the market selloff in Q1 because they have very low exposure to global stocks and high exposure to bonds which act as a natural hedge in a risk off environment.

But a low exposure to global stocks also means when the beta winds are blowing the right way, OPTrust doesn't benefit as much as other pensions which have a higher exposure to stocks.

Still, as James Davis explains, they aren't interested in shooting the lights out every year, the focus is on members and maintaining the plan's fully funded status.

To be blunt, OPTrust's entire asset mix is constructed in a way as to minimize downside risk as much as possible to maintain a fully funded status when a storm hits, like now.

And unlike other large Canadian plans, OPTrust (and OMERS) has guaranteed inflation protection to its core members, not conditional inflation protection, so it has to be extra risk cognizant to mitigate downside risk.

I'm on record stating I think it's only a matter of time before OPTrust and OMERS join OTPP, HOOPP and CAAT Pension and adopt conditional inflation protection. I just don't think it's in their members' long-term best interest not to and I don't think it respects intergenerational equity when active and retired members don't share the risk of the plan.

Anyway, apart from that, I think James gave an excellent overview of how they constructed their portfolio to take into consideration all risks.

Do I agree with him on everything? I agree with a lot but I have my own firm views on markets, the deflation supercycle and how it will impact private markets and real estate in particular.

I see a paradigm shift going on in private equity and serious challenges in commercial real estate.



The Fed pumping trillions into these markets benefits the BlackRocks, Vanguards and Fidelitys of this world, as well as some top hedge funds speculating on markets, but not so much the Blackstones, KKRs and TPGs of the world (however, the Fed buying junk bonds helps them out a lot).

In essence, private markets are more vulnerable to economic shocks because when unemployment is soaring, it isn't good for mid-size private firms, real estate and infrastructure. The only good thing is it gives large private equity firms the opportunity to buy assets a lot cheaper and ride out the storm.

This pandemic adds yet another layer of uncertainty because people aren't driving or commuting into work, they're mostly staying at home, working remotely and definitely not flying like they used to.



Over the last two months, the world has changed in ways we are still trying to comprehend and there will be long-term consequences.

I know many of you think it's only a matter of time before everything gets back to normal. I wake up every day and pray we can get back to the good old days but I have come to terms with the stark reality, the world has irrevocably changed for better or for worse regardless of whether they find a vaccine any time soon:



The sooner people and investors accept this new normal, the better off they'll be.

We are now living in the Twilight Zone as unprecedented central bank and government stimulus is keeping the economy and financial system afloat, but once it wears off -- and it will -- then reality will sink in and hit many people very hard.

I'm not saying this to be negative, I'm saying it to be realistic, you need to prepare for a long, tough bear market and economic hardship unlike anything we have ever experienced before.

It pains me when I see people losing their job, waiting for hours in their car to get food at a food bank and not having any emergency savings to their name.

James is right, since the 1980s there has been rising income and wealth disparity causing big social risks and the environment is ripe for some big political changes as a result of that.

Fed Chairman Powell said this morning that around 40% of Americans earning less than $40,000 a year lost a job in March, citing a Fed study set to be published on Thursday.

"This reversal of economic fortune has caused a level of pain that is hard to capture in words, as lives are upended amid great uncertainty about the future," he said during a webinar.



Meanwhile, the tech giants, corporate elite and speculators on Wall Street are making off like bandits.

No wonder the French economist Thomas Piketty is once again sounding the alarm but reflecting on the opportunities this pandemic may present to build fairer, more equal societies:



I remain skeptical and hopelessly cynical. The Fed's QE may have been necessary but the chief beneficiaries were the very hedge funds and private equity funds pensions invest in.

Every crisis is met with more money printing and this just bails out big banks and their big hedge fund and and private equity clients.

Sure, governments are sending checks directly to people but these are crumbs compared to what the financial elite are getting as central banks inflate their balance sheets.

Just look at the increase in the Fed's balance sheet and compare it to what the rest of the country received in bailouts from the government (and this expansion in the Fed's balance sheet primarily helps the prosperous few on Wall Street).



I guess what I'm getting at is there is something fundamentally broken in American capitalism when the Fed creates trillions from a few computer key strokes after each crisis to bail out speculators on Wall Street and the corporate elite buying back their shares while the restless many lose their job and are still waiting for a $1,200 check to pay the rent as they rely on food banks to survive.

Something is going to give and it won't be pretty when these social tensions reach a boiling point, which they will if this financial charade keeps repeating itself after every crisis.



As far as resilience, one good thing about this pandemic is it will hopefully teach us all a valuable lesson in resilience. Just remember this, it will be tough but life will go on no matter what and everyone needs to adapt to this new normal.

I personally can share a lot of valuable lessons on resilience that life circumstances have taught me but that's another subject for another day.

All I can tell you is if you find it hard working from home and are stressed out, just remember what ER doctors and nurses working on the frontlines are going through every day and count your blessings if you and your loved ones are still healthy. That's the only thing that matters.

Lastly, since OPTrust and other pensions are concerned about climate change , I bring to your attention this blog comment which Mantle314 just published on how the federal program ties to climate.

Joy Williams of Mantle314 shared this with me:
We wrote this blog as a quick starter guide because, for some companies, this is going to be a daunting task and we wanted to give everyone some practical tips.

But here's what I find really interesting about this:

We've heard suggestions from many around the world that economic recovery from Covid is an opportunity for governments to build in climate considerations (and they should do so). However, I think this is the first time I've seen economic RELIEF being linked to climate change. And I have to give kudos to the Canadian government in taking this step. It was a recommendation from the Expert Panel on Sustainable Development and to be honest, the effort to develop an initial climate disclosure is a small ask compared to the work that actual comes after. Despite this, the government has gotten blowback on this LEEFF principle.

If you step back and think about this, the "ask" is for large companies to disclosure their approach to an issue that they should have already been looking at before Covid because it's not a new issue. Also, as my colleague said in his op-ed on the Bank of Canada appointment of Tiff Macklem "The economic impact of COVID-19 may be the immediate priority, but climate change won’t go away just because we are standing six feet apart." The problem is that while the focus has been on large fossil fuel companies (who arguably have already spent time and effort thinking about climate change), other large companies like airlines and retailers have not spent the time and effort needed.

However, the devil really will be in the details. TCFD (the voluntary climate disclosure framework) allows for quite a bit of flexibility in their reporting recommendations - so what type of disclosure will satisfy the Canadian government? How does a company know they have fulfilled this LEEFF principle? We completed a review of Canadian climate disclosures not that long ago for CPA Canada and found that there is no standard format or content yet. Climate disclosure happens over multiple documents and the details vary widely over the 11 TCFD recommendations. Despite the fact that it's early days for climate reporting, I would urge the government to not set a low bar. (And I would gladly speak to them about this!) Noone is going to get this right the first time, and that isn't the expectation. You have to just start.

Basically, this is a significant step forward and could result in really consolidating a national climate response if the government focusses on substance and if companies respond and follow the spirit of this principle.
I thank Joy willams for sharing these insights with me and think you should all read their latest blog comment here.

Below, Federal Reserve Chairman Jerome Powell said Wednesday that policymakers may have to use additional weapons to pull the country out of an economic mire that has cost at least 20 million jobs and caused "a level of pain that is hard to capture in words." Watch Chairman Powell's full prepared statement before the discussion at the Peterson Institute for International Economics.

And is it do or die for commercial real estate? Have a listen to this interesting discussion.

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