HOOPP's CEO on LDI 2.0 in a Zero Bound World

Yaelle Gang, the Canadian Investment Review recently wrote a comment on how HOOPP is looking to LDI strategy 2.0 amid low interest rates:

The Healthcare of Ontario Pension Plan is well-known for its liability-driven investing strategy, which helped it successfully weather the 2008 financial crisis.

During the coronavirus fallout, in an era of historically low interest rates, the HOOPP is working on developing LDI 2.0. “We’re very focused on liabilities, but what you do when interest rates are at really extreme lows, in our view, is different than what we did in the past,” said Jeff Wendling, the plan’s president and chief executive officer, during Benefits Canada and the Canadian Investment Review‘s 2020 Plan Sponsor Week in mid-August.

In 2006 and 2007, the HOOPP had very large fixed income holdings, he said. “We’ve ridden those fixed income positions all the way down to these lows [in yields] here now and that’s worked out very well for the fund. But at this point, we think fixed income assets provide minimal returns going forward. So that’s a big challenge for us.”

For instance, he noted, fixed income assets don’t hedge the plan’s liabilities as well as they did when yields were higher nor do they provide the same kind of diversification benefits. “We’re really looking right now at what we need to do, or what we can do differently, to generate the returns that we need and manage the risk appropriately.”

Of late, the biggest change the HOOPP has made is implementing an infrastructure program. “That is underway now and I think that will be one of the assets that we’ll use to provide a replacement to some of the returns that we’re looking to get out of the fixed income assets. And I think it provides some hedging benefits as well, whether it’s to inflation or to a decline in rates,” said Wendling.

In addition to infrastructure, the HOOPP has launched an insurance-linked securities program. And although the pension plan has historically been largely internally managed, it’s selectively starting an external manager program focused primarily on hedge fund managers. “We’re looking at other sources of return — types of other return that we need that we’re not going to get from those fixed income assets. Infrastructure is a big part of it. There are many other assets there. I think, at the end of the day, we will also own more equities than we have for the last number of years.”

The pension fund is also changing the mix of its bond portfolio and is looking at diversifying its international exposure to find higher yields, he said.

While Wendling said he believes deflation is a risk, it’s not the plan’s base scenario. “Our primary scenario is that we’re in a low inflation period of time, a low interest rate period of time for a number of years and then we think you may get inflation at some point after that.”

That said, he noted the risk of deflation is why the HOOPP doesn’t want a zero nominal bond portfolio weighting. “We’re going to have significant exposures there and that would actually help us in a deflationary scenario. Those are assets that are very important for liquidity purposes for a fund like HOOPP as well.”

In addition to looking at generating required returns in a low interest environment, Wendling said the HOOPP is also focused on ensuring the fund continues to manage risks well as it grows larger and more complex. “We’re looking at new risk systems to bring into HOOPP, new tools on the risk side and we’re actually going to be hiring our first-ever chief risk officer.”

Of note, the HOOPP entered the coronavirus crisis with a very strong funded position and remains fully funded today.

Alright, this afternoon I had a long discussion with HOOPP's CEO, Jeff Wendling, on its LDI strategy 2.0 amid low interest rates.

Before I get to this discussion, let me first thank Jeff Wendling for taking the time to chat with me and also thank James Geuzebroek, Senior Manager, Media and Public Affairs, for setting up a Microsoft Teams meeting where I got to see them both for the first time.

And today, I only called Jeff "Jim" once and apologized as it is a force of habit (Jim Keohane and I used to have long conversations. Jeff told me he's doing well, isolating with his wife in their country house).

So, I began by asking Jeff some operational questions regarding to how HOOPP employees have adapted working from home.

He told me "surprisingly well" and that pensions are being paid, contributions are being made, servicing their members well remains a top priority.

He also told me they haven't missed a beat on the investment side, doing extensive trades using total return swaps and they've been holding their regular investment committee meetings at 8 a.m. and that doing it from home has made it easier for more people to join in (I think he said three times a week).

Recall, back in June, I wrote a comment on HOOPP's successful IT journey, profiling Reno Bugiardini, HOOPP’s Senior VP, IT and the great work he and his team have done to allow all of HOOPP's operations to continue seamlessly working remotely.

In terms of getting employees back at the office, Jeff told me their priority remains on the health and safety of their employees and that he doesn't see a full return to the office before January 2021 or potentially later, depending on circumstances.

Having said this, they did internal surveys and some team meetings will be allowed at the office but "this will only be on a voluntary basis, we are not imposing on anyone and we will be tracking people closely and making sure all precautions are taken."

Again, the health and safety of all employees is their top priority but some employees feel cooped up and it might do them some good to interact socially with their colleagues. 

HOOPP's LDI 2.0

Let's get into HOOPP's LDI 2.0 approach, after all, that's why you're all reading this comment.

Jeff told me that HOOPP has an extensive allocation to bonds which has served the plan's members well over the years. "It has provided us with liquidity, diversification benefits and meaningful returns, especially on a leveraged basis" (HOOPP repos out its bond portfolio to invest in other asset classes).

But with bond yields at record lows and many sovereign bonds yielding negative or flirting with negative yields, it's clear HOOPP has to diversify away from its massive bond portfolio and look into other ways to generate yield.

Jeff Wendling reiterated what his predecessor Jim Keohane told me on many occasions, namely, "we will never invest in negative-yielding bonds" (even if you can make a lot of money if bond yields go more negative, it's not something they want to do as it's very risky).

He also admitted they don't want to take on more leverage in bonds to invest elsewhere.

So if not bonds, then what? Well, Jeff said they're slowly ramping up a few things:

• Infrastructure: HOOPP has been late to embrace infrastructure because they thought the asset class was overvalued for many years. Jeff told me only 25% of their assets are in private markets, "much lower than our peers" (they are closer to 50%). But with bond yields continuing to go lower, they decided to start investing in infrastructure. "We set up a team, we committed $1 billion in two infrastructure funds and will co-invest alongside them in bigger deals but it's still early, so we haven't deployed a lot of that billion dollars yet."
  
•  Insurance-linked securities: In addition to infrastructure, it launched an insurance-linked securities (ILS) program. I'm not an expert on this but read a great comment on it from Marsh here. Basically, "ILS is another form of reinsurance available to insurance entities. However, instead of facing a rated balance sheet, the insurance entity faces a fully secure, collateralized form of funding dedicated to a precise risk requiring coverage. Usually the collateral takes the form of highly-rated, highly-liquid investments, such as government gilt funds or pure money market funds. Premium flows are determined by the type of risk and investor appetite."
• Allocating more to external absolute return managers: HOOPP has prided itself over the years for delivering great risk-adjusted returns in a very cost effective way. They do a lot of absolute return strategies internally but as the size of the Fund approaches $100 billion (they're at $99 billion now), they need to find scalable alpha strategies they can't replicate internally to help them continue delivering great risk-adjusted returns. Jeff confirmed to me they are using Innocap's managed account platform (the same one OTPP and CPP Investments use for their external hedge fund managers) to onboard new hedge fund managers but they are proceeding very selectively and cautiously. I told him I used to allocate to external hedge funds and warned him: "When things go well, it runs like a car in cruise control, but when things start to falter, get ready to hear all sorts of lame excuses as to why they're not performing. Proceed with great caution." He agreed and told me they have smart people internally working on finding good managers offering unique alpha they cannot replicate internally.
• Taking more concentrated positions in higher yielding equities and bonds: This was an interesting topic, Jeff told me back in March/ April, they moved quickly to buy more Canadian banks at low prices because they were "yielding 7%" and they also gorged on provincial bonds when "spreads widened". He said they're looking to be more opportunistic and more concentrated in public equities. "Traditionally, we invested synthetically in the S&P 500 and the S&P/TSX but we will be adding to our holdings of high yielding securities when opportunities arise. That's what we did with Canadian banks and provincial bonds." 

I'll give you another good example of this last strategy. My friends and I have been looking at shares of Exxon Mobil (XOM) which along with other energy shares have been hammered over the last five years:

Exxon Mobil shares currently yield over 9% , they have been hammered because of the rise of ESG investing, but the world still needs oil and yet its shares keep dropping as if everyone switched to driving a Tesla and is heating their house using solar panels.

Now, I warned my friends that "it will make a double-bottom so don't rush to buy it" but they didn't listen to me. Still, when you have a huge oil company trading at these valuations, you need to take some risk and adopt a long-term view, which is what pensions do (I would be nibbling on Exxon's shares here and adding on any strength). 

Can Exxon Mobil cut its dividend? Sure but I strongly doubt it and even if they cut it in half, it's still a great yield for pensions starving for yield. 

What about pensions that divested from oil and gas? Well, that's a dumb move if you ask my frank opinion.

Anyway, I'm getting off topic but you see the point. If you don't like oil, look at Simon Property Group, a REIT offering a great yield, or some utilities, etc.

The point being, in a zero or negative rate world HOOPP and other pensions will be looking to make yield everywhere they can, and that requires taking more risk but more intelligent risk.

What else? We talked a little about real estate, private equity and private debt.

Jeff told me HOOPP doesn't have as much retail real estate as its peers because "they bought most of the prized assets in Canadian retail and office space a long time ago. We have some retail and will take some writedowns there like others have done."

Instead, HOOPP diversified and bought US offices and even took development risk by building their current office tower One York which was awarded LEED platinum certification. 

What else did HOOPP do in real estate? They got into industrial properties (logistics, warehouses) early on and are now the biggest Canadian logistics landlords (see my comment on how HOOPP will develop Waterloo's iPort Cambridge).

HOOPP also invested in logistics properties in Western Europe and has teamed up with Amazon on a few deals there and in Canada (like Delta iPort in Vancouver). 

In private equity, Jeff told me they look at deals very closely and depending on terms, "sometimes they take on more equity, other times more debt". 

I asked him specifically about private debt given that pensions have a love-hate relationship with it and he told me they have done some deals over the last five years but on an opportunistic basis (they made a killing on the Home Capital deal).

I ended by asking Jeff a question on his dual role. I asked why he holds the dual title of CEO/ CIO and whether he plans on holding both titles indefinitely. He said he was still CIO when COVID hit (became CEO on April 1st) and that he wanted to continue that role for now but that he will revisit it next year.

Interestingly, he told me they adopted BlackRock’s Aladdin risk and portfolio management  system and hired their first ever Chief Risk Officer and are excited to bring this person into the organization. I told him "make sure to give this person power or else it won't make a difference" and he assured me that they will play a critical role as the Fund grows and takes more risk across public and private markets.

Jeff told me that coming off a great 2019, the Fund was positioned more cautiously going into this year and that helped cushion the blow of the pandemic. "We had a better Q1 than our peers and bounced back nicely in Q2". 

However, he did admit the drop in long bond yields impacted their liabilities but they remain fully funded. 

He also told me they didn't engage in the same vol strategy as AIMCo but they took some hits in some strategies in Q1. Still, they used discounted cash flow (DCF) models to find attractive opportunities and that why they bought Canadian banks shares in late March/ early April.

Lastly, I mentioned to Jeff that I read a conversation with Ray Tanveer, HOOPP's Vice President of Interest Rates & Inflation. 

I told Jeff I'm still in the deflation camp and he told me they don't see deflation but rather "a long period of low growth and very low inflation". Still, he said they don't see runaway inflation either.

By the way, I shared the conversation with Ray Tanveer with a former colleague of mine from PSP Investments, Mihail Garchev, the now former VP and Head of Total Fund Management at BCI, and here is what he shared with me: 

Liquidity and leverage are at the center of the interplay between public and private assets and the liabilities and are key aspects of total portfolio management. It is because of liquidity that one can invest in private assets to start with. It is the public assets that provide liquidity and leverage and meeting the liabilities critically depends on liquidity. Leverage is also important to increase the expected returns but also at times for the purpose of diversification, risk mitigation, and even better alignment with partners in certain cases in private assets.

Therefore, it is crucial for investors to understand the interplay and impacts. As funds grow in size and complexity it becomes more and more challenging manage all these effects for an optimal total portfolio outcome and with a clear and managed process.

While the key aspects of liquidity and leverage are well-understood by practitioners, there are few perspectives related to total portfolio management worth considering avoiding any potential blind spots and unintended consequences.

First, whether one applies leverage depends on the expected returns of the assets being levered, both absolute and relative. If the expected returns are negative or lower on the relative basis, and depending on the horizon, one might be better off of not levering, or even doing the opposite whichever way this could be achieved. There are great examples of perceptive investors de-levering even private asset classes (e.g. real estate) during the Global Financial Crisis (it is not only about having leverage but also its second derivative - how leverage is structured and achieved in the portfolio might matter a lot).

Second, when the process is based on levering bonds, a lot of the total portfolio benefits presume some risk mitigation properties of the bonds and immediate liquidity to liquidate. Considering some of these properties in quantitative models sits very well. As an exaggeration to illustrate the point, if it were not for liquidity, one can generate arguably infinite leverage in the repo market. Now the problem is whether bonds will have the same properties as they had in the past, or they will be less efficient going forward.

A lot of this depends on the equity-bond correlation which is highly dependent on inflation and a few other factors. One could argue bonds may not be that efficient going forward. There is one more aspect related to this lowered efficiency. In the context of risk mitigation, even if the correlation works in favor, in exceptionally low yield environment, the magnitude of the benefit is much lower. This means that yes, one might get the diversification benefit (correlation impact), but if the total portfolio goes, say from $100 to $80, and the bonds only help offsetting $5, the total has shrunk and nothing can bring the size back to $100. One needs something which would produce dry powder. In the past, the bonds might had have added say $10. Therefore, in risk mitigation, dry powder is a key consideration, not only correlation.

The third aspect is the liquidity of the bonds. In many cases, government bonds are assumed as “highly liquid” when added to the various risk measures, such as liquidity coverage ratios, for example. It is an intuitive assumption, but have we tested it? Who would provide this backstop liquidity? It is assumed that the banks will purchase back at any time and the Bank of Canada will step in. In a true liquidity event, however, where cash and only cash is king, if banks need hard cash, they might not be purchasing back the bonds. Like the Fed, the Bank of Canada would need to provide an explicit guarantee so that this assumption is 100% tested. There could also be potential political and social aspects related to topic of “moral hazard” that might come into play. Such an assumption of ultimate liquidity of bonds might provide level of comfort, but if this one assumption is not hard tested (not just presumed), it may lead unforeseen consequences. Always ask the question – what is this one thing that we take for granted that if not true, could lead to ruin?

Last aspect is related to where actually the leverage flows. In some cases, leverage is created via repos in the bond portfolio and it is assumed that one has levered bonds. It is important to know where this leverage is sitting in the asset mix table. The total pie is certainly not 100% anymore but say 140%. If leverage is not explicitly shown in the bond line of the asset mix, then it means that leverage is re-distributed in some fashion in the other assets of the portfolio. There are two implications of this: first, it might create a situation of adding leverage on leverage without realizing it – e.g. if some of this leverage ends up in say, in a private asset which already uses non-recourse leverage (with all the risk and performance implications to consider).

The other more important question is about decision-making and the importance of being cognizant to which asset leverage actually flows. Without this consideration, it may lead to a completely wrong decision. And this is fundamental. As an example, if the leverage is truly in bonds (and presuming bonds are a good risk mitigator), when markets fall, it would be good to lever the bonds. This is the right decision. Now imagine that this leverage was actually in an equity-like private asset (with or without additional leverage at the asset level). Then levering (even if it is done via bonds as a transition mechanism) may potentially be the wrong decision, because the private asset would most likely have a negative return (exacerbated if additional leverage is there). To make such a decision, one needs a good process to determine short- to medium-term relative and absolute expected returns. Fundamental to this is to understand the how leverage flows through the portfolio (e.g. the bond transmission mechanism) but also the ultimate impact on the performance of the individual asset classes and the total portfolio. Important in this aspect are also risk, performance measurement and attribution.

The discussion above provides some initial aspects to consider. Particular circumstances, like portfolio structure, accounting, valuation, or actuarial practices, among others, may support, negate, or mitigate some of the impacts and conclusions, and make this an investor-specific consideration.

Mihail is a phenomenal mind, one of the best people in the country when it comes to understanding all aspects of total fund management, a topic which will be increasingly more important in a record low-rate world.

Anyway, there's a lot of coverage and food for thought here, I thank Jeff Wendling and James Geuzebroek once again and thank Mihail Garchev for his great insights.

My only problem with HOOPP -- and I let Jeff know about it -- is they are flying too low under the radar. I'd like to see Jeff a lot more in the traditional media, just by talking to him, I can tell he's a gifted investment professional and great communicator. He needs a lot more coverage. 

Jeff Wendling recently spoke to Yaelle Gang, Editor of the Canadian Investment Review, about HOOPP new LDI approach. The interview is available here.

Below, Mark Machin, chief executive officer of the Canada Pension Plan Investment Board, discusses the lessons he's learned while investing during the Covid-19 pandemic. He spoke with Bloomberg's Erik Schatzker on "Bloomberg Markets: The Close" last Friday.

Second, Jim Keohane, former CEO of HOOPP, spoke to Real Vision's Ed Harrison back in February about the remarkable obstacles pension funds face and how they can survive and thrive in the face of these challenges. Great long discussion, well worth listening to it.

Lastly, Mohamed El-Erian, chief economic advisor at Allianz, told CNBC's "Squawk Box" on Monday: "If you look at the supply side, it is unambiguously inflationary. What we need for inflation is for the demand side to come back. That is where the uncertainty is right now."