OPTrust’s Kevin Zhu on Innovation, Culture and Risk Mitigation
OPTrust, with net assets of over C$23 billion, has been on the innovation journey to ensure the long-term sustainability of the Plan, and subsequently, its members’ retirement security. In advance of Portfolio Innovation and Resilience Forum this November, Institutional Connect interviews speaker Kevin Zhu, Managing Director and Head of Portfolio Construction Group, OPTrust, who comments on the Plan’s approach to innovation, how it responds to inflation, manages risks and addresses climate risks in its total portfolio.
Institutional Connect: OPTrust, as one of Canada’s largest defined benefit pension plans, has won awards for its innovation. Can you describe the pension plan’s journey on innovation?
Kevin: As a defined benefit pension plan, OPTrust deals in incredibly long-term time horizons. This means that we’re not only working in today’s economy, but also the economy of the future. Innovation is part of culture and mindset, and because of our long-term focus, OPTrust has made a concerted effort to build an environment to support and propel investment innovation.
In 2015, OPTrust launched our Member-Driven Investing (MDI) strategy. The strategy has a clearly defined investment objective that is fully aligned with the best interest of our members – delivering pension certainty. This innovative approach transformed the Plan’s investing philosophy and portfolio management framework from solely focusing on value-add generation (or outperforming benchmarks) to focusing on total portfolio construction and management against liabilities. OPTrust was one of the few global institutional investors who made early and courageous moves to adopt a Total Portfolio Approach (TPA).
To build the right culture and mindset to foster innovation, we started by including ‘innovation’ as a core component in our investment philosophy and beliefs.
Support from leadership was also critical to the success of our innovation journey. Innovation requires idea generation and in-depth research. To achieve this, we have developed an internal process to facilitate collaboration on our key annual investment research initiatives across the organization. More importantly, this process was designed to incentivize innovative idea generation and in-depth research from the bottom, especially from those highly motivated and skilled junior team members. Our culture of encouraging ‘speaking-up’ and ‘tolerance for mistakes’ have created a healthy ecosystem for innovative idea generation. To ensure that our team has the right mindset, we also put a lot of energy into our hiring process, to make sure we hire individuals whose mindsets and motivations are aligned with our own. Finally, innovation is built into each individual’s annual performance goal-setting and evaluation to drive the right behaviour.
Innovation is a journey, and it happens every day at all levels of our portfolio. We will continue to improve our culture and lever up our internal capabilities and our external relationships to advance our investment research and innovation. We believe this is key to delivering on our mission for our Plan members.
Institutional Connect: How are your fund’s asset mix strategies positioned for the currently low interest rate and potentially rising inflation environment?
Kevin: At the beginning of 2020, we were already in a challenging investing environment that has since been amplified by the COVID-19 pandemic. Bond yields have been driven to historical lows. This poses significant challenges to most pension plans’ portfolios that have heavily relied on fixed income historically for three main reasons:
1. Return-enhancing;
2. Liability-hedging; and
3. Equity tail risk hedging (in deflationary environment).
However, with rapid declines in interest rates to their current levels, all those benefits of holding fixed income have diminished significantly, making it difficult to justify a sizable allocation to bonds in this environment. Furthermore, unprecedented policy responses since the onset of the COVID-19 crisis, both on the monetary and fiscal sides, have shifted the key macro risk from deflation to inflation – the macro regime that is typically detrimental to nominal fixed income. For those reasons, we made significant adjustments to our portfolio at the end of last year by reducing a sizable amount of our nominal fixed income exposures.Inflation is one of the most discussed topics of the current environment. To OPTrust and our members, inflation is clearly a risk, however, how this risk will transpire and how capital markets are going to respond is much less clear.
Historically, there have been two main types of high inflation regimes (one of which being much more detrimental to the economy and markets than the other). Under one regime, when high inflation was accompanied with strong economic growth, most risky assets tended to fare well. Under the other regime, however, when high inflation occurred with low economic growth, risky assets were generally negatively impacted. This latter more adverse inflationary environment is the risk we should be concerned with.
From this historical perspective, one of the key drivers to differentiate those two inflation environments is policy responses, and aggressive policy tightening to fight inflation has typically triggered significant economic slowdown. However, in the current environment, we are in uncharted territory, and there remains a lot of uncertainty regarding how the macro environment will transpire over the next few years.
While we recognize inflation is a rising risk, we have been very thoughtful about portfolio strategy adjustments in a more holistic way rather than biasing our views towards one specific macro scenario or risk. With that in mind, our focus has been on developing what we call “regime-agnostic” risk-mitigation strategies, and those strategies are designed to reduce severe market drawdowns, regardless of the causes. In other words, our hedging strategy design is goal-driven (i.e., mitigating risky assets’ severe drawdowns) rather than cause-driven (i.e., inflation or deflation).
We are increasingly using a data-driven approach in the design of those strategies to further remove potential biases in the decision-making process. We believe this innovative approach will help us make better decisions, and ultimately, deliver long-term pension security for our members.
Institutional Connect: Climate change risks are impacting on the long-term investments for institutions. How is your organization addressing climate risk factors in portfolio construction processes?
Kevin: Climate risk has now been widely recognized by global investors as one of the critical long-term systemic risks to portfolios. There are two main types of risks related to climate:
1. Physical risk – the risk associated with physical damages to different sectors of the economy due to global warming effects; and
2. Transition risk – the risk associated with negative economic impacts on different sectors and companies as a result of government policies towards a ‘greener’ economy.Similar to our peers, OPTrust takes this risk seriously. One of our key corporate initiatives this year is to renew our climate strategy. The work is still ongoing, and it is a truly collaborative effort across the entire organization.
We are taking a holistic and practical approach to ensure our climate strategy is fully aligned with our mission and objectives, while at the same time accountable and achievable. We are using a top-down and bottom-up combined approach to make sure our climate strategy is developed from a total portfolio perspective. From a top-down standpoint, we are using a climate scenario analysis in our asset-liability framework to help understand and communicate the key impacts of different climate pathway scenarios on the Plan’s funding risk, as well as their impacts by asset classes, geography, sector and time horizon. The bottom-up approach is to look at individual asset class portfolios to understand their current climate risk profiles.
In the end, the top-down and bottom-up analyzes will be put together to help make informed decisions on our climate strategy.
Institutional Connect: The market volatility triggered by COVID has amplified the importance of risk mitigation strategies in total portfolios. What is OPTrust’s approach in managing risks?
Kevin: The current low expected return environment combined with our Plan maturity poses challenges to the Plan’s sustainability going forward. We must be innovative in our approach in order to deliver our target return, while effectively managing downside (or drawdown) risks to our funding. In terms of the ‘effectiveness’ of risk mitigation, we focus on both benefits and costs. On the benefit side, we look at the magnitude as well as consistency of drawdown protection, and on the cost side, we target our risk mitigation strategy to generate zero expected return in the long run. In other words, we do not want this strategy to become a long-term return drag to our portfolio.
We have developed and implemented a well diversified (left tail) cost neutral Risk Mitigation Portfolio (RMP) with a clearly defined objective to mitigate severe drawdowns from our Return-Seeking Portfolio (RSP). This portfolio went through a real-world test during the pandemic-induced market sell-off last year, and it delivered the needed protection to our total portfolio. Currently, our risk mitigation research focus is moving in the direction of developing data-driven systematic strategies as part of the ongoing RMP enhancement. Early this year, we have implemented our first AI/machine learning-based systematic strategy for equity tail risk protection.
These are just a few of the innovative approaches we are taking to ensure the long-term sustainability of the Plan, and subsequently, our members’ retirement security.
Kevin Zhu, Managing Director, Head of Portfolio Construction Group, OPTrust, will speak at Portfolio Innovation and Resilience Forum.
Let me begin by thanking John He of Institutional Connect for sending me this excellent interview and putting me in touch with Kevin.
Earlier this afternoon, I had a chance to talk to Kevin and it was a great discussion. I thank him for taking the time to speak to me and thank Claire Prashaw and Jason White for setting up the conference call.
Kevin began by giving me his background. He joined OPTrust in January 2015 around the same time the organization launched its Member-Driven Investing (MDI) strategy.
Prior to joining OPTrust, he was working at OTPP for ten years in the Risk & Strategy group with James Davis whom he followed to OPTrust.
You can tell by talking to Kevin that he really knows his stuff, and just like Mihail Garchev, VP and Head of Total Fund Management at BCI, he really understands the total portfolio approach.
And I enjoy talking to experts who think at a total portfolio level because as Kevin rightly notes, "your asset mix determines 85% of your returns" and it's important to think at a total portfolio level, not just in terms of beating some benchmark (the added-value approach).
He gave me the example: "If your fund experiences a loss of 18% and the benchmark is down 20%, you're adding value relative to a benchmark but still experiencing a steep loss."
Thinking at a total portfolio level, however, requires the right culture and mindset to foster innovation, which is why they started by including ‘innovation’ as a core component in their investment philosophy and beliefs.
More on that below.
First, it's important for people to remember that OPTrust is a mature plan which still offers its members guaranteed inflation protection.
As Kevin told me, this means their cash outflows are bigger than their inflows and this factors heavily into their market risk tolerance and liquidity risk management.
He told me that OTPP is a more mature plan but it and HOOPP which is a younger plan have adopted conditional inflation protection which is "a major advantage when managing funding risk."
I told him that OTPP, HOOPP and CAAT Pension Plan have all adopted conditional inflation protection and most recently, so has OMERS, and that only OPTrust hasn't which baffles me.
I asked him if this will change and at that point, Jason White interjected and said: “This is a decision for our sponsors.”
Fair enough but here is my stern but friendly warning to OPTrust's sponsors: adopt conditional inflation as soon as possible.
Not only is it the right thing to do from an intergenerational risk transfer perspective (more retired workers should share more of the risk of the plan), it will also add an important lever to make sure the plan is sustainable over the long run.
Anyway, given all these issues that OPTrust faces, you begin to really understand why their market risk tolerance is less than at other plans and why they are so focused on the total portfolio approach.
By the way, I did ask Kevin, Claire and Jason if OPTrust Select will make their plan younger and Claire told me "it's still early so there's a marginal difference" and she pointed out that new members in OPTrust Select contribute 1/3 of what regular members contribute and they have conditional inflation protection which Jason said was to make sure their "contribution rate remains stable".
The important point is that OPTrust Select is available to employers in Ontario’s Broader Public Sector (BPS) and charitable and nonprofit organizations that operate in Ontario and it provides a defined benefit pension to their employees, but it doesn't make a difference in terms of how OPTrust manages risk from a total portfolio perspective.
Now, getting back to the interview above, Kevin notes this:
In 2015, OPTrust launched our Member-Driven Investing (MDI) strategy. The strategy has a clearly defined investment objective that is fully aligned with the best interest of our members – delivering pension certainty. This innovative approach transformed the Plan’s investing philosophy and portfolio management framework from solely focusing on value-add generation (or outperforming benchmarks) to focusing on total portfolio construction and management against liabilities. OPTrust was one of the few global institutional investors who made early and courageous moves to adopt a Total Portfolio Approach (TPA).
To build the right culture and mindset to foster innovation, we started by including ‘innovation’ as a core component in our investment philosophy and beliefs.
Support from leadership was also critical to the success of our innovation journey. Innovation requires idea generation and in-depth research. To achieve this, we have developed an internal process to facilitate collaboration on our key annual investment research initiatives across the organization. More importantly, this process was designed to incentivize innovative idea generation and in-depth research from the bottom, especially from those highly motivated and skilled junior team members. Our culture of encouraging ‘speaking-up’ and ‘tolerance for mistakes’ have created a healthy ecosystem for innovative idea generation. To ensure that our team has the right mindset, we also put a lot of energy into our hiring process, to make sure we hire individuals whose mindsets and motivations are aligned with our own. Finally, innovation is built into each individual’s annual performance goal-setting and evaluation to drive the right behaviour.
Innovation is a journey, and it happens every day at all levels of our portfolio. We will continue to improve our culture and lever up our internal capabilities and our external relationships to advance our investment research and innovation. We believe this is key to delivering on our mission for our Plan members.
Of course, I wanted to dig deeper and asked Kevin what that means in practice.
He told me there's a "planning process" that takes place every year with the asset class teams to determine the opportunities and challenges in their respective asset classes and to see if they can maintain the required allocation.
"The planning process is critically important, we plan over a 2-3 year horizon and we don't want to perversely incentivize asset class teams to deploy capital if opportunities aren't there or risks are high."
This is where research and data are important and Kevin said all research (quantitative and qualitative) figures prominently and this is where the junior members of the teams are called upon for idea generation and more.
Let me give you an example. Last year, I wrote a comment on whether there's a secular shift going on in real estate and noted this:
Now, clearly things have gotten better since last year, we can see the light at the end of the tunnel despite the delta wave hitting mostly the unvaccinated population, but it's still unclear if real estate will go back to the way things were before the pandemic.When you think about the effects the pandemic has had on Retail and can potentially have on Office and Multi-Family, you begin to understand why big pensions are very worried.
Retail typically makes up 15-20% of a real estate portfolio, Office & Multi-Family can make up 40-60% and Industrial the rest. That's a big chunk of assets that can potentially be impacted since Real Estate typically makes up 15% of a large pension fund's total assets.
Most of the experts I talk to think we are not going back to pre-pandemic ways of operating and that some form of hybrid work week will likely be the new normal.
I don't know, have no idea, but these are the things all pensions need to be discussing among themselves and with their global partners.
Getting back to my conversation with Kevin, we talked quite a bit about their Risk Mitigation Portfolio (RMP) which he discusses in the interview above:
The current low expected return environment combined with our Plan maturity poses challenges to the Plan’s sustainability going forward. We must be innovative in our approach in order to deliver our target return, while effectively managing downside (or drawdown) risks to our funding. In terms of the ‘effectiveness’ of risk mitigation, we focus on both benefits and costs. On the benefit side, we look at the magnitude as well as consistency of drawdown protection, and on the cost side, we target our risk mitigation strategy to generate zero expected return in the long run. In other words, we do not want this strategy to become a long-term return drag to our portfolio.
We have developed and implemented a well diversified (left tail) cost neutral Risk Mitigation Portfolio (RMP) with a clearly defined objective to mitigate severe drawdowns from our Return-Seeking Portfolio (RSP). This portfolio went through a real-world test during the pandemic-induced market sell-off last year, and it delivered the needed protection to our total portfolio. Currently, our risk mitigation research focus is moving in the direction of developing data-driven systematic strategies as part of the ongoing RMP enhancement. Early this year, we have implemented our first AI/machine learning-based systematic strategy for equity tail risk protection.
These are just a few of the innovative approaches we are taking to ensure the long-term sustainability of the Plan, and subsequently, our members’ retirement security.
Interestingly, Kevin told me they do allocate to external hedge funds as part of their Return-Seeking Portfolio but the risk mitigation strategies are done internally and they target zero expected return in these strategies over the long run.
Moreover, the strategies used in the Risk Mitigation Portfolio offer consistent drawdown protection, are relatively inexpensive and they don't sell volatility like AIMCo and others have done.
Equally impressive, the Risk Mitigation Portfolio kicked into high gear in Q1 2020 and it continued delivering gains as markets bounced back strong, ending the year with a 26% gain.
You'll recall when I went over OPTrust's 2020 results with their CEO, Peter Lindley, I noted this:
Critically important, unlike its peers, OPTrust has only 10%-15% of its total assets in Public Equities, most of the risks are taken in Private Markets where they feel there are decent risk premia and where they can add value (Peter mentioned their drawdown was a fraction of the drawdown the TSX experienced last March and they had ample liquidity to redeploy in stocks).
I also noted this:
You can read the report for all the details of each asset class but clearly Private Equity generated the bulk of the returns in private markets, real estate generated a very decent 1.2% during an extremely challenging year, and infrastructure was down marginally owing to some transportation infrastructure investments.
But the big gains came from the Risk Mitigation portfolio which Peter explained is made up of U.S. Treasuries, safe-haven currencies, gold and trend-following strategies (CTAs), all of which came through big last year.
It's important to note, however, that the bulk of the assets are in growth and that's mostly Private Equity, Real Estate and Infrastructure and that OPTrust has roughly 10% in Public Equities, which is good when stocks get clobbered, less good when stocks melt up.
Still, overall I have to say, these are impressive returns during a very difficult year and Peter did mention they used very little leverage and were very diversified across geographies and sectors in private markets which helped mitigate the downside.
In fact he explicitly stated: "We use less leverage in private equity than our peers and we focus on being diversified by sector and geography."
On leverage, Kevin told me they do repo bonds but it's "government bonds" as they are very mindful of the collateral they use to leverage their portfolio.
More importantly, he told me "leverage is often misunderstood as increasing risk but in our case we use leverage in our Risk Mitigation Portfolio to reduce overall risk." (balance sheet leverage and derivatives)
We ended up with a discussion on inflation versus deflation but I note this part from the interview above:
Historically, there have been two main types of high inflation regimes (one of which being much more detrimental to the economy and markets than the other). Under one regime, when high inflation was accompanied with strong economic growth, most risky assets tended to fare well. Under the other regime, however, when high inflation occurred with low economic growth, risky assets were generally negatively impacted. This latter more adverse inflationary environment is the risk we should be concerned with.
From this historical perspective, one of the key drivers to differentiate those two inflation environments is policy responses, and aggressive policy tightening to fight inflation has typically triggered significant economic slowdown. However, in the current environment, we are in uncharted territory, and there remains a lot of uncertainty regarding how the macro environment will transpire over the next few years.
While we recognize inflation is a rising risk, we have been very thoughtful about portfolio strategy adjustments in a more holistic way rather than biasing our views towards one specific macro scenario or risk. With that in mind, our focus has been on developing what we call “regime-agnostic” risk-mitigation strategies, and those strategies are designed to reduce severe market drawdowns, regardless of the causes. In other words, our hedging strategy design is goal-driven (i.e., mitigating risky assets’ severe drawdowns) rather than cause-driven (i.e., inflation or deflation).
We are increasingly using a data-driven approach in the design of those strategies to further remove potential biases in the decision-making process. We believe this innovative approach will help us make better decisions, and ultimately, deliver long-term pension security for our members.
The key here is they are "regime-agnostic" taking the same approach as the Bridgewater's All-Weather Portfolio but across public and private markets.
As far as using a data-driven approach in the design of those strategies to further remove potential biases in the decision-making process, that is continually being revamped and improved.
They also use data quite heavily for addressing climate change risk across their portfolio but I couldn't get into this topic, noting this from the interview above:
Similar to our peers, OPTrust takes this risk seriously. One of our key corporate initiatives this year is to renew our climate strategy. The work is still ongoing, and it is a truly collaborative effort across the entire organization.
We are taking a holistic and practical approach to ensure our climate strategy is fully aligned with our mission and objectives, while at the same time accountable and achievable. We are using a top-down and bottom-up combined approach to make sure our climate strategy is developed from a total portfolio perspective. From a top-down standpoint, we are using a climate scenario analysis in our asset-liability framework to help understand and communicate the key impacts of different climate pathway scenarios on the Plan’s funding risk, as well as their impacts by asset classes, geography, sector and time horizon. The bottom-up approach is to look at individual asset class portfolios to understand their current climate risk profiles.
In the end, the top-down and bottom-up analyzes will be put together to help make informed decisions on our climate strategy.
I really enjoyed my conversation with Kevin Zhu and remind my readers he will be speaking at Institutional Connect's Portfolio Innovation and Resilience Forum this November.
I thank Kevin, Claire and Jason for taking the time to speak with me earlier today.
Below, MacroVoices Erik Townsend and Patrick Ceresna welcome ECRI co-founder Lakshman Achuthan to the show to discuss how all those economic cycle indicators that were turning up last time they spoke with him are starting to turn down now, meaning the risk of an economic cycle downturn is heightened now.
Take the time to watch this and remember, now is not the time to chase Chase Coleman, Soros and other gurus, now is the time to worry about risks!
Comments
Post a Comment