An In-Depth Conversation with OPTrust's CIO James Davis

Alicia McElhaney of Institutional Investor reports in why OPTrust’s James Davis is chief investment officer of the year:

When James Davis was hired as OPSEU Pension Trust’s chief investment officer six years ago, his mandate was clear: Provide Ontario employees with a secure retirement — without making them pay more to achieve it.

As CIO, Davis has shifted how the pension fund invests, moving to a model that prioritizes members receiving the benefits they’ve been promised without their contribution rates increasing.  

Davis’s work at OPTrust, which serves Ontario employees, earned him the title of Chief Investment Officer of the year at the fourth annual Allocators’ Choice Awards, held on Wednesday. Davis was one of ten finalists nominated for the award.  

He spoke with Institutional Investor about what makes OPTrust’s investment strategy differs from its peers, how the pension mitigates risk, and how the investment office is positioning the fund to tackle climate change and diversity challenges.  

The Strategy

OPTrust operates differently than some of its pension fund peers, as it focuses mostly on ensuring that its members do not have to increase their contribution rates over time. This focus has led OPTrust to emphasize taking on the lowest risk possible to achieve its target return.  

“What I think is missing in our industry is an understanding that risk and return are two sides of the same coin,” Davis said. “Everyone seems to be focusing on returns, returns, returns. They tend to be focusing on short-term returns and not paying adequate attention to risk.” 

In a market downturn, this can be problematic, as returns can turn negative thanks to the added risk investors have taken on. Rather than using a risk budget as its starting point like many of its peers do, OPTrust starts with its target return, then develops a plan to hit that mark while taking on the least amount of risk possible.

It’s worked so far: The pension, which had just over C$23 billion (USD $18 billion) in assets under management as of December 31, 2020, is fully funded and has been for the past 12 years.   

OPTrust’s portfolio includes liability-driven strategies, private equity, infrastructure, hedge fund, and real estate investments, plus a completion portfolio designed to complement its other strategies.  

“It ‘completes’ the risk profile we need at the total fund to help us deliver on our mission of earning the return we need to keep our plan sustainable at the lowest risk possible,” Davis said.    

Over the past few years, Davis has been working to build a risk mitigation portfolio, which is included within that completion strategy.  

This portfolio includes assets like gold, TIPS, nominal bonds, defensive currencies, and trend strategies, Davis said. OPTrust employs machine learning to inform some of these investments. The portfolio returned 26.3 percent in 2020, Davis said.  

Diversity and Inclusion Goals

Davis also made note of the “journey” OPTrust is taking with respect to diversity and inclusion at the organization.  

“What’s first and foremost is cognitive diversity,” Davis said. “When we are building out systematic strategies as an example, we need people who are thinking of the world through different perspectives.” 

A little over a year ago, Davis created what he calls the office of the chief investment officer internship program. His goal is to bring in two new people each year who rotate through different areas of OPTrust’s investment division over the course of two years.  

He is specifically seeking out candidates who do not all have MBAs, or are CFAs, or who are quantitative engineers. “We are looking at people who are bringing a different perspective,” Davis said. “We hope we’re attracting people who are interested in the pension world and pension investing.” 

The recruiting process is unique, too. In addition to the typical interview questions and processes, OPTrust also administers a creativity assessment and an enneagram test to candidates.  

“The process is more complex than it may be in a typical recruiting exercise,” Davis said. “It allows us to have another dimension to look at the quality of candidates.” 

Combating Climate Change  

As OPTrust looks toward its future, one of the organization’s major priorities is creating a climate change strategy, which Davis expects the organization to complete in 2022.   

His team is looking at three top-down scenarios that could play out: a Paris Orderly Transition, a Paris Disorderly Transition, and a Failed Transition, each of which the team has evaluated over the five-, ten-, and 20-year period. According to Davis, each potential scenario is detrimental to the plan as it stands now.   

But that is likely the case for many organizations: In Davis’s view the market has not yet adequately factored in the effects of climate change on investment outcomes.  

Although OPTrust has already invested one third of its infrastructure portfolio in renewables (“We have been an early mover into that space,” Davis said), there is more to do.   

As with the organization’s overall investment strategy, though, Davis wants to make sure OPTrust does it right. “We want to make sure we’re doing it right for us,” he said. “Markets will begin to price this in with more vigor in the near term, more so than perhaps people are thinking. We need to be on top of it, but we need to do what’s right for our plan.” 

This is an excellent interview with James Davis, OPTrust's CIO.

On Friday, I had an hour long conversation with James to "dig a little deeper".

Before I get into our conversation which was truly excellent, I want to thank him and congratulate him for getting this well-deserved award. I also want to thank Claire Prashaw and Jason White for setting up this call. 

I enjoy talking to senior members at pensions I cover and particularly enjoy the perspectives from CIOs who are closer to the investment side of the portfolio and have a more holistic view of the total portfolio.

James is always a pleasure to speak with. He's a deep thinker, manages the entire portfolio with members in mind and is always focused on risks and how to mitigate them in a cost-effective way. 

I began by congratulating him on this Institutional Investor award which he told me focuses on "asset allocators," not money managers.

He said his "very proud" of his entire team across public and private markets and total fund management and shares this award with them.

"Here we focus on portfolio construction and everything we do is with the total portfolio in mind," he told me.

Since we talked about what it takes to be a great CIO, I told him that through this blog, I've spoken to some great ones like Bob Bertram and Neil Petroff.

I asked James how his experience working at Ontario Teachers' Pension Plan helped him become a better CIO.

"I stand on the shoulders of giants, learned a lot working at OTPP with Barb Zvan and others. It was an incredible experience working at a place where Claude and Bob had a profound influence."

In 2016, James left OTPP to join OPTrust and soon after, the organization began implementing its member-driven investing approach.

Recall, In 2015, OPTrust introduced its member-driven investing (MDI) strategy, which was designed to increase the likelihood of plan certainty for members by balancing the objectives of sustainability and stability. They began implementing that strategy in 2016.

James called this shift a major philosophical shift because it was no longer about trying to obtain the highest return over a benchmark (the value-add approach), it was about ensuring the plan remains solvent and sustainable over the long run and that required a different approach, one that takes into account the risk/return tradeoff to ensure stability of contribution rate and benefits.

Similar to OTPP and HOOPP, OPTrust is a pension plan which manages assets and liabilities. Its demographics are a bit younger than OTPP's but it still needs to manage risks carefully to make sure the plan remains stable and sustainable. 

Like all mature pension plans, demographic maturity, low interest rates and volatile markets present fundamental and persistent challenges the plan faces and it affects their ability to bear risk. Operating in this environment and keeping the plan fully funded requires new approaches and a willingness to innovate. This is why they introduced member-driven investing to focus their attention on what ultimately matters most.

In this way, OPTrust has a healthy allocation to private markets (Infrastructure, Real Estate and Private Equity) where they feel they can add value over the long run and they use capital markets to dial up or down risk through their "completion portfolio".

As James states in the article above: “It completes the risk profile we need at the total fund to help us deliver on our mission of earning the return we need to keep our plan sustainable at the lowest risk possible.”

The way he explained it to me is to think of public markets/ capital markets operations as a way to manage liabilities and assets are primarily (but not exclusively) managed in private markets where they seek long-term returns through value creation.

"These go hand in hand to complement value creation. We are always asking ourselves what do we need to augment this to get the best total portfolio approach."

He was careful to specify: "We manage risk in the value creation as well."

He added: "In my opinion, there's way too much attention in the value-add and not enough on managing risks to get a better risk-adjusted total portfolio return."

Again, here I need to specify, pension plans like OPTrust, HOOPP, OTPP, OMERS and even CAAT, have a different objective function than pension funds like CPPIB, BCI, PSP and IMCO.

It's really important to understand the nuances in the plan design and demographics to really understand the risks each plan or fund can bear.

At OPTrust, they want to ensure the contribution rate stays the same no matter what and benefits too. 

Moreover, OPTrust is the only large Canadian pension plan which still offers guaranteed inflation protection, not conditional inflation protection to its anchor members (not new members at OPTrust Select), adding more pressure on James and his team to manage risks at a total fund level more tightly.

Again, the focus is on two critical elements:

  1. Stability: in the contribution rate and benefits.
  2. Sustainability: Need to ensure they take enough risk to generate the long-term returns to make sure the plan is sustainable over the long run.

But James was honest: "It gets harder and harder to do this as you mature. It's like someone who plans to retire, the closer they get to retirement, the less risk they can take because they don't have time to make up for a severe drawdown." 

"Given we are a mature plan, we cannot bear the same risks as our peers. We only take the amount of risk needed to ensure the plan is sustainable over the long run."

As such, OPTrust's asset mix is always tailored in a way to generate the highest return at the lowest level of risk, which is indeed different than many larger peers. 

"For our long-term portfolio, we are looking to deliver sufficient returns to lower funding risk."

Interestingly, I asked James about their asset mix which is heavily skewed in private markets and is very different from that of CAAT Pension Plan (more skewed to public markets).

He confirmed this stating they have 30% in Equities split evenly (15/15) between Public and Private, 15% in Infrastructure, 15% in Real Estate, 10% in Hedge Funds (part of Public Markets) and 10% in Credit.

Then they use a Risk Mitigation Portfolio "which is made up of real-return bonds, gold, different safe haven currencies and trend-following CTA-type strategies" to mitigate against large equity drawdowns.

Recall my recent conversation with Kevin Zhu, Managing Director and Head of Portfolio Construction Group at OPTrust,where he explained 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).

James confirmed all this to me and stated: "The Risk Mitigation Portfolio is there to reduce tail risks of the Return Seeking Portfolio in a cost-effective way and reduce overall risk."

We go into a discussion on the Long-term Acceptable Risk Portfolio which was a bit technical but again, the focus is always on members and maintaining stability and sustainability of the plan. 

We then got into markets a little more in-depth and discussed how there is a paradigm shift in fiscal and monetary policy, how this is increasing geopolitical risks.

In the near term, he fears retrenchment of fiscal and monetary policy will lead to more volatility but he was careful to state they are 'regime agnostic' and manage the portfolio knowing that "the only constant is uncertainty."

We ended our long discussion by going over climate change risk.

Here is where James really excels as he understands this risk extremely well.

"One way or another, we are going to deal with climate change risk. We can take a top down approach for macro risks and some bottom-up approaches to deal with climate risk but we really need to take this risk into account because it will impact all our portfolios."

Interestingly, just like the article above, he gave me three scenarios:

  1. An orderly transition to net-zero
  2. A disorderly transition to net-zero
  3. No transition whatsoever

"In all three scenarios, we worked with Ortec Finance and found that they all lower our capital market assumptions on long-term returns for each asset class. Importantly, climate change is not priced into markets right now."

These rising risk premiums because of climate change will impact long-term returns and all assets wil be impacted as the discount rate rises.

But climate change doesn't just present risks, it presents opportunities too.

Here James gave credit to Alison Loat and her team looking at sustainable investing and innovation and also looking at how they can implement the best responsible investing policies across OPTrust's entire portfolio.

Most interestingly, on climate change, James told me consumers are leading the charge, demanding change, making better choices, forcing businesses and governments to respond

"There's a tidal wave of change, renewed focus on climate change. At OPTrust we are looking at not only doing what is right for our members but doing what is right for our planet."

Let me be clear however, this doesn't include divesting from fossil fuels. 

As James said: "fossil fuels will be with us for many more years, we need to engage these companies. We are more thoughtful, not reactive."

He added: "We are mindful that our members want to retire in a better, more sustainable world but will ensure we always maintain the sustainability of the plan as or top priority." 

Let me once again thank James Davis for another highly engaging and thought-provoking conversation and congratulate him for a well-deserved CIO of the year award. 

Below, climate change “is a mega-trend that if you take advantage of it, and get ahead of it, it’s going to be an alpha generator for the next 30 or 40 years,” CalSTRS Chief Investment Officer Christopher Ailman said last week at CNBC’s “Delivering Alpha.” “If you don’t pay attention to it, it’s going to be a negative alpha and you’re going to be stuck with a low-beta return.”

And the first Columbia Climate School Earth Series presents a discussion on the intersection between climate risks and the allocation of private capital, and the role of the financial services industry in achieving climate solutions.

Climate School Founding Dean Alex Halliday leads a conversation with Lamont-Doherty Earth Observatory climate scientist Radley Horton, the Earth Institute’s sustainability management and economics expert Satyajit Bose, and leading asset management firm AllianceBernstein’s Michelle Dunstan to explore the power of partnerships and collaborative research to change decisions and bend the trajectory of climate change toward a more sustainable future.