The Healthcare of Ontario Pension Plan’s struggles when the dot-com bubble burst planted the seeds for the liability-driven investing strategy it’s so well known for today.
At the time, the plan had a traditional 60/40 portfolio of equities and bonds, and saw its significant funding surplus quickly turn into a deficit as equities took a hit. During the same period, interest rates dropped, increasing the plan’s liabilities.
“It was kind of this perfect storm environment we went through,” said Jim Keohane, the former president and chief executive officer of the HOOPP, in a fireside chat reflecting on his career during the Canadian Investment Review’s Defined Benefit Investment Forum in December.
Read: Q&A with HOOPP
Unpacking the dot-com bubble’s burst, the plan learned two key lessons, he said. First, its portfolio actually held more risk than previously thought. And second, there was a mismatch between the assets it held and its liabilities.
Keohane, who retired from the top job at the HOOPP on March 31, 2020, recalled being hired on in 1999 to create a derivative portfolio that would allow the fund to increase its exposure to foreign markets without running afoul of Canadian ownership rules. At the time, a pension wasn’t permitted to invest any more than 30 per cent of its assets outside of Canada.
Derivatives can be a precise and powerful risk management tool, he said, but plan sponsors thinking about them should implement robust controls and a separation of functions to ensure they’re used properly, as well as strong risk modelling.
“Derivatives can be put in positions where the risks are nonlinear or are actually multipliers as things move against you, or they do the reverse. So you have to understand that and make sure you understand what a worst case scenario actually looks like to right size your position.”
Derivatives made up an important part of the fund’s liability-driven investment strategy, which sought to separate alpha from beta and ultimately created two portfolios. One was a liability-matching portfolio of long-term and real-return bonds and real estate. The other put derivative overlays on top of the first portfolio to develop a return-seeking element with exposure to equity, credit and absolute return strategies.
The transition to the LDI strategy went into effect in December 2007, when the HOOPP reduced its equity exposure by 30 per cent and put that capital into long-term bonds, real estate and real return bonds — just in time to help the fund weather the 2008/09 global financial crisis. It still took a small hit on equities, but its fixed income and real estate assets increased in value.
“Because we were never in a crisis position . . . we were able to buy long-term assets at extremely attractive valuations that have probably not been seen since. And because we were able to buy assets at a very attractive price at that time, that really helped our performance for several years after that.”
Coming up to the coronavirus pandemic, the LDI strategy had been losing its potency as interest rates and bond yields have continued to fall.
“What always kept us in fixed income was again looking at the risk/return tradeoff,” Keohane said. “As you get toward zero the actual amount of interest rate exposure you have goes down. So now it’s at the point where the amount of risk left in the liabilities is very small, so your need to own fixed income gets greatly diminished.”
While fixed income’s potential upside remains small, he said there may still be opportunities for pension funds in distressed debt if they can find good companies that should be able to turn their balance sheets around. Looking to other asset classes, Keohane said public equity’s risk premium is “pretty good” and while companies that are particularly exposed to the economy, such as oil producers and banks, have taken a hit, the roll out of vaccines could support their rebound.
Among alternatives, the pandemic accelerated some real estate trends that were already underway, including the decline of shopping centres and online shopping’s growing dominance, the latter pushing demand for industrial warehouse space, Keohane said. As for offices, he expects demand to remain, although growth in that demand will slow as an increasing share of the workforce continues to work from home after the pandemic ends.