I recently sat down with Jim Keohane, president and CEO of the $63.9 billion Healthcare of Ontario Pension Plan to ask him five questions about how pension funds are investing and the risks he sees evolving in the marketplace.
This is the first post in an ongoing series we’ve introduced to Canadian Investment Review that will see us posing five questions to Canada’s top pension investment leaders.
Our questions – and Jim Keohane’s responses – are below.
Is real estate a good substitute for fixed income for pension funds? Or are there additional risks?
We own real estate because of its inflation hedging characteristics – particularly for wage inflation. But there are a number of additional risks that come along with owning real estate that aren’t in fixed income – if you buy a 30-year Ontario bond you are pretty much assured of getting your money back in 30 years. But there’s a lot that can go wrong when you own a building. It has normal business risks – you have to run the buildings. You can’t dabble in it, you need scale.
There are risks and you need to know what they are and you need to get compensated though an adequate risk premium.
Real estate is not a substitute for fixed income — you can’t simply switch them. It has inherent risk and many investors don’t appreciate that. It’s hard to find deals that are attractively priced in the current market. We’ve found some deals of interest – but I see other transactions happening at very high prices.
It takes a fair amount of expertise to do it – and if you’re investing in real estate through a fund structure, it’s often not optimal for a long-term investor. Managers want to get paid – they may own long-term 30-year assets with a fund structure that winds up in five years in order for the manager to collect their fees.
We see a number of transactions happening at cap rates that offer no additional returns over long-term government bonds – so people are buying risky assets and not getting paid for it which is not rational risk taking. We witnessed similar irrational risk taking before the 1987 crash and in 2007. It’s a red flag.
What’s the number one risk that keeps you up at night?
It’s exactly that – people out there who hold risky assets and have no idea how much risk they hold. Pension funds, individuals – people are moving out the risk curve to get a yield who have no ability to absorb the risk. For example, people taking money out of an FDIC-insured fund are buying high yield exchange-traded funds – it’s a big leap up the risk curve and they’re treating it like it’s the same.
I also see a potential liquidity problem in the high yield ETF space. There have been significant inflows into them over the past few years as individual investors seek to earn a higher return on their investments. At the same time, regulatory reforms have significantly diminished the liquidity in the underlying corporate bond market. I see a potential liquidity problem happening when we get the next credit downturn and investors try to exit. Unlike equity ETFs, the underlying corporate bond market is a dealer market and it simply doesn’t have the liquidity to absorb a disorderly exit. When these things start to unwind, it will be uglier than you think.
We’ve heard much about the potential negative impact of Donald Trump’s ascendancy to the U.S. presidency – but does his promised rollback of Dodd-Frank have an upside for institutional investors?
Yes, there is a positive side – it will lead to better liquidity not just in the fixed income space but for big derivatives traders like us. It is almost impossible to execute large scale derivative transactions without a bank acting as an intermediary. For example, if HOOPP enters into an index option transaction, a bank will almost always be the counterparty on the trade and they may take a long period of time to unwind that trade in the marketplace. The Volker Rule, as part of Dodd-Frank, has made it much more difficult for large banks to engage in big trades like this because regulators are telling them that trades with a holding period of more than five days can no longer be considered market making and are interpreted as proprietary trades which violate the Volker Rule. Removing this regulatory uncertainty would be a positive development.
Corporate debt will also benefit – you have to carry significant inventory to be a market maker in that business. Reversing some of this will be helpful – it will boost liquidity and help us execute some transactions.
Another regulatory development that has been tough on investors are the Basel 3 rules that put a capital charge in bank balance sheets – basically, it tells banks to get out of the high balance sheet, low margin businesses, like the bond repo market. Bond repo is really important to the liquidity function of the market but banks are moving out of the space because the capital charge makes the economics unattractive. The bond repo market is an important mechanism for the Bank of Canada to inject liquidity into the Canadian market particularly during times of financial stress. On the whole, the regulatory pendulum has swung too far and it’s created additional risks in the market. Some relief from these rules would be a positive development.
How and why are pension funds using leverage today – and are there risks to doing so?
We have a levered balance sheet – but we didn’t set out to have one. Leverage at HOOPP allows us to minimize interest rate risk. We have a liability matching portfolio which contains real estate, fixed income and real return bonds. It’s the closest match for our liabilities. The trouble is, the returns from those aren’t enough to meet our obligation – so rather than owning physical equities we overlay derivatives on top. That makes it less risky than a traditional portfolio because we don’t have to sell the matching assets to get equity exposure.
Leverage allows us to take on equity market risk without creating the interest rate mismatch – we still own long-term bonds but we’ve taken on equity risk to enhance returns in a much less volatile way. In that context, even though our balance sheet has expanded, it actually reduces the overall risk in the fund.
Any advice for Ontario’s recently announced new pension regulator?
I think that all of us in the industry would agree that taking a big picture policy view is the best approach. It’s all about what is best in the public interest. The new regulator should have a mandate that allows them to consider what is in the public interest when making judgements.
I believe that most people are better off being in a defined benefit plan than a defined contribution plan. The world is changing – and we need a more flexible approach that makes it easier for employers to continue to offer DB plans. If DB plans closed are turned into DC plans or closed, members won’t be better off in the end. You need to look at the big picture and adapt the regulatory rules to accommodate a rapidly changing environment.