Derivatives Dean


HOOPP’s Jim Keohane deploys futures, options and swaps to clear the pension plans’ return hurdle without taking undue risk

Jim Keohane dabbles in woodworking.

When the chief executive of Healthcare of Ontario Pension Plan makes a dresser, his tool of choice is the radial arm saw, for its power and precision versus a hand saw.

In managing HOOPP’s $46 billion fund, Keohane uses futures, options and swaps as power tools. The derivative securities allow for an increased return with the same level of risk compared with a standard stock-bond mix, a vital component in enabling the Toronto-based pension plan to clear its return hurdle.

“Running a pension fund without derivatives is like working with hand tools,” Keohane told Markets Media in an Oct. 17 interview at his Toronto office, which overlooks Lake Ontario. “Derivatives allow you to construct a much better portfolio.”

To be sure, using derivatives is not costless or risk-free. An investment manager needs expertise to deploy derivatives effectively and not run into trouble, just as a woodworker must know how to use a power saw in order to make a good dresser and avoid accidents. “You’re not going to cut your thumb off with hand tools, but you produce an inferior product,” Keohane said.

The first part of HOOPP’s portfolio is constructed to match the liabilities of the pension plan. The liability-matching component holds 95% of HOOPP’s physical assets, and consists primarily of long-terms bonds (70%), real estate (12.5%), and Real Return Bonds (12.5%), which are inflation-adjusted securities issued by the Government of Canada.

But there’s a sticking point, and a reason why a second portfolio component is needed.  HOOPP needs to earn an annual return of 6.75% to fund its plan, but persistently low interest rates have compressed the liability-matching portfolio’s return to about 4%. “So we need to engage in additional return-seeking strategies to make up that 2.75%,” Keohane said.

HOOPP generates this additional return through a series of derivative overlays. “You can think of it as equity futures backed by long-term bonds,” Keohane said.

Typically, using futures to synthetically replicate the Standard & Poor’s 500 equity benchmark would entail owning futures backed by money-market assets-the investor earns the actual return and pays the three-month London Interbank Offered Rate. “We instead back that with long-term bonds, which does a couple things: it creates a carry trade where we’re earning long and paying short, and the interest-rate sensitivity more effectively matches the characteristics of our liabilities,” Keohane explained. “If we just replicated equities, that wouldn’t match our liabilities at all. But the hybrid security we create by owning long bonds with an equity overlay gives us the higher return we need, and it also tracks our liabilities much more closely than just plain equities.”

Jim Keohane

Jim Keohane

The derivative overlays are part of the second part of HOOPP’s portfolio, which is actively managed, synthetic, and broadly consist of a series of absolute-return strategies. “Most people would outsource this to hedge-fund managers, but we manage it internally,” Keohane said. “These strategies are essentially self-funding and don’t use any of the fund’s capital, but they do add return. For example, selling long-term options generates cash.”

Keohane acknowledged an incremental risk to using derivatives, “but there are very few times in history when we didn’t get paid for taking that risk.”

In 2011, HOOPP generated an investment return of 12.2%, more than two percentage points better than its benchmark’s 9.9%, in a year that saw strong investor demand for bonds push up the return on U.S. Treasuries to the most since 2008. The pension plan reported an investment gain of 13.7% in 2010 and 15.2% in 2009, versus benchmark returns of 10.3% and 9.8% respectively.

Regarding 2012 returns, Keohane said “we are well ahead of our actuarial objectives, and on course to do better than last year. From an absolute-return point of view, we’re well ahead of our benchmark.” HOOPP was 102.7% funded as of year-end 2011.

HOOPP derives much of its equity exposure through index futures and swaps, and only about 28.5% of HOOPP’s overall portfolio is invested in public equities, less than most peers. Stock holdings are split about equally across Canadian, U.S., and international markets. HOOPP also has a 30% overlay in long-term option volatility, 10% in corporate credit, and 5% in private equity.

Investment managers at Canadian pension plans such as HOOPP and Ontario Teachers Pension Plan generally are more derivative-savvy than their U.S. counterparts. This is largely attributable to a since-scrapped law that prohibited Canadian pensions from having more than 30% of their assets in foreign markets.

Given that Canadian markets are limited in their size and liquidity, pensions turned to derivatives to get the the cross-border exposure they needed while still complying with the rule. “If we held S&P futures backed by Canadian money-market assets, that would be considered a Canadian asset,” Keohane said.

While the rule was why HOOPP first got involved with equity and credit derivatives, the strategies expanded from there for one simple reason: they worked. “We found that we could structure portfolios to manage risk more effectively using derivatives than with physical securities,” Keohane said. “Derivatives allow you to be much more precise about which risks you want to take and which risks you don’t want to take.”

For example, Keohane noted that HOOPP’s liabilities are in Canadian dollars, so the purchase of a U.S. corporate bond would come with three risks: duration risk, credit risk, and foreign exchange risk. “Using derivatives, we can unbundle those risks,” he said. “We can take only the credit risk using credit derivatives, or take duration risk with interest-rate futures. We can actually disaggregate the risk and take the risks we want to take and avoid the ones we don’t want to take.”

HOOPP also benefits as a broad derivatives user in a market where others are limited in what they can do. “There are a lot of inefficiencies between cash markets and derivatives markets,” Keohane said. “This is particularly the case in fixed income, where you see a fair amount of segmentation. Some market participants can only play in certain segments of the market.”

“For example, within the credit space, some people can’t deal in credit derivatives, so the credit derivatives can be mispriced relative to the cash markets,” Keohane said. “It’s surprising how out-of-whack it gets sometimes-you’d think it would get arbitraged away, but it doesn’t. It’s a real advantage to be able to deal in both markets.”

“The question is what do they do now? It could well be using some of their risk budget.” –Keith Ambachsteer, president of KPA Advisory Service

Keith Ambachsteer, president of KPA Advisory Service

Keith Ambachsteer, president of KPA Advisory Service

HOOPP’s two-pronged portfolio is a leading-edge methodology for pension plans, according to Keith Ambachsteer, president and founder of consultancy KPA Advisory Services. “They manage a balance sheet, which is very different from managing just an asset portfolio,” Ambachsteer said. “They define their home base to be fully hedged against their liabilities, and they dynamically think about how much of their risk budget to spend by assessing the investment-opportunity set over time.”

Created in 1960, HOOPP has 265,000 active members and pensioners spanning 370 employers. The organization was called Hospitals of Ontario Pension Plan before changing its name in 2010.

Keohane, 57, ascended to chief executive in January 2012 with the retirement of John Crocker, who had led HOOPP for a decade. Keohane was hardly an outsider though, as he joined HOOPP in 1999 and was chief investment officer since 2006. He has more than 35 years’ institutional investing experience.

Keohane has stayed the course in his first year as CEO. “I didn’t make a lot of changes in the strategic direction of the organization because I was part of creating the strategic direction under the previous CEO,” he said. “I believe that the organization is well-positioned from a strategic point of view.”

HOOPP is still working on its transition from a traditional portfolio, which is typically comprised of stocks and bonds with an objective of maximizing investment return, to a liability-driven portfolio, which seeks to match investment income with payout obligations.

“Moving to an LDI format is a big undertaking,” Keohane said, noting that HOOPP started the transition about eight years ago. “We had to change all of our systems to support the alternative portfolio structure, and there are still some things we’re working on in terms of moving some of our risk-management systems to a stress-testing approach.”

Macro concerns such as a weak global economic recovery, European debt crises, and a looming U.S. ‘fiscal cliff’ are front-burner concerns for institutional investors. Keohane and colleagues don’t make investment decisions based on big-picture predictions, but they closely watch macro developments for how they affect valuations.

“We look for opportunities that may arise,” Keohane said. “For example, if the market were to sell off sharply going into the fiscal cliff, it may get to valuation levels that we think are very attractive long-term.”

Keohane said HOOPP seized such an opportunity in 2008, when the pension plan bought equities as the risk premium on the asset class expanded to 40%. “It has surprised me in the last few years how violently the market can react-it seems like there’s a lot of fast-trading money out there that pushes the market around,” Keohane continued. “But generally speaking, these events turn out to be short-term noise and don’t affect things over the long term.”

Keohane expects Europe to “muddle its way through”, and he anticipates some resolution to the  U.S. budget situation, as “it’s in nobody’s interests from any political vantage point to go off the fiscal cliff.”

Accordingly, Keohane is “reasonably constructive” on stocks and corporate bonds. “We see decent opportunities in risky assets,” Keohane said. “Public equities look pretty attractive-they’re not the bargains they were in June when we thought they were 15-20% undervalued, but it’s around fair value. And as earnings improve, fair value will go up.”

“The hybrid security we create by owning long bonds with an equity overlay gives us the higher return we need.” – Jim Keohane

Keohane is less bullish on private equity, which makes up about 5% of HOOPP’s portfolio, mostly in the mid-cap growth area. “Private markets look pretty pricey,” he said. “We’ve had a couple of very significant realizations over the past year or so in private equity, and we’re finding it difficult to find things right now. We’ve done a few deals but we’ve probably taken in more money this year than we spent.”

Private-equity markets aren’t as deep as public equity, and they don’t absorb institutional money as readily; Keohane noted HOOPP could easily buy $1 billion of public equity in one day, but the same amount could take a year to efficiently deploy in private equity.

“I see a lot of people out there trying to push money into private equity, which I don’t think makes a lot of sense,” he said. “Valuations should drive your investments, not whether it’s public or private. We have an allocation to private versus public, but we let the opportunity set drive the allocation.”

Keohane didn’t offer a market prediction for 2013, but he said “one of these years, we’re going to surprise people on the upside. I see decent things going on in the underlying economy—housing, which has been a big negative for the past five years is turning to a positive, which can have a very stimulative impact.”

While many claim they are long-term investors, Keohane said HOOPP truly has a long-term horizon: the pension plan is collecting contributions from a 25-year-old nurse today, and may be paying her when she’s 95. “We’re not managing on a daily basis like some mutual-fund managers do, or even on a quarterly basis,” he said. “It’s one of the big advantages of running a fund like this.”

HOOPP’s investment staff of about 40 runs hedge-fund strategies such as equity long-short, credit long-short, and index arbitrage, which generates a significant part of the pension plan’s return stream. Keohane receives about five calls per day from hedge funds looking for business, but HOOPP finds it more efficient to run the strategies internally.

“There are a lot of things we can do that a hedge fund can’t, because we have a big balance sheet,” Keohane said. “People overpay for credit derivatives because they don’t have the balance sheet to buy physical bonds, but we are very creditworthy and banks want to deal with us. If we were to get rated, we would be triple-A. No hedge fund would have that rating.”

Keohane also noted that as a public pension plan HOOPP is non-taxable, which is an advantage because its assessment of fair value is different than it would be for a taxable entity. “There are a lot of things we can do given the nature of our entity that gives us a leg up on others in the market,” he said.

Keohane could allocate money to a hedge fund if there was an attractive opportunity that HOOPP doesn’t have the capability to exploit, for example in distressed debt. Another scenario could be if an outside investment firm showed a cost or scale advantage of being part of a bigger entity, “but given our own scale I haven’t seen such a situation,” Keohane said.

Regarding risk management, HOOPP runs daily risk reports looking at credit exposure, liquidity exposure, and counterparty credit exposure. “The big risks within pension plans come from mismatches between assets and liabilities-they dwarf everything else,” Keohane said. “Our three biggest risks are a decline in long-term interest rates, an unexpected rise in inflation, and equity-market risk.”

“It has surprised me in the last few years how violently the market can react.” –Jim Keohane

“We’re trying to control the big risks much more effectively and then take a series of smaller risks so that if any one doesn’t succeed, it doesn’t create a catastrophic event for the fund,” he continued. “We have specific risk controls around each of those strategies in terms of limits, and they are monitored on a daily basis.”

Additionally, Keohane and colleagues have been running stress tests and modeling the pension plan’s assets and liabilities to understand how the fund would act under various scenarios, including worst-case.

Keohane said the synthetic nature of the return-seeking portfolio precludes HOOPP from using the standard methodology of controlling risk based on capital allocations. “The capital-allocation rules-based approach used by most funds allows you to have so much money in U.S. equities, so much money in Canadian equities, etc.-but once you get into an overlay portfolio with no capital being used, you can’t use capital allocation.”

Instead, “you have to think in risk terms, like how much risk is that contributing, and try to measure the amount of risk in a particular strategy,” he continued. “We’re using a stress-testing approach to model these assets under different scenarios and come up with metrics to measure and control risk more effectively within that part of the portfolio.”

And despite the perception that derivatives add risk, Keohane said it’s the contrary at HOOPP. “Derivatives allow us to reduce overall portfolio risk, because the bigger risk is the mismatch between assets and liabilities,” he said.

“We can reduce that risk by using derivatives to get equity exposure. If we just owned the S&P 500, that would give us the same return profile but it would be a big mismatch with our liabilities. If we own long bonds with S&P futures on top, that acts much more like our liabilities, so we are reducing the mismatch between assets and liabilities. That structure produces a higher expected return while reducing overall portfolio risk.”

As might be expected given the complexity of derivatives and some peoples’ wariness of the synthetic securities, HOOPP didn’t build its capabilities as one of the world’s largest derivatives users overnight. HOOPP hadn’t traded a single derivative when Keohane was hired in 1999.

“We started with baby steps, which were successful and allowed people to get more comfortable.” he said. “We have a very tight control environment around this, which is very important for confidence… Before we started using derivatives, we could see that separation of functions was critical—separate valuations, separate people doing the trades, valuations and settlements. All those were separated from day one.”

The volatility of HOOPP’s returns is “way down” versus 10-15 years ago, Keohane said.

Keohane doesn’t expect much impact from developing regulation because HOOPP already runs a tight ship. “To me, Dodd-Frank is not necessary because the industry has already done a lot to move in that direction,” he said.

“We invested in a system to send and receive collateral to reduce counterparty credit exposure, and on a daily basis we mark all our derivatives to market,” he explained. “If a counterparty owes us money we get collateral from them, and if we owe them money they get collateral from us. So exposure is brought down to essentially zero every day. We’ve invested in the systems and capabilities to manage very tight.”

HOOPP is in the markets every day and it has established itself as a liquidity provider in some areas, but Keohane said the pension plan is not an active trader. Given its derivatives-oriented equity structure, Keohane said liquidity is not a big issue and HOOPP’s trading-friction costs are low.

“Most of our equity beta exposure is achieved through derivative transactions, S&P futures or S&P swaps for example,” Keohane said. “We run equity long-short on top of that. The positions we take on the equity long-short are not that big relative to the market.”

Keohane said HOOPP may trade 100,000 shares of Microsoft via its long-short strategy, but the equivalent embedded position in the futures portfolio may be 1 million shares or more.

HOOPP was the world’s 74th-largest pension plan as of year-end 2011, according to a Pensions & Investments/Towers Watson ranking that includes public and private plans. It is the fifth-largest pension fund in Canada, according to Benefits Canada, behind the Ontario Teachers’ Pension Plan, the Ontario Municipal Employees’ Retirement System, the Public Service Pension Plan (for Canadian federal employees), and the Quebec Government and Public Employees Plan.

Keohane expressed support for the recent purchase of Canadian exchange-operator TMX Group by Maple Group, a consortium of banks and pension funds not including HOOPP. As part of the transaction, TMX merged with Alpha Group, which was Canada’s second-largest exchange operator.

“The Canadian market was getting pretty fragmented,” Keohane said. “It is not deep enough to support two or three exchanges-in my opinion you want to have one central order book. “You may have different providers to plug you into that and different blind pools that may add to the market as peripherals, but when they had two exchanges competing with each other I think it just fragmented the market and really was not beneficial as it reduced liquidity.”

HOOPP generally buys and customizes, rather than builds, technology systems. The pension plan uses SimCorp Dimension as its main portfolio management and accounting system. “It really supports alternative portfolio structures-it has derivatives, and a collateral-management module, which are critical for the functions we run,” Keohane said.

“For trading we use Eagle Pace as a database and pricing engine, and for order management we use Bloomberg AIM.”

HOOPP’s investment gains averaged 6.28% per year between from 2001 to 2010 inclusive, before the pension plan spit out double-digit gains in 2011 and 2012. The numbers show HOOPP’s investment process works, according to Ambachtsteer of KPA Advisory. “The proof is in the pudding,” he said.

Ambachtsteer noted that the especially strong recent returns were driven by HOOPP’s hedging of  interest-rate risk ahead of bond yields declining to historic lows. “They did so by having the risk-management discipline that says unless we want to make a bet, we hedge interest-rate risk,” he said.

“Of course this doesn’t means they’ll do it again next time,” Ambachsteer said. “They’re now faced with a different decision process, because given how low the yield curve is, it’s not going down another 200 or 300 basis points. So the question is what do they do now? It could well be using some of their risk budget.”

In a broad sense, pension funds face a dilemma going forward. Put simply, they need to make considerably more than low-risk income-oriented investments provide. Bond yields seem stuck near historically low levels, with no visible catalyst that would push them higher. At the same time, pension funds’ performance hurdles, mostly set years ago when fixed-income returns are much higher, are for the most part not budging.

That’s where derivatives are HOOPP’s ace in the hole. Without futures, options and swaps, “it’s very challenging to meet return requirements without taking undue risk,” Keohane said.

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