There is no denying it is a bold move. A former hedge fund manager will soon take over as the head of one of Canada’s largest pension plans. Ron Mock, senior vice-president of fixed income and alternative investments at Ontario Teachers’ Pension Plan (OTPP), will step into the CEO role on January 1, 2014 when Jim Leech retires after 12 years at the helm.
Mock, who joined OTPP in 2001 as director of alternative investment, was previously CEO of Phoenix Research and Trading, where he was responsible for all of Phoenix Canada’s fixed income business, including the Phoenix Fixed Income Arbitrage hedge fund which closed in 2000 after losing C$125 million in the US bond market, according to a Ontario Securities Commission settlement document.
The experience was clearly formative. OTPP’s move only a year after the Phoenix debacle was a remarkable vote of confidence in Mock and his skills. For a pension plan that is known not only for innovation across the board but also for its commitment to hedge fund investing, the promotion of Mock may not come as too much of a surprise.
Mock (pictured) has his work cut out for him. With nearly C$130 billion in net assets, OTPP is the largest single-profession pension fund in Canada. It manages and administers the pension assets of 303,000 active and retired teachers in Ontario. Before the fund was set up on December 31, 1989, the Ontario government was the sole sponsor of the plan and invested in government bonds only.
Since then OTPP has significantly changed its asset allocation and employs active risk management, which starts with determining how much risk the fund can afford to take. This calculation underpins all its investment strategies and seems to be working well.
The plan has a strong performance record with an average annual return of 10.1% since inception. It announced a 13% rate of return for the year ended December 31, 2012, which raised assets to C$129.5 billion compared with C$117.1 billion at the end of 2011. The fund’s total value has nearly doubled since 2002 when net assets totalled C$66.2 billion.
The investment strategy focuses on finding an appropriate asset mix across equities, debt, commodities and real assets. OTPP employs active management, selecting investments it believes are undervalued and then using various business strategies to optimise returns. It does not believe passive investing through market indexes can generate the risk-adjusted returns required for the plan.
OTPP’s strategy also focuses on liquidity, making sure it has cash on hand to meet payments and make opportunistic investments.
This approach is designed to counteract funding risks: assets falling short of liabilities over time. OTPP is playing for the long term, looking to maximise investment returns at an appropriate level of risk while taking into account the cost of future pension benefits and the challenges presented by the plan’s mature membership demographics. It believes closing the gap between asset values and pension obligations is the best way to achieve contribution rate and benefit stability for its members.
“We are not just an asset manager. The plan is responsible for delivering the promises to the teachers. We are also very focused on the liabilities. The goal at the end of the day is really to ensure long-term retirement security for our members,” says Mock.
“We have to manage the assets and the liabilities together. When we are looking at what assets at a broad fund level we are going to employ, we have to keep a very close watch on our liabilities and how they are being affected by the environment, particularly interest rate movements. We also have to be very aware of the various asset classes and how they will respond through time. It is managing the total fund and its liabilities that really establish our investment priorities.”
For Mock, how OTPP allocates assets and invest is a key question. The process is comprehensive and takes a 10-year view.
“We try and get a sense of how various asset classes will respond both from a risk and return perspective. Then knowing our liabilities, we look into what weightings we need in our various asset classes, from real estate to private capital, infrastructure, bonds, stocks etcetera. This investment-planning process takes a decade view but we update it every single year; it is an annual investment process because market conditions change, volatility changes and asset class opportunities change fairly substantially.”
Within the annual investment planning process, there is a separate risk-budgeting process where risk is allocated to each individual asset class. What is important, stresses Mock, is to make sure the fund is properly balanced and diversified between asset classes.
“What we really have to do is make sure the asset side is performing the way it needs; that the liabilities to the best of our ability are being matched off. What this does is drive us to innovation; it is one of the cornerstones of the thinking here at the plan. We are not shy about innovating and being the first mover in a number of areas. We look to achieve the highest risk-adjusted return that you can in assets to match liabilities.”
On the asset side there are two pillars. One is what he calls “a normal asset-mix process”. This relates to how stocks, bonds, real estate, infrastructure and other assets are weighted. The weightings are established every year based on market conditions and the investment plan. These, says Mock, are “fairly standard policy weights”.
These assets are also weighted in a risk framework.
The second cornerstone is what OTPP calls “a value-added pillar’ and that is where the focus is on finding value-added opportunities by investing in unique and innovative strategies. “We look to try and add 1% or 1.5% of the total fund’s benchmark every year. Every single department is charged with the responsibility of also trying to deliver value-added above and beyond the benchmark.”
It is in the framework of the value-added that hedge funds come into their own. “One of the most important cornerstones for the hedge fund world and all of our value added [investments] is to have a low correlation between the value-adding activities and the rest of the fund. That enhances the stability of the overall return stream,” he says. “We look for the best we can: absolute value-added returns in our value-added strategies. We don’t look for absolute returns in our asset mix, our core portfolio, only in our value-added space.”
OTPP takes a holistic approach to analysing value-added investments, taking into account the risk and correlation of the strategy as well as its return. “The risk-budgeting process is a key component. The hedge fund portfolio, for example, is allocated a risk budget that basically says once in 99 years theoretically you can lose up to x. Our goal is to get a return on this value-added strategy by assigning a return objective and a risk objective. Additionally, the planning focuses on what correlation benefits the investment is bringing.”
In the value-added part of the plan, Mock says investments can be “a little more opportunistic”. As the plan grows its assets under management, there will be a desire to increase the allocation to hedge funds, he says. So from year to year, allocations will be “opportunistically” modified.
“We do not allocate on dollars; we allocate more on risk in the value-added space. We are not pushing a fixed amount of dollars out of the door and into hedge funds, where someone says we will have C$5 billion in hedge funds,” he explains.
Instead, the group decides on a specific risk-adjusted return and the size of the allocation fluctuates depending on market conditions. “The value-added world generally is growing with the assets of the fund but we also go at it opportunistically. The discretion is left with the various value-added groups to put more or less out; it’s at their discretion to do that.”
So if the plan invests $100 million in 10 hedge funds and each of those funds has a risk of loss according to the OTPP model – a risk loss of C$10 million dollars every 100 years – and there are no correlation benefits, the plan will put C$10 million roughly into each hedge fund.
“If in fact we can put it into 10 hedge funds and we get great correlation benefits and they are offsetting one another, our portfolio construction is very strong and we are comfortable with it. Then we might be able to invest in 20 hedge funds because we will have correlation benefits under stress market conditions. The risks that the types of funds we invest in and the correlation benefits between hedge funds start to define how many dollars we will employ,” he concludes.
The investments made in the value-added pillar are completely separate from the core asset mix. “We do not try and trade off equity and our core asset mix and the use of equities in the value-add portfolio. They are two separate worlds.” Although these investments may be run by the same people, Mock says OTPP thinks of them as separate organisations: one is focused on getting value-added and absolute returns while the other is concentrating on the core fund’s value asset mix.
This core asset mix – stocks, bonds and real estate, infrastructure – should satisfy the vast majority (90%) of the plan’s liabilities. The value-add is trying to earn a more absolute return on top of that.
“If you have a value-add string of activities that are all correlated with one another and uncorrelated with the rest of the fund, you have actually got a robust portfolio construction. Think of them as two separate functions,” explains Mock.
Picking the hedge funds once the risk allocation is decided is a different matter. Looking again at the market environment, Mock says he is constantly looking six months forward. “The number one thing that we are always thinking about is what risk environment will we be operating in over the next six months,” explains Mock. “We prefer to say risk will double over the next six months or risk will be cut in half over the next six months. Once we define the risk environment we are in over the next six months, we can then emphasise hedge fund strategies.”
For example, if he thinks it will be a rising risk environment, OTPP steers away from equity long/short since this strategy does not do particularly well in a high-volatility environment. Instead, allocations to CTAs or fixed income-style managers may increase.
“When we define the risk environment we are operating in, we can then start to allocate or ‘emphasise’. We have allocations in most hedge fund strategies all the time. This is really a nuance of emphasis. We define the risk performance six months on according to our macro view without trying to guess where stockmarkets are going to be. If the risk is going up or down, that will define the strategy in the hedge fund space that we will over or under-emphasise.”
Most of OTPP’s hedge fund investments are direct into commingled funds, although some allocations are through managed account platforms. While Mock shies away from funds with lock-ups, there are some strategies that give a liquidity premium that he is willing to balance with the rest of the portfolio.
“I would describe our approach here as almost like a barbell, meaning we will invest in commingled funds, those that are very unique in the royalty space, drug royalties and longer royalties, those that tend to be longer-haul investment and require very specific expertise. For those, we are prepared to take a liquidity premium and a longer lock-up. For more liquid strategies we prefer a managed account approach,” says Mock.
“We are not suggesting that one is better than the other. We are looking for great partners and unique strategies and uncorrelated alpha when we can get it. We are trying to optimise our liquidity transparency and control against the opportunity set that exists out there,” he adds.
Along the way, OTPP also likes to encourage best practice by hedge funds. Mock believes OTPP has been “a real leader in the area of good corporate governance”. He believes it is good for the pension plan, its partners and the marketplace in general.
An example of encouraging best practice is in helping managers improve their valuation capabilities and ensuring independently evaluated portfolios. Another area Mock emphasises is segregation of duties from an operational due diligence perspective.
“We have got to help them and they have got to help us. As an institutional player that means that both of us end up getting stronger and if both of us are stronger, the industry is stronger,” he explains.
“In some cases, given some of the hedge funds that we have seen in the last 15 to 16 years, we see a part of the world that some of the hedge fund managers might not see. They see a part of the world that we may not see. The goal is to put the two together and make two plus two equal five. If we can strengthen our partners and execute good governance as a fiduciary, which we must do, then we all win and most importantly the industry wins. [Hedge funds are] an important source of return for us. [What we do] promotes a strong industry; a reputable industry is a very good thing for all of us.”
Looking at lessons learnt from investment, Mock points to three areas: liquidity, leverage and transparency. “We need proper alignment on the liquidity front. On the leverage front we have really learned that as interest rates fall and money becomes much more plentiful, those managers that start to increase leverage substantially to maintain returns, particularly under the weight of a two-and-20 fee structure, ultimately are problematic when volatility turns the other way. We watch those dimensions very carefully, which is why managed account platform transparency becomes quite important to us,” he says.
In addition, Mock wants to make sure that valuations are done independently wherever possible. “We also want to make sure that we have a close relationship with the managers so we understand what the nature of the investments are.”
OTPP is also noted for taking a lead in other areas. A good example of this was its decision to open an office this year in Hong Kong. Since around 2005 OTPP has had a “fairly substantial” investment in Asian hedge funds. Other asset classes such as private equity and real estate were also attractive in the region. Mock believes that while it was possible to run Asian investment from North America when such investment represented around 10% of the portfolio, with the investment opportunity set enlarging, a more sustainable relationship was needed.
“When you think about the number of transactions and the number of deals and opportunities that are there today, you need boots on the ground and to develop long-term partnerships,” he says.
“We have capital to allocate and we want to allocate it with strong and good partners. Singapore and Hong Kong have developed substantially, so we decided that we have to be there; we have to make sure that we have people on the ground and we are plugged into the information flow not just for the hedge fund side. It is true for the infrastructure, private capital and all the other types of investments that we do.”
On advice to other pension plans about hedge fund investing, Mock is somewhat circumspect. “When it comes to investing in hedge funds, you absolutely need to have the commitment of the organisation to understand what you are doing. Second you need to find good partners and talent. Managers have to commit to building some talent internally to understand the space,” he advises.
“But I think most importantly you need to know why you are investing in hedge funds and you need to know what it is you are trying to accomplish. Without a clear understanding of why you are investing in hedge funds and what it is you are trying to accomplish from a portfolio perspective, you are really just following the crowd. It may just get you nowhere.”
OTPP certainly knows what it wants to accomplish and why it believes hedge funds can help deliver on those objectives.
“We are very clear when we go into the hedge fund space: what it is we are after and why we are doing it. Why? Because it offers us an opportunity to build uncorrelated portfolios and therefore have a better chance of delivering absolute returns,” he says.
“It also allows us to extend our partner network globally. There are a lot of smart people out there and we are not going to build something internally, say music royalties for example, when there is better and more confident talent and expertise outside.”
As for the future of OTPP when Mock takes over in 2014, the assumption is possibly more of the same. “Our hedge fund mandate will not change but for everything else I think we should do another interview in 2014 when we get a broader perspective.”
Ontario Teachers’ Pension Plan received the Americas Awards 2013 outstanding contribution to the industry by an institutional investor
We are very clear when we go into the hedge fund space: what it is we are after and why we are doing it. Why? Because it offers us an opportunity to build uncorrelated portfolios and therefore have a better chance of delivering absolute returns.
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