Head of Portfolio Construction Group
OPTrust, with net assets of over C$23 billion, has been on the innovation journey to ensure the long-term sustainability of the Plan, and subsequently, its members’ retirement security. In advance of Portfolio Innovation and Resilience Forum this November, Institutional Connect interviews speaker Kevin Zhu, Managing Director and Head of Portfolio Construction Group, OPTrust, who comments on the Plan’s approach to innovation, how it responds to inflation, manages risks and addresses climate risks in its total portfolio.
Institutional Connect: OPTrust, as one of Canada’s largest defined benefit pension plans, has won awards for its innovation. Can you describe the pension plan’s journey on innovation?
Kevin: As a defined benefit pension plan, OPTrust deals in incredibly long-term time horizons. This means that we’re not only working in today’s economy, but also the economy of the future. Innovation is part of culture and mindset, and because of our long-term focus, OPTrust has made a concerted effort to build an environment to support and propel investment innovation.
In 2015, OPTrust launched our Member-Driven Investing (MDI) strategy. The strategy has a clearly defined investment objective that is fully aligned with the best interest of our members – delivering pension certainty. This innovative approach transformed the Plan’s investing philosophy and portfolio management framework from solely focusing on value-add generation (or outperforming benchmarks) to focusing on total portfolio construction and management against liabilities. OPTrust was one of the few global institutional investors who made early and courageous moves to adopt a Total Portfolio Approach (TPA).
To build the right culture and mindset to foster innovation, we started by including ‘innovation’ as a core component in our investment philosophy and beliefs.
Support from leadership was also critical to the success of our innovation journey. Innovation requires idea generation and in-depth research. To achieve this, we have developed an internal process to facilitate collaboration on our key annual investment research initiatives across the organization. More importantly, this process was designed to incentivize innovative idea generation and in-depth research from the bottom, especially from those highly motivated and skilled junior team members. Our culture of encouraging ‘speaking-up’ and ‘tolerance for mistakes’ have created a healthy ecosystem for innovative idea generation. To ensure that our team has the right mindset, we also put a lot of energy into our hiring process, to make sure we hire individuals whose mindsets and motivations are aligned with our own. Finally, innovation is built into each individual’s annual performance goal-setting and evaluation to drive the right behaviour.
Innovation is a journey, and it happens every day at all levels of our portfolio. We will continue to improve our culture and lever up our internal capabilities and our external relationships to advance our investment research and innovation. We believe this is key to delivering on our mission for our Plan members.
Institutional Connect: How are your fund’s asset mix strategies positioned for the currently low interest rate and potentially rising inflation environment?
Kevin: At the beginning of 2020, we were already in a challenging investing environment that has since been amplified by the COVID-19 pandemic. Bond yields have been driven to historical lows. This poses significant challenges to most pension plans’ portfolios that have heavily relied on fixed income historically for three main reasons:
2. Liability-hedging; and
3. Equity tail risk hedging (in deflationary environment).
However, with rapid declines in interest rates to their current levels, all those benefits of holding fixed income have diminished significantly, making it difficult to justify a sizable allocation to bonds in this environment. Furthermore, unprecedented policy responses since the onset of the COVID-19 crisis, both on the monetary and fiscal sides, have shifted the key macro risk from deflation to inflation – the macro regime that is typically detrimental to nominal fixed income. For those reasons, we made significant adjustments to our portfolio at the end of last year by reducing a sizable amount of our nominal fixed income exposures.
Inflation is one of the most discussed topics of the current environment. To OPTrust and our members, inflation is clearly a risk, however, how this risk will transpire and how capital markets are going to respond is much less clear.
Historically, there have been two main types of high inflation regimes (one of which being much more detrimental to the economy and markets than the other). Under one regime, when high inflation was accompanied with strong economic growth, most risky assets tended to fare well. Under the other regime, however, when high inflation occurred with low economic growth, risky assets were generally negatively impacted. This latter more adverse inflationary environment is the risk we should be concerned with.
From this historical perspective, one of the key drivers to differentiate those two inflation environments is policy responses, and aggressive policy tightening to fight inflation has typically triggered significant economic slowdown. However, in the current environment, we are in uncharted territory, and there remains a lot of uncertainty regarding how the macro environment will transpire over the next few years.
While we recognize inflation is a rising risk, we have been very thoughtful about portfolio strategy adjustments in a more holistic way rather than biasing our views towards one specific macro scenario or risk. With that in mind, our focus has been on developing what we call “regime-agnostic” risk-mitigation strategies, and those strategies are designed to reduce severe market drawdowns, regardless of the causes. In other words, our hedging strategy design is goal-driven (i.e., mitigating risky assets’ severe drawdowns) rather than cause-driven (i.e., inflation or deflation).
We are increasingly using a data-driven approach in the design of those strategies to further remove potential biases in the decision-making process. We believe this innovative approach will help us make better decisions, and ultimately, deliver long-term pension security for our members.
Institutional Connect: Climate change risks are impacting on the long-term investments for institutions. How is your organization addressing climate risk factors in portfolio construction processes?
Kevin: Climate risk has now been widely recognized by global investors as one of the critical long-term systemic risks to portfolios. There are two main types of risks related to climate:
1. Physical risk – the risk associated with physical damages to different sectors of the economy due to global warming effects; and
2. Transition risk – the risk associated with negative economic impacts on different sectors and companies as a result of government policies towards a ‘greener’ economy.
Similar to our peers, OPTrust takes this risk seriously. One of our key corporate initiatives this year is to renew our climate strategy. The work is still ongoing, and it is a truly collaborative effort across the entire organization.
We are taking a holistic and practical approach to ensure our climate strategy is fully aligned with our mission and objectives, while at the same time accountable and achievable. We are using a top-down and bottom-up combined approach to make sure our climate strategy is developed from a total portfolio perspective. From a top-down standpoint, we are using a climate scenario analysis in our asset-liability framework to help understand and communicate the key impacts of different climate pathway scenarios on the Plan’s funding risk, as well as their impacts by asset classes, geography, sector and time horizon. The bottom-up approach is to look at individual asset class portfolios to understand their current climate risk profiles.
In the end, the top-down and bottom-up analyzes will be put together to help make informed decisions on our climate strategy.
Institutional Connect: The market volatility triggered by COVID has amplified the importance of risk mitigation strategies in total portfolios. What is OPTrust’s approach in managing risks?
Kevin: The current low expected return environment combined with our Plan maturity poses challenges to the Plan’s sustainability going forward. We must be innovative in our approach in order to deliver our target return, while effectively managing downside (or drawdown) risks to our funding. In terms of the ‘effectiveness’ of risk mitigation, we focus on both benefits and costs. On the benefit side, we look at the magnitude as well as consistency of drawdown protection, and on the cost side, we target our risk mitigation strategy to generate zero expected return in the long run. In other words, we do not want this strategy to become a long-term return drag to our portfolio.
We have developed and implemented a well diversified (left tail) cost neutral Risk Mitigation Portfolio (RMP) with a clearly defined objective to mitigate severe drawdowns from our Return-Seeking Portfolio (RSP). This portfolio went through a real-world test during the pandemic-induced market sell-off last year, and it delivered the needed protection to our total portfolio. Currently, our risk mitigation research focus is moving in the direction of developing data-driven systematic strategies as part of the ongoing RMP enhancement. Early this year, we have implemented our first AI/machine learning-based systematic strategy for equity tail risk protection.
These are just a few of the innovative approaches we are taking to ensure the long-term sustainability of the Plan, and subsequently, our members’ retirement security.
Leo Kolivakis, Pension Pulse editor, wrote a further featured article, which can be viewed at: http://pensionpulse.blogspot.com/2021/09/optrusts-kevin-zhu-on-innovation.html