Insourcing asset management is often driven by cost and capacity considerations.
“There are many reasons why managing assets internally makes sense, of course the obvious one is that it is very cost-effective if you have the scale to do so,” Davis says in an interview with [i3] Insights.
“But it also allows you to tailor the portfolio to what you need to make sure you meet your liability obligations. Internal asset management from a member-driven investment perspective is critical,” he says.
OPTrust is Ontario’s fifth largest public sector pension fund with CAN$ 18.4 billion in assets under management.
The defined benefit scheme is fully-funded and its main aim is to remain so, Davis says.
“Our members tell us that they want pension certainty; they want to know that they are going to receive their pension as promised and at the contribution rate that was agreed to.
Through strong relationships and partnerships, you can identify opportunities and we are very selective about those opportunities, but it means you’ve got to have the skill in-house to do that. It takes time to build that up and you have to have a certain amount of scale.
“If you think about that, you’ve got a very tall deliverable in this challenging investment environment and it is even more challenging for a mature pension plan like ours where your ability to take risk is somewhat restrained,” he says.
Davis says the fund needs to earn a rate of return that is sufficient enough to pay pensions today and into the future, but at the same time avoid taking so much risk that the sustainability of the fund is at risk.
“We don’t want to have to go back to the members and say: ‘Well, the markets are bad and these are turbulent times and now we have to make an adjustment to benefits or contributions’.
“So by taking into account the funded status and volatility, we are bringing investment decisions in alignment with what members want, which is certainty,” he says.
Getting paid for taking risk
A member-driven investment model is all about risk management and in the current environment it means ensuring that the fund is compensated adequately for taking risk.
“It is not about traditional asset allocation anymore. When we take risk, we need to make sure that we are actually getting paid for taking that risk.”
“You can say: ‘I need to earn a 6 per cent rate of return between now and the next 20 years to keep the plan sustainable’.
“But that doesn’t mean that you need to earn 6 per cent each and every year, it means you need on average 6 per cent.
“So if you feel you are not getting paid with risk premiums being so low, then is this the time to be taking that risk or should you be prudent and pull back on taking that risk?
Today, many institutional investors feel that infrastructure assets have become expensive as more people are searching for yield. In some cases, this has led to investors taking on higher risks to get the desired rate of return.
“What I find is that people are focusing more on return targets, going out into the market in search of that return and taking whatever risk is necessary to get that rate of return,” he says.
“We actually flip it on its head: member-driven investing is focused more on targeting risk, not targeting return.”
“It doesn’t mean that you won’t invest in infrastructure, but it means you have to be more thoughtful and deliberate in pursuing those assets. It is a marriage between being opportunistic and thoughtful in your decisions.”
“Diversification is where it all starts; you need to be as diversified as you possibly can.”
Internalising asset management at OPTrust
Managing assets in-house is an important part of executing OPTrust’s member-driven strategy, Davis says, and the fund has been managing a significant portion of its assets in-house for the greater part of a decade.
Yet, in contrast to the recent efforts of some of the Australian superannuation funds, which focussed on equities, OPTrust started with illiquid assets, including infrastructure, real estate and private equity.
“Part of it is a function of where it gives you the most cost-effective and attractive opportunities,” Davis explains.
“Let’s take public equities for example: insourcing a public equities portfolio is costly in the sense that you have to have a lot of analysts covering a lot of different stocks in a market which for the most part is quite efficient.
“So you’ve got to ask yourself: Is that really where I want to put my internal resources or can I put my internal resources in those places where the market is less efficient?
“I believe in the private markets – in the illiquid, alternative space – the markets are less efficient.
“Through strong relationships and partnerships, you can identify opportunities and we are very selective about those opportunities, but it means you’ve got to have the skill in-house to do that.
“It takes time to build that up and you have to have a certain amount of scale.
“Then there is the low-hanging fruit, like foreign exchange hedging or managing a government bond portfolio, that is the type of thing you would want to be doing in-house anyway, because you can do it cost-effectively, and also because you get a window on the market in doing that.
“You get to talk to the street; those that are actively engaged in the market to find out how the market is responding to news. What is the risk appetite out there?
“That helps you in assessing what the overall market profile is like and it gives you a better indication of how you can manage your risks,” he says.
OPTrust has now decided to insource public markets as well, including fixed income, foreign exchange, hedge funds and derivatives.
“We are embarking on a process to internalise our public market activities: we are going through that process right now.
“Outsourcing your public market activities makes managing risk very challenging.
“At the end of the day, if you, in this challenging environment, hope to be nimble and react to changing market conditions you need to be managing those public market assets internally. This is the next step in our evolution of how we manage risk,” he says.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.