Canadian fund OPTrust employs a risk mitigation portfolio to help protect the fund from the worst volatility that can be experienced in growth assets, and it has proven quite resilient during the recent turmoil.
OPTrust, a C$22 billion (A$24 billion) Canadian pension fund, has managed to limit the impact of the financial crisis caused by the coronavirus by using a risk mitigation portfolio that aims to balance out the volatility caused by its allocation to growth assets.
OPTrust’s Risk Mitigation Portfolio
This portfolio contains a mixture of defensive strategies that help the fund in its member-driven investment (MDI) approach.
“What I can tell you is that in our risk mitigation strategy we are up over 30 per cent year-to-date,” James Davis, Chief Investment Officer at OPTrust, says in an interview conducted with [i3] Insights at the end of April.
“We are really pleased because that helped to mitigate the losses in our return-seeking portfolio and it has really helped to make our portfolio more resilient.
“Trend following is part of that portfolio. We own gold, we own defensive currencies and we own TIPS (Treasury inflation-protected securities) and long-term US Treasury bonds as well. It is quite diversified and we continue to do a lot of research on that.”
Trend-following strategies are an important part of a risk mitigation strategy, but the implementation of this is key as there has been quite a wide dispersion between the performance of different managers.
OPTrust applies trend following in a number of different ways, Davis says.
You have to keep in mind that trend following has not worked very well since the global financial crisis. And this may very well be one of the longest periods that we’ve seen in history where trend following has not performed particularly well
“We do it across individual securities and then we do it across time in single asset classes. Where we probably use trend following the most is in our risk mitigation portfolio. It has been very successful and it has performed well in this crisis,” he says.
“But you have to keep in mind that trend following has not worked very well since the global financial crisis. And this may very well be one of the longest periods that we’ve seen in history where trend following has not performed particularly well.
“It keeps us mindful and humble that no matter what strategies we are looking at and no matter how smart we think we are, there will always be periods of time that we will experience underperformance in any particular strategy.
“So it is important to look at the portfolio from a total portfolio perspective and not just on a strategy-by-strategy perspective.
“All that being said, I think trend following is poised to do well in the future because I think what we are seeing in terms of the policy response, both from a fiscal and monetary perspective, is unprecedented, highly significant and likely to lead to more trends in markets. Trend following can help to take advantage of that kind of environment.”
OPTrust Plans to Build on Machine Learning
OPTrust has been looking to expand its risk management approach by incorporating machine learning techniques and has conducted research to see if these provide benefits at the total portfolio level.
“We are doing research to see if we can add a dynamic component to our risk mitigation portfolio that is partly driven by machine learning technology,” Davis says.
“In the risk mitigation portfolio, we are trying to make that as systematic as possible and we think that machine learning will complement that very well. So we’ve been using some specialised, reinforcement learning type of strategies that are now under development and so we are not using them live in the overall portfolio yet, but we see significant promise in that.”
He sees the risk mitigation portfolio as a way to stay invested in risky assets during periods of volatility and ensure the fund remains fully funded.
There is a simple logic behind this, which is that, generally speaking, it is very hard to time markets and so we like to sit and collect or harvest risk premia over time. We don’t like to sell assets that generate risk premia and give that up, especially in the private markets
“There is a simple logic behind this, which is that, generally speaking, it is very hard to time markets and so we like to sit and collect or harvest risk premia over time. We don’t like to sell assets that generate risk premia and give that up, especially in the private markets,” he says.
“We’d rather hold those assets and then overlay them with risk mitigation strategies that are cost-effective when it makes sense for us to do so.”
As a result, OPTrust’s approach to machine learning is predominantly risk focused.
“It looks at a number of different types of defensive asset classes and strategies, so those that tend to do well in deflationary or stagflationary environments. And we look at a lot of different data and we look at a lot of different risk management algorithms within the overall machine learning process,” Davis says.
“It is not just: ‘Mine the data and tell me what to do.’ A lot of it is built on the same basis that you would have for any systematic strategy. And again, it is very risk-centric. We are always focused on not just the risk of holding a particular asset, but also the risk that our expectations may not come to fruition.
“We try to quantify how uncertain we are in the estimates that we’re making and the more certain we are, then the more likely we are to use a larger size in the overall process.”
Currently, the machine learning strategy for risk mitigation is still under development, but OPTrust is planning to run small amounts by eventually including it in its broader incubation portfolio.
“At this point it is relatively new for us. We run an incubation portfolio as well, which runs very small-sized strategies across different types of assets and the objective there is to learn. We do them without having to worry that if they are not working that we are going to significantly and negatively impact the performance of the overall portfolio,” Davis says.
“I could see these particular machine learning algorithms potentially going into production in very small size in that portfolio first, possibly before the end of the year.”
OPTrust Allocation to Liquid Alternatives
As part of its efforts to diversify risk, OPTrust also has an allocation to liquid alternatives, but the results from these strategies have not been quite as good as what the team had been expecting.
“I would mention that it has been a more challenging space than we expected partly because of the low-growth environment. Where I think alternatives can be most helpful is in risk factor diversification. So we are still a huge believer that a risk factor approach is critical to the success of our MDI strategy,” Davis says.
“The value factor has really been punished since the global financial crisis and that is simply because we are in a low-growth environment and if you want to earn returns you have no choice but to focus on growth. So value has typically been penalised and that has weighed on factor diversification.
“Our results have been mixed. What we have concluded from that is that within certain strategies there are probably some disruptions occurring and so the results depend very much on which manager and what time period you are looking at.
The value factor has really been punished since the global financial crisis and that is simply because we are in a low-growth environment and if you want to earn returns you have no choice but to focus on growth. So value has typically been penalised and that has weighed on factor diversification.
“We are doing this externally, not internally, and some of these disruptions are probably happening because of changes in technology. Some of the advantages that we have seen that have accrued in that liquid alternative space have been due to having technology available to execute in very short time horizons in order to minimise execution costs.
“That allows you to diversify into much shorter time frames. But I think the low-hanging fruit around that has been picked and many people in that space are competing, so that is disappearing.
“But, of course, there will be technologies and new approaches, including some using machine learning, that will replace those kinds of strategies. So our investment team is constantly looking at different options or different alternatives in the hedge fund space, in the liquid alternatives space and developing new relationships. And we are finding some good opportunities.
“Some of our focus is towards smaller managers, managers that are in niche spaces and in seeding new managers. So we are doing some of that as well.”
OPTrust’s risk mitigation strategies do help with boosting the liquidity profile of the fund and it has remained liquid at a time when many other institutional investors are struggling to do so.
“First and foremost, when it comes to liquidity, I’d like to say that we have liquidity by design. So one of the things that we did when we put the member-driven investment strategy in place at the end of 2015, was to say: ‘We want to diversify our risk factor exposure as much as possible and we want to have an abundance of liquidity,’” Davis says.
“That abundance of liquidity was there as insurance, but also to allow us to be able to capitalise on market opportunities. In fact, in this particular period, our liquidity has remained well above the level that we feel comfortable with.”
OPTrust not Revaluing Unlisted Assets
OPTrust is a proponent of the Canadian Model and as such has significant allocations to unlisted assets. The fund has not revalued these assets yet and isn’t planning to bring valuations forward, as some of the Australian funds have done, Davis says.
“When we make investment decisions, we are making them over the long term and one of the biggest benefits of being in unlisted assets, such as private equity, infrastructure and real estate, is that the deal teams are not distracted by market noise,” he says.
“They can stay focused on business fundamentals and value creation and this will pay off for our members over time.
“But the reality is that there isn’t enough visibility in the current economic environment to draw any conclusions as to what the fair value of those assets should be. In fact, it appears as though Australia may be experiencing a relatively quick recovery from this COVID crisis and so could see a limited impact on unlisted assets.
“We do scenario analysis, but we mark-to-market our portfolio when we have real valuations and so some of our funds will value at the end of March or June, but most of our direct holdings we won’t value until the end of the year.”
However, OPTrust does run scenario analysis to see what a crisis would mean for the portfolio, including its holdings in unlisted assets. These scenarios have included a drawdown of the magnitude we saw earlier this year due to the coronavirus. Davis is, therefore, confident unlisted assets won’t jeopardise, but instead will contribute to, the team’s mission.
“We work very closely with our portfolio businesses so that we understand for each individual business where the challenges and opportunities are. The objective is to minimise the probability that our members might have to experience a contribution rate increase any time over the next 20 years. By that, we are first and foremost focused on a long-term horizon and we have to be sure we are managing the risks that might occur while we are on our way to the long term,” he says.
“What we want to be sure of is that we are earning the return needed to keep the plan sustainable at the lowest risk possible, because if we didn’t, if we earned an insufficient return or experienced outsized losses, then we are almost guaranteeing that our members have to pay higher contributions. But I am very pleased to say we are fully funded and in a strong position to deliver on our mission for the long term.”