5 Questions for OPTrust CIO James Davis

OPTrust CIO talks internalization, smart beta and the risks of complacency.

March 27, 2017

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As part of a new series of interviews in Canadian Investment Review, I sat down with OPTrust chief investment officer, James Davis, and asked him five key questions about what his fund is working on right now what he thinks the big risks facing investors are today.

OPTrust is focused on moving asset management in house – why and what are the challenges?

When we introduced our member-driven investing initiative back in November 2015, one of the key enablers for us was internalizing some of our public market asset management – not just the operational capabilities but internal skills as well.

Since member-driven investing is all about managing risk better, direct access to the markets allows us to customize our investment strategies and be more agile and nimble in execution. We also get better access to information on what’s happening in the market and how investors are responding to it. Internalization helps us separate the signal from the noise – it gives us a better read on where the market is headed.

But there are challenges – one is making sure we have the right skill set in-house. Some of this is operational but we have service providers to take on the middle and back office – and we manage the front office internally. Another challenge is cultural change – we are moving in a direction where we are held more accountable for managing total fund risk rather than having a manager doing it within an asset class with a value add objective. For us, it’s about the funded status of the plan and that goes beyond value add. It means we now focus on making sure we earn the returns we require for the risk we are taking, while not taking so much risk that we jeopardize stability of contribution and benefit levels. We use our read on what’s happening in public markets to help us understand and manage risk better.

What do you mean when you talk about separating the signal from the noise?

Information asymmetry is key in asset management – that means getting access to information that explains why markets are doing what they are doing. And information helps identify opportunities to position yourself in the context of the market environment.

You’re in a much better position to manage risk and improve returns – that direct interface with the market is akin to what they call being close to the coal face. I come from Cape Breton and the coal mining analogy is apt here. As an example, having good information worked when we saw a widening in credit spreads in early 2016. Our information showed us that low oil prices were having an impact on Middle East investors who, in turn, were liquidating credit positions in their portfolios. Without that information, we could easily have interpreted widening credit spreads as an indication that the world is falling apart and that equities were falling as the world shifted into risk off mode.

Having this kind of information can help long-term investors step in and take a position – in that case it helped us understand the market and to manage risk more efficiently.

Buffet recently blasted 30-year bonds – how have pension funds, including OPTrust, responded to challenges in the bond space? And do 30 year bonds still make sense for them?

I have all the respect in the world for Warren Buffet as one of world’s greatest investors — but his objectives are very different from those of OPTrust and most DB plans. We have liabilities that are sensitive to interest rates so investing in bonds helps mitigate that sensitivity. One way of looking at bonds is as an insurance contract as opposed to an investment contract — for those of us who need to mitigate interest rate sensitivity in our liabilities, we will look at that in the context of the stability of our funded status. And we will accept a lower rate of return in exchange for that.

That’s the asset-liability view of bonds. From an asset-only perspective, bonds are an excellent hedge against deflation. They are one of the best performing assets in a deflationary environment. I was a bond trader early on in my career and my boss would ask why would anyone own Japanese bonds when they were only yielding two and a half percent. But for decades after that, Japanese bonds turned out to be one of the best performing asset classes.

The reality is that you don’t know what is going to happen – holding bonds are a way to ensure you continue to invest for the long-term in a well-balanced portfolio.

OPTrust recently stepped up its commitment to smart beta – why? And is overhyped?

Smart beta fits into our strategy of managing risk more efficiently. Smart beta actually segregates the equity risk factors so that you can gain exposure to those risk factors you think are most important for your portfolio – as opposed to an overall market cap index like the S&P 500, wherethese risk factors are not balanced. In a market cap index, you don’t have control of the exposures you’re taking because you’re merely accessing what everyone else wants.

For us it’s about customization – it’s about tailoring our equity portfolio so we are getting risk factor exposures in the amounts that are most appropriate for our portfolio.

As for whether it’s overhyped – it depends on why and how you’re using it. There’s smart beta – and there’s smarter beta. We aren’t trying to time the market or risk factors – we are trying to get as much diversification in the portfolio as possible.

What is the number one risk you see brewing in the market today?

Complacency. When I look at the markets today I see how expensive assets are in an environment where there is a lot of uncertainty. That uncertainty is compounded by political and geopolitical risk. You just have to look at some of the uncertainty around potential policies in the U.S. around trade and protectionism. There are also elections coming up in Europe over the next six months and uncertainty in the Korean peninsula. Combine this with an environment where fiscal policy is on the front burner – the U.S. economy is close to full capacity which means a potential for inflationary pressures. How will the Fed react to that and what will the pace of monetary tightening be? Rising rates in an overvalued market is a high-risk environment. Couple this with the impact on the U.S. dollar, which is likely to be stronger and less competitive and you have an explosive mixture.

Complacency has translated into low volatility. We track the VIX index as a measure of volatility and it’s near cyclical lows. So, at a time when valuations are high and interest rates are rising, this has us very concerned.

Inflation or deflation or reflation? What is it?

I might be dating myself when I say, this is the $64,000 question. We don’t know if all of this will translate into an inflationary environment. In fact, it could translate into stagflation, where we get inflation without growth. Or we could even revert to where we were a year ago with fears of deflation. It depends on how policy evolves in the U.S. – how confidence evolves. Add into the mix uncertainty in Europe and Asia and you really do have several potentially different outcomes.

All this uncertainty creates opportunities — but also risks. The best thing a portfolio manager can do is make sure you can weather it. That means a well-balanced portfolio where you’re capturing as many risk premia as you can — as the fog clears be willing to step up and take advantage of low risk opportunities as they arise.

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