Reprinted with permission from:

December 2019 Issue

MONITORBenefits and Pensions

Low Return EnvironmentPrompts Different Approaches

PENSION RINVESTMENT TRENDS 2019

BENEFITS AND PENSIONS MONITOR

MEETINGS & EVENTS

As pension plans mature and with new regulatory con-straints, plan sponsors are con-stantly seeking new investment opportunities to generate the

returns they need to match their liabilities. Compound this with the low yield environ-ment and it poses problems with portfolio construction to unlock reliable alpha

At the Benefits and Pensions Monitor ‘Pension Investment Trends’ Meetings & Events session, David Onyett-Jeffries, Vice President, Multi Asset Class Solutions, at Guardian Capital LP; Margaret Childe, Director, Environmental, Social and Gover-nance (ESG) Research and Integration, at Manulife Investment Management; Erwan Pirou, Associate Partner and Canada Chief Investment Officer at Aon; and David Ross, Managing Director, Capital Markets, at OPTrust; discussed a variety of current pen-sion investment approach, to find the return they need.

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To generate future, sustainable perfor-mance and long-term returns, “I’m going to introduce a fairly novel idea to the in-vestment community ‒ focusing on high quality companies and holding them for a long time,” said David Onyett-Jeffries, Vice President, Multi Asset Class Solutions, at Guardian Capital LP.

Since the 1960s, the average turnover of stocks has been shrinking consistently. “We’re seeing shorter and shorter holding periods as people focus on short-term fluc-tuations and prices.” Yet, the actual under-lying fundamentals of companies and the economy in which they operate don’t really change that much.

And “when you actually take a step back and focus on not the individual trees, but the forest, there’s a huge difference,” he said. These small points, which may be a huge deal on a day-to-day basis, “don’t actually

matter much in the grand scheme of things.” Yet, to take a long-term view, “you have

to block out that noise.” With equity port-folios, stocks go up. Other than a couple of periods in and around the 1980s and around the 2000s where things flat-lined, in general, markets go up. So “if you were simply to buy and hold an asset, you’re going to see posi-tive performance over time,” said Onyett-Jeffries. 

‘Forever’

For example, if an investor had bought and held on January 4, 1988 and then sold at the end of December of last year, annu-

alized performance is about seven per cent. If, however, they happened to be out of the market for the 10 best days of those 8,000 trading days, the annualized performance drops by two percentage points per year. This is why investors like Warren Buffet say that their ideal holding period is “forever,” he said.

A study by Martijn Cremers, a professor of finance at the University of Notre Dame’s Mendoza College of Business and a Kellogg Institute Faculty Fellow, bears this out. Over a 25-year period from 1990 to 2015, those with the longest holding periods were, net of fees, sizeably able to outperform the shortest holding periods.

Not only does this long-term focus yield better results, combined with high active share (a measure of how different an equity portfolio is from its benchmark) and this outperformance becomes massive.

BENEFITS AND PENSIONS MONITOR | DECEMBER 20191

PENSION INVESTMENT TRENDS 2019

BENEFITS AND PENSIONS MONITOR MEETINGS & EVENTS

Low Return EnvironmentPrompts Different Approaches

Quality & Time

Benefits and Pension Monitor: Pension Investment Trends

November 14, 2019

David Onyett-Jeffries, CFA, MAVice President, Multi Asset Class Solutions, GCLP

From the left, Margaret Childe, Director, Environmental, Social and Governance (ESG) Research and Integration, at Manulife Investment Management; David Onyett-Jeffries, Vice President, Multi Asset Class Solutions, at Guardian Capital LP; David Ross, Managing Director, Capital Markets, at OPTrust; and Erwan Pirou, Associate Partner and Canada Chief Investment Officer at Aon.

The best way to generate active share is concentration. Shrinking a portfolio from 250 stocks makes it different from a bench-mark because it doesn’t hold a lot of the same names. “Now intuitively, this outper-formance makes sense. If you are an invest-ment manager and you are able to go and fo-cus on your best ideas, your best of the class, your high conviction strategies and ignore those ones you don’t have a lot of emphasis on, those would be the better performing stocks,” said Onyett-Jeffries. And it needs to be emphasized that concentration doesn’t mean added risk since the benefits of reduc-ing stock-specific volatility are pretty much maxed out at 20 stocks. This is actually in contrast to what is taught ‒ “when you think back to your Finance 101 class, the idea was hammered home that more stocks provide a better risk adjusted performance because it decreases the overall risk of portfolio.”

One strategy that has consistently

worked is buying quality companies. Over a 30-year period where there were three very sharp bear markets, the relative outperfor-mance of quality was amplified. These are fairly boring companies, he said. They have sustainable and stable earnings growth, low leverage so they’re not exposed in changes of cost capital, and they have a high return on equity. These are companies that generate their own internal profits and, over a longer period of time, their performance is quite at-tractive.

Smooth Out Ride

And while financial markets in general are a roller coaster ride in terms of volatil-ity, one of the characteristics of these quality strategies is they actually smooth out that ride.

These portfolios are also not impacted by interest rates. “There’s a lot of concern about interest rates right now. They’re going

up, they’re going down,” he said. However, with quality strategies, the emphasis is on low leverage so they don’t really care about cost of capital. When rates go down, quality outperforms. When rates are going up, be-cause these companies aren’t pegged to cost of capital because of excess leverage, they outperform as well.

“From my perspective, it seems like a slam dunk, no brainer sort of investment approach, especially when you’re focused on the long run,” he said.

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The early inception of Sustainable and Responsible Investing often manifested itself in the form of negative screening on investments in tobacco, alcohol, and weap-ons, for example. It’s important to remem-ber, however, that it was in 1970 that Milton Friedman argued that companies’ sole pur-pose was to generate money for sharehold-

ers and businesses’ with a social conscience could be less competitive and put sharehold-ers’ profits at risk. “So these early pioneers in sustainable investing were really going against the grain,” she said.

Today, the Sustainable and Responsible market has matured, with $30.7 trillion in assets under management (AUM) marked as sustainable assets globally at the start of 2018, a 34 per cent increase from two years prior. The momentum is also evident with markets talking about ESG. “We now have over 2,300 signatories to the UNPRI (Unit-ed Nations Principles of Responsible Invest-ing). And it’s during this maturation phase that we see a focus on reporting frameworks that look at the materiality of ESG,” said Childe.

Comparable Financial Data

To provide an example of how the field of Sustainable and Responsible Investing

is maturing, one trend being seen is the increased use of SASB (Sustainability Ac-counting Standards Board), a framework that tries to look at industry specific ESG topics to facilitate a communication be-tween companies and investors. “SASB aims to establish industry-specific disclosure standards across environmental, social, and governance topics that facilitate commu-nication between companies and investors about financially material, decision-useful information which is relevant, reliable, and comparable across companies, on a global basis,” she said.

The Task Force on Climate-Related Fi-nancial Disclosures also had a big impact when it released its recommendations that focused on very strong governance practices for the reporting of climate-related financial disclosure. The focus is for companies to dis-cuss climate risk in terms of the governance at the board level and the management in-

volvement of that governance, strategies for managing those issues, the process in which issues are included in the overall risk man-agement of the company, and the extent to which metrics and targets are used to report on this information.

A shift in regulatory focus toward sus-tainable finance is also being seen. For ex-ample in the EU, the action plan focuses on the idea of a sustainable taxonomy where to qualify as an environmentally sustainable activity, companies must substantially con-tribute to one of six environmental catego-ries ‒ climate change adaptation, mitigation, sustainable water use, circular economy, pol-lution prevention, and healthy eco systems.

Another important part of the EU action plan is the development of climate transi-tion benchmarks. However, “Canada is also developing its own transition benchmarks that apply more specifically to our resource-based economy,” said Childe.

2DECEMBER 2019 | BENEFITS AND PENSIONS MONITOR

PENSION INVESTMENT TRENDS 2019

BENEFITS AND PENSIONS MONITOR MEETINGS & EVENTS

Presentation to Pension Investment Trends

Prepared by Aon

14 November 2019

Presentation to Benefits & Pensions Monitor:

Pension Investment Trends

Erwan Pirou, CFA

Prepared for Pension Investment Trends

Margaret ChildeDirector of ESG Research and Integration, Manulife Investment Management

For a discussion of the risks associated with this strategy, please see the Investment Considerations page at the end of the presentation.

Integrating Climate Risk Management

into the Investment Process

November 2019

The science confirms the threat of cli-mate change. The earth has warmed signifi-cantly over the past 100 years. “In 2018, we experienced the hottest year on record and the top three warmest years have all oc-curred in the past decade. What we know is the magnitude of actual warming and other effects will depend upon the level at atmo-spheric concentrations of carbon dioxide and other greenhouse gasses. Scientists have modeled the results of a projected doubling of accumulated CO2 in the earth’s atmo-sphere and some of the negative predictions include a loss of land in coastal areas due to sea level rise, disruption of water supplies to cities and agriculture, and the spread of tropical diseases.

From the investor perspective, “these uncertainties and the impacts from climate change need to be kept in mind when we’re trying to evaluate the economic impacts globally,” said Childe.

However, financial modelling is playing catch up to science in understanding the cli-mate value at risk (CVaR) for an investment portfolio. There are multiple approaches to doing this, but many of the models have their own drawbacks.

One model ‒ the Carbon Delta CVaR ‒ aims to understand how climate risk can be assessed at the level of individual securi-ties as well as the aggregate level in terms of portfolio construction.

Physical Impacts

The model takes into account the physi-cal impacts from climate change, looking at both the chronic risks and the acute risks. It also looks at the idea of transition risk ‒ the policy risk from regulations and technolo-

gies as well as changing consumer demand, investor sentiment, and disruptive business innovations. Finally, it looks at the oppor-tunity from the transition to a low carbon economy.

One of the lessons learned from this analysis is that active management may re-duce climate related risk exposure of portfo-lios, she said.

And an important consideration in ad-dressing climate risk for all investors is that this can’t be done by one investor or by one stakeholder alone. It really has to be a multi-stakeholder collaborative approach, she said.

●●●

Looking at historical returns for bonds, everything looks great for the past year, said Erwan Pirou, Associate Partner and Canada Chief Investment Officer at Aon.

For one year to October 19, the return was over 10 per cent.

And one way to predict bond returns is to look at the current yield to maturity. Yields are very low today and Aon’s 10-year return assumption for Canadian all maturity bonds is 1.7 per cent. For corporate bonds, it’s a little bit higher at 2.4 per cent. But these are nominal returns, they don’t include inflation. If you adjust for inflation, you get negative returns, he said.

Inflation linked bonds may sound like a better option, but negative real yields on these means that Aon’s return expectation is only 0.8 per cent over the next 10 years. The lower return is because most real returns bonds are federal bonds, so there’s no credit premium and they have longer maturity and, therefore, are more vulnerable to rising in-terest rates.

For Pirou, Core Plus is a better option. It opens the set of opportunities because in-stead of telling a manager to only buy bonds in the benchmark, “you’re saying we’re going to keep the Canadian benchmark, but you can still go outside if you think a different part of the market is going to provide better risk adjusted return,” he said.

Opportunity Set

While the opportunity set is reason-ably wide ‒ U.S. high yield, U.S. investment grade, European debt, mortgages, rates, or currencies ‒ “you won’t necessarily do all of these” he said. The majority of the Core Plus holdings will still be Canadian because the benchmark is Canadian. It’s only a small portion that gets invested in the “Plus” sec-tors.

Looking at the Core Plus peer group, the relative performance numbers are bet-ter than Core. “Historically, you were almost guaranteed to outperform,” said Pirou.

One benefit of this approach is that most active managers have been able to add value consistently, even net of fees. And while fees are a little bit higher for Core Plus than they are for Core, they are actually quite cheap, especially compared to U.S., UK, or Euro-pean Core Plus. “You only pay a few extra basis points and you get much higher re-turn,” he said.

And it’s not surprising as by letting man-agers have more ways to add value, it gives them the autonomy to buy a different type of the market if they don’t, for example, like high yield.

Although tracking error is higher be-cause assets outside the benchmark are be-ing bought, “the question is, do you care

BENEFITS AND PENSIONS MONITOR | DECEMBER 20193

PENSION INVESTMENT TRENDS 2019

BENEFITS AND PENSIONS MONITOR MEETINGS & EVENTS

Margaret Childe, Director, Environmental, Social and Governance (ESG) Research and Integration, at Manulife Investment Management

Erwan Pirou, Associate Partner and Canada Chief Investment Officer at Aon

David Ross, Managing Director, Capital Markets, at OPTrust

David Onyett-Jeffries, Vice President, Multi Asset Class Solutions, at Guardian Capital LP

unless you set the strategy as a way to hedge your liabilities and you really want this eight-year duration that is in the benchmark? Quite often, you don’t,” he said.

“What you care about more is volatility on an absolute basis.”

Quite Aggressive

However, going Core Plus doesn’t neces-sarily increase the volatility for the median manager. Although some Core Plus manag-ers are quite aggressive and have a really high allocation to high yield which can drive vola-tility higher, the majority are more sensible. Volatility can be managed through diversifi-cation by investing in assets not perfectly cor-related with Canadian fixed income.

A drawback of Core Plus is lower liquid-ity, although if “I invest in U.S. investment grade, that is probably more liquid than the Canadian benchmark. However, if I buy high yield, if I buy emerging markets, it might be more difficult to redeem if you are using this allocation as a source of liquidity in your portfolio.”

Core Plus also comes with greater com-plexity because of the greater use of deriva-tives, “so you’ve got to be comfortable with that. Most of our clients allocate to Core Plus using pooled funds, so they don’t have to manage all of the portfolio and derivative complexity,” said Pirou.

●●●

For one of Canada’s largest defined ben-efit pension plans, investing in a low-return environment is no easy challenge.

According to David Ross, Managing Di-rector, Capital Markets, at OPTrust, low in-terest rates, shifting geopolitical forces, and a challenging macro-economic environment are all factors causing OPTrust to take an in-

creasing strategic approach to delivering on its mission of paying pensions today, preserv-ing pensions for tomorrow.

In detailing the current macro-economic environment, Ross noted that developed market yields are close to 50-year lows. One of the reasons for the decline is the rise in the global savings rate over the last 15 years, increasing from just over 22 per cent to just under 27 per cent now. This is swamping the available investible assets and depressing as-set yields.

He also noted that demographics and ris-ing income inequality are both impacting the supply of savings and the demand for private investment. The extraordinary monetary pol-icy in place since the global financial crisis is having an effect as well. Quantitative easing is driving up asset yields and putting money into the pockets of those with the highest propensity to save. “This effectively is not helping income equality and it is pushing the global savings rate higher,” he said.

Structural Shift

One thing that could change the back-drop is a structural shift. The entry of China into the global economy is one possible rea-son behind the rise in global savings. China’s savings rate has been quite high, but based on demographic projections, savings rates should begin to drop moving forward.

Positioning portfolios in this global, low-yield environment requires preparation for a policy response that could occur if the econ-omy slips into a recession. However, policy-makers are going to have to find a new tool kit, said Ross. That tool kit very likely needs to include fiscal policy. Investors need to prepare for a broader range of potential out-comes including future inflation, stagflation, or deflation if the policy prescription fails.

Many are arguing this is the time for gov-

ernments to borrow and invest in infrastruc-ture and greener technologies. If governments borrow at these negative real rates, “you don’t really need to generate much of a return to have a successful investment,” said Ross. “We start going down a rabbit hole when we think about a world where a government can get paid to borrow, but it does suggest that there is ample opportunity in this yield environ-ment for governments to borrow and spend.”

Another challenge is that the present extraordinary monetary policy has pushed expected returns down the risk spectrum. “This is a significant concern,” said Ross. “As an investor, it means when you take on risk, you’re not being rewarded with commensu-rate returns.”

Mature Pension Plan

As a mature pension plan with close to one retiree for every active member, this cre-ates a challenge for OPTrust.

“The key is to stay focused on our funded status,” said Ross. “The measure that matters to a pension plan’s members is the funded status. This is the benchmark that directly de-termines the plan’s ability to pay the pensions we’ve promised and OPTrust is fully funded.”

One of the ways OPTrust maintains this focus is through its portfolio construction.

According to Ross, OPTrust has close to 40 per cent of the fund in private assets ‒ in-frastructure, real estate, private equity. It uses public markets to complete that exposure and seeks to add value or alpha into the process.

“We want a portfolio that’s going to be suitable in all states of the world – an all-weather portfolio that is exposed to risk fac-tors that will do well in varying macro-eco-nomic outcomes,” said Ross.

“Pension plans deal in long-term horizons and we need to be prepared for whatever comes our way.” BPM

BENEFITS AND PENSIONS MONITOR WOULD LIKE TO THANK THE SPONSORS OF THIS EVENT

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