Why derivatives processing capability counts
Why derivatives? What makes these instruments so special for HOOPP as a pension plan? Deploying derivatives is not without cost or risk. An investment manager needs expertise and the right technology to deploy derivatives effectively and trouble-free. Derivatives are complex instruments to account and settle for especially in view of the recent regulatory demands we have seen.
At HOOPP, we deploy a wide range of derivatives including futures, options and swaps to generate an excess rate of return on our total investments without taking undue risk. To do this, we need the right investment strategy and the right investment management system acting in tandem.
Perspective on performance
Since its creation in 1960, HOOPP has developed into one of the leading pension funds in Canada. Serving as the main provider of pension services to the Ontario healthcare sector, it has risen to become the largest private pension fund in Canada with assets under management (AuM) totaling almost CAD 60 billion.
Strong double-digit returns propelled HOOPP’s 10-year average rate of return to more than 10%, one of the best long-term records among pension plans worldwide.
Liability-driven model as technology-enhanced investment strategy
Helping to account for this fast-paced performance is the way in which HOOPP structures its investment strategy with technology support. For several years now, HOOPP has implemented a liability-driven investment (LDI) strategy with technology-enhanced derivatives structures playing a pivotal role.
LDI requires modeling of both liabilities and assets, and the matching of cash flows, which in turn require technology support. The liabilities are modeled in terms of calculating what the cash flows look like, what interest-rate sensitivities are built into the liabilities, what inflation-rate sensitivities are involved, and also the demographic profile of our pension membership.
Against this is placed what we describe as a liability-hedge portfolio. One of the main parameters considered in this approach is interest rates: The lower they go, the more they drive up the liabilities – a 0.25 percentage point move in interest rates amounts to a difference of CAD 1-2 billion in shifting valuations.
The benefit of the liability-hedge portfolio is that most of the assets and liabilities move together so that if interest rates go up or down, the assets move accordingly and in tandem.
Return-seeking derivatives portfolio
On top of this, we have what we describe as a return-seeking portfolio, which includes equity overlays, hedges, alpha strategies, various equity-based strategies, private-equity instruments, cross-market arbitrage, etc.
LDI’s basic aim is to match assets with liabilities, to try to ensure we remain fully funded even in periods of market volatility. To achieve that, HOOPP invests heavily in long-dated bonds to make assets match more closely the long-term nature of pension liabilities.
But bonds simply do not earn enough to successfully fund a pension plan like HOOPP in the long term. To earn additional returns in an era of low-bond yields – and to further hedge risks – we also deploy a sophisticated derivatives strategy delivered with leading edge technology, using futures, swaps and other instruments to give the fund extra equity exposure without having to own a large traditional stock portfolio that is vulnerable to market volatility.
The fact that HOOPP is fully funded, at a time when other pension plans are struggling with funding shortfalls, has a lot to do with the decision to adopt the kind of LDI model we have selected.
How derivatives help HOOPP manage risk
The LDI model is hardly risk-free, however. HOOPP’s derivatives portfolio is huge, dwarfing its portfolio of stocks and bonds. Its array of derivatives contracts have a total notional value of around CAD 200 billion, including all the currency hedging and swaps that are layered together to protect its investments.
For HOOPP, derivatives serve as a precision-engineered risk management tool. The use of derivatives allows us to have exposure to risky assets, such as equities, with less risk for the pension fund. If you sell a bond and buy a stock, that’s a level of risk. If you instead use an underlying bond asset to have exposure to a stock, it’s a less risky way of equity exposure than direct ownership.
To this end, we use derivatives to cover our exposures and get a more effective control of risk than we could through a traditional equity and bond portfolio structure.
New system to match new strategy
Helping HOOPP to succeed where other pension plans have failed was the decision in 2004 to on-board a new state-of-the-art investment management system. The decision was based on the aim to reduce portfolio management risk and power the derivatives processing on which implementation of a successful derivatives strategy is based.
At a time when HOOPP was increasingly moving into derivatives and other alternative portfolio compositions, we were using an old legacy IT system as our core operational platform. We found ourselves in a situation where, with business processes increasingly dominated by the use of derivatives, the system was just not capable of keeping up with the growing complexity of derivatives portfolio structures.
Consequently, we were ending up with hundreds of spreadsheets, controlling and risk-managing them, and involving time-consuming and costly workarounds. These error-prone and risky manual processes were no longer acceptable, as in our business errors can translate into heavy losses.
It became increasingly clear to us that the existing portfolio management and accounting system would not support the types of activities we wished to undertake going forward. What we needed was a portfolio management and accounting system that could handle all the various investment products we wanted to employ.
This requirement led us to start a search to replace our legacy system with a solution that could deliver our complex strategy without a lot of manual workarounds and enabling us to obtain more flexibility and functionality in the type of products our investment team handles. A staff of about 40 runs hedge-fund strategies, such as equity long-short, credit long-short, and index arbitrage, all of which generate a significant part of our return stream.
Because of its ability to support the investment team with a fully integrated, front-to-back office architecture with robust capabilities including derivatives processing, management and accounting, we chose to deploy the SimCorp Dimension investment management solution.