Bjarne Graven Larsen, who recently stepped down as chief investment officer of Ontario Teachers’ Pension Plan, talks about the most meaningful discussion to have prior to constructing the portfolio, getting rid of uncompensated risks and his plans for what to do next.Take the time to download and read the full article which is available here. I will be referring to some passages throughout this comment.
After two and a half years of holding one of the top chief investment officer jobs in the asset owner world, Bjarne Graven Larsen returned to Denmark this summer. His time at the Ontario Teachers’ Pension Plan and the new experiences brought back in the luggage have, however, probably reaffirmed rather than altered his beliefs of how to think about portfolio construction and successfully manage an institutional portfolio.
Asked about his time in Canada in charge of the pension fund’s CAD 193.9 billion (EUR 130 billion) portfolio and an investment department of about 350 members of staff, he has only praise for his former employer.
“It has really been terrific and the pension plan looks as great from the inside as the outside. I would be long Ontario Teachers’ if you could buy it in the market,” comments Bjarne Graven Larsen, who is known to many in the industry for his more than a decade spent as chief investment officer of Denmark’s largest pension fund ATP and one of the key figures behind its all-weather and risk-based approach to investing.
The full article, which was published in issue 5 of Nordic Fund Selection Journal, can be accessed here.
First, before I get to the content, you might be asking yourself why FBNW did an article on Bjarne Graven Larsen, OTPP's former CIO who left that organization in early April.
It's no secret that Mr. Graven Larsen's time at Teachers' was challenging and many employees struggled with his management style.
If Neil Petroff and Bob Bertram, his predecessors at Teachers', were more hands off and let people run with ideas while overseeing risks in their portfolio, Bjarne Graven Larsen was more of a micro manager and rubbed some people the wrong way (to be fair, what they perceived as arrogance could be due to cultural differences between Canucks and Danes).
Still, Mr. Graven Larsen had one very big backer at OTPP, Ron Mock, the president and CEO and in that regard, the positive spin in the article above doesn't surprise me, it's in everyone's mutual interest.
I have never met Bjarne Graven Larsen but I can tell you Ron told me "he's brilliant" and "executed the strategy brilliantly" which I have no doubt but some of the HR moves that went down under his watch made me scratch my head.
In particular, Wayne Kozun, OTPP's former SVP Public Equities, and Andrew Claerhout, the former senior managing director Infrastructure and Natural Resources left the organization while Bjarne Graven Larsen was the CIO.
I don't know exactly what went down but these were bonehead HR moves and I'm not shy to publicly admit this as these two gentlemen have tremendous investment experience, knowledge and leadership skills and Teachers' suffered a huge loss with their departure.
I will stop there as I don't want to turn this into a negative comment on Bjarne Graven Larsen whom I never met. Far from it, I urge all you to read the FBNW article carefully because it has great content on portfolio construction and risks.
Let me go over some passages that caught my attention. First, on removing uncompensated risk:
At ATP, he notes that starting to hedge the liabilities removed one uncompensated risk. “At Teachers’, the portfolio construction team spent a lot of time on currency. But what they did, which I think was very appropriate, was a thorough analysis of the optimal currency exposure. That led to a reduction of currency risk, which was really an uncompensated risk that was taken away. When you remove uncompensated risk, you actually free up some risk budget because now you have less risk but the same return. And then you can start spending that risk budget elsewhere,” he says.I agree with removing the uncompensated risk to free up the risk budget and invest elsewhere where you can get a higher risk-adjusted return.
When Ron Mock was managing Teachers' huge hedge fund portfolio, the old joke was "you'd better use your risk budget or else Ron will allocate it to an external manager."
But I have to say something on currencies, most large Canadian pensions don't fully or even partially hedge currency risk (except for HOOPP which fully hedges as part of their ALM telling me "we don't get paid for taking currency risk").
The truth is over the long run it's simply not worth hedging currency risk when you're a large pension investing across public and private markets in the US, UK, Europe and Japan.
Having said this, let me share another secret with you, none of Canada's large pensions have consistently made money trading currencies, NONE. It's one area which I always found very weak and while I admit trading currencies is far from easy, the long-term performance of the currency departments at all of Canada's large pensions is far from stellar (sure, some made money over one or two years but over the long run, they lost a whack of dough!).
Anyway, I had to get that off my chest because I personally know of some horror stories in currency trading at the large shops and I always wondered why they can't hire people who know how to deliver consistent alpha trading currencies. Admittedly, they're hard to find but some of the people that were hired for these positions only looked good on paper with fancy degrees and industry accreditations, they never made money trading currencies (don't take my comments personally, just sharing with you what I saw and what I've been told by others in the industry).
Back to the article. Once you figure out uncompensated risk, Mr. Graven Larsen states only then can you move on to proper portfolio construction:
[...] he notes that it is only when you really have all of that figured out that you can move on to the asset allocation. “Then you can start with how much exposure you want to the compensated risk: how much in equites, fixed income, style premia and then you can start looking for areas where you can harvest alpha. People often jump too soon to areas where they think they can harvest alpha. I do believe in trading alpha if you can attract skill and smart people but if you start your investment allocation on that basis, there’s a danger that you don’t get rid of the uncompensated risks,” he says.I agree and disagree with that last statement. Diversification helps but when everyone is chasing yield in private equity, infrastructure, real estate, private debt, hedge funds, stocks, corporate bonds, and you name the risk asset, returns are much harder to come by and you need to be innovative.
Another core part of his philosophy is about being in charge of one’s destiny. “You do that by controlling the risks and making sure you don’t take risks that you will regret in bad times,” he says.” And to do that, you sometimes need to accept that you might underperform a bit in good times. If you give away a bit of the upside to protect against bad scenarios, you have to stomach the fact that you can have three or four years of great returns because markets are up but not as great returns as your competitors. And that’s eally difficult for many people.”
Asked whether he believes that a well-diversified portfolio need to look different now compared to in the past considering the low expected yields from both equities and fixed income, he does not appear to be in the camp of those arguing that this time is different.
“During all the years I’ve worked within investments, people have been saying that they don’t know where to look for returns. When I started at ATP in 1999, all of the conferences I attended had the search for yield as the main topic. There’s always a tendency for people to think that they won’t get returns from anything. But you will always get returns from something - you just don’t know from what,” he says, which again is an argument for diversification.
Also, the yield on the 10-year US Treasury note was at 6% in 1999, not 3.2%, so investors absolutely need to adjust their return expectations lower.
On alternative premia and success going forward, he shared this:
Alternative risk premia is also the topic that comes up in relation to new innovation within investments. “I think it’s now very solid that there are some alternative risk premia that you can pick up, whether that’s momentum, carry or value. It’s not a free lunch and you have to be careful but I think a lot of investors in Europe are under-allocated to that part of the investment universe. That’s probably the building block that I feel is having the brightest future,” he says.Interestingly, from the people that worked with him, they told me "Bjarne is anything but a crocodile". In fact, it can be argued that Bob Bertram was a crocodile shorting tech stocks back in 2000 and even Neil Petroff shorting oil back in 2008 (it might have still been Bob back then).
He explains that the way he would construct a portfolio is, after having answered the questions on how to measure risk and having dealt with the uncompensated risks, to start putting together the building blocks. The first would be a market risk premium block with exposure to equities and rates as well as the appropriate inflation exposure. “Then, I would construct a block of alternative risk premia across asset classes, which should be market neutral,” he continues. “Then, I would do real alpha. That could be in private equity because you have a really great team or it could be in long-only equities because you have a fundamental equity team and believe in that. It could be in real estate or within the factor space.”
With the building blocks in place, it is then time to move on to how to allocate. “Maybe an external manager can implement all the equity premiums in his equity mandate to a very low price,” he says. “Or maybe you want to use all your equity risk in private equity, where you can do alpha at the same time. That was actually what we did at Teachers’. We reduced the passive listed equity portfolio but we didn’t reduce risk. Instead, we increased actively-managed listed equities and, even more so, the allocation to private equity. Since the team was so skilled and had outperformed the markets with a huge margin for 25 years, we said that this is one of the areas where we believe we truly can harvest alpha and get exposure to equity markets.”
Furthermore, he says that unbundling the risks and breaking it up into building blocks in this way and deciding how big exposure you want to each risk factor provides a lot of freedom in picking a manager. At the same time, he notes that getting pure exposures isn’t always possible.
“You have to accept that some things only come bundled, so you have to unbundle stuff in your risk system. But the good thing about unbundling, at least on paper, is that you ask yourself how much you’re willing to pay for pure market exposure. I think the pension plans that are thinking in this way will be able to lower the fees they pay going forward. And a lot of asset managers that are delivering a bundled product but charge too high fees for the passive part or the market risk premium will have a more difficult time,” he comments.
With many predicting tougher times ahead also for asset owners, Bjarne Graven Larsen points to a few things that he believes will characterise successful investors in the years ahead. “I think the investors that will be successful going forward will be the ones that on the one hand will be able to continue to invest in illiquid assets or wherever they can harvest alpha, because they have strong teams and can beat the market,” he says. He continues: “At the same time, you need to make sure that you have a risk management policy and, probably more mportantly, a liquidity and leverage management policy that will allow you to, for example, protect yourself against inflation risk without having to sell out from your illiquid assets. How can you keep your private equity allocationand at the same time get more exposure to inflation? Well, you probably need to use derivatives. And if you do, you need to make sure that you have cash for margin calls and variation margin calls and that means that you really have to think about liquidity management and risk management in a version 2.0.”
He notes that while he sees using derivatives and actual balance sheet leverage as two sides of the same coin, you need to be able to do both in order to be successful. “Ontario Teachers’ was AAA-rated by Moody’s and while I was there, we started a medium-term note program, so a trust controlled by Teachers’ started issuing bonds. So you don’t just use leverage synthetically but you actually issue bonds as well. Very few European pension plans do that but it’s quite common in Canada. By doing that, you get longer term financing, so you reduce some of your liquidity risk,” he says.
He believes that having this strong focus on liquidity management and funding is of great advantage in a time of crisis.“Then you could be in a situation where you could actually benefit from the crisis and buy a lot of stuff at distressed prices. So making yourself able to do what I like to call crocodile strategies: you hold liquidity, make sure you have enough and then, like a crocodile, you just wait and wait. You don’t need to eat every month, you can just let all the small fish pass by and then suddenly a wildebeest comes – and then it’s time to eat,” he says.
Again, to be fair, Bjarne Graven Larsen wasn't at Ontario Teachers' long enough to sink his teeth into any wildebeest but he doesn't strike me as a crocodile man.
Anyway, take the time to read the full article here, it is excellent and Mr. Graven Larsen provides a lot of great insights on unbundling risks and portfolio contruction.
Lastly, it should be noted there's been a bit of a "promotion party" going on at Ontario Teachers' recently. You can read this press release and this one as well.
No doubt, these are all highly qualified candidates as is Ziad Hindo, Teachers' new CIO, but I heard there was real fear in the organization after two veteran managing directors in private equity, Steve Faraone and Mike Murray, left OTPP to launch a new fund, Peloton Capital Management.
In any case, this proves OTPP has very talented individuals working for them and they probably wanted to send a message they value their employees and will promote hard workers who add value to the organization. That, and morale was low at Teachers' after a series of high profile departures so they needed to boost it.
Below, an older (2016) clip where Bjarne Graven Larsen sat down with Pensions & Investments to discuss what attracted him to the organization, the “Canadian model” of pension management and investments at the pension fund.
He might not be a crocodile man and his time at Teachers' was challenging but he is extremely bright and he certainly knows what he's talking about when it comes to pensions and portfolio construction.