https://www.bankofcanada.ca/2021/08/staff-analytical-note-2021-20/
We are thrilled to be able to honour the career of veteran investor, Jim Keohane, at the CLC’s upcoming Challenge of Change Forum in Vancouver, from October 13-15.
Jim was president and CEO of the Healthcare of Ontario Pension Plan (HOOPP) from 2011 until his recent retirement in March 2020 and now, he serves on AIMCo’s board of directors. He is widely viewed as a pioneer in the risk management space and was the architect of HOOPP’s liability-driven investment strategy.
We were able to sit down with Jim in advance of the event (thanks to Zoom) and talk to him about what he’s learned through his career, discuss his thoughts on what’s happening in markets today and to ask the question, what if the uptick in inflation isn’t temporary?
What was the biggest challenge you ever faced in your career?
The Dot-com bubble and crash of 2001-2002 was a real eye opener, not just for me but for everyone at HOOPP. We went very quickly from having a comfortable surplus to a deficit. Our assets dropped from around $20 billion down to $14 billion and our liabilities went up because interest rates went down. We went quickly from discussing what to do with the surplus to whether or not we needed to raise the price.
It was such a dramatic shift. And it made me realize that there was way more risk in the plan than we had previously thought. When we unpacked it, there was a big mismatch between the assets and the liabilities. At the time, it was thought that this was a generally accepted part of being in the pension business. But I always thought you don’t just accept risk — you manage risks by taking the risks you want to take and avoiding the ones you don’t want to take.
So at that time, we moved from a traditional portfolio to a non-traditional portfolio. It was a big effort. It involved a lot of education for the board and people had to have faith in the outcome.
What did that process teach you?
One challenge for me is that I see facts and I see solutions and I figure out how to get there along the way intuitively. But people in the investment business have to see all the steps you plan to take there on the way. So you have to paint a clear picture of how you’re going to get from here to there. That was a big learning for me: that something that seems obvious to me might not seem obvious to other people.
And just trying to get those ideas across and explain why you want to do it is a big challenge. You need to take that big idea in your head and translate it into something tangible and explain it to others.
I think people see what HOOPP did as revolutionary. But it didn’t happen that way. It was evolutionary. We did things with an endgame in mind — and we did them incrementally along the way. If you keep the end in mind, you will get there.
How has your approach to risk management evolved?
It was a challenge for HOOPP. The typical risk management systems people started using were originally designed for banks. And they start with the wrong definition of risk for a pension plan. Banks are in the business of being dealers — they are not really investors, they’re traders. Their time horizon is about five days and those systems are built based on five-day VaR, annualized. That is completely meaningless for a pension plan.
A pension plan’s main risk is not being able to pay members. You have a much longer time horizon and a different view on what communicates that risk.
How has the understanding of risk management evolved in the pension space over the last couple of decades?
The big change has been defining risk based on your funded ratio. That gives you a very different definition of risk. But I still see organizations talk about active risk. And that’s a really small component of your total fund. You could do all kinds of dumb things with your active risk and it really won’t impact your ability to pay pensions in the long run — unless you do something really stupid.
What really determines whether or not you will be successful is how you construct the policy portfolio and perhaps some tactical decisions you make along the way. But which stock you own or whether you’re overweight TD or BMO? That doesn’t make a difference to anything.
You’ve managed through a few major market crises. From that standpoint, what does today’s market look like to you?
Valuations look okay relative to interest rates. They are fully valued but not extremely overvalued. However, it really depends on what interest rate you apply on a forward-looking basis. So if you look at the current yield curve, it looks okay. But that yield curve is artificially depressed by central bank actions and rates are absurdly low relative to what they should be.
An investment book I’ve read again and again is Manias Panics and Crashes by Charles Kindleberger. The author looks back at manias and crashes from 1300 to today and analysed what happened — like the Tulip Bulb crash. Manias are characterized by speculation in stocks, housing and commodities fueled by cheap credit.
That explains exactly today’s situation.
How so?
Take bitcoin for example — if you substitute bitcoin for tulip bulbs it’s exactly the same. There is no intrinsic value underlying it all. Only, is there a greater fool out there that will pay a higher price than I did? That’s the essence of it, it’s pure and utter speculation. Bitcoin isn’t overvalued — it’s worth nothing.
So where do we go from here?
We are in a mania phase right now. Low interest rates are a complete bubble fuelled by central banks. There are lots of signs of inflation around. It’s being brushed off as temporary at the moment. If that turns out not to be the case and you have a permanent move up in inflation from a target rate of 2 up to 4, then we’ll see 10-year treasuries trading at one and a quarter — that’s nonsensical. If inflation is at four, then 10 years should be 5.
The math is ugly on that. It would mean a current 10-year bond is worth about $20 bucks. A 30-year bond would be worth a bit more.
You would have a significant capital loss in your bond portfolio. But you think of people with cheap mortgages, even if mortgages went from one and a half today to three, which isn’t much historically, then peoples’ costs would double. If you have a million dollar mortgage at $3,000 a month and all of a sudden your cost goes to $6,000 a month? A lot of people won’t be able to swallow that. So any uptick in rates of any magnitude is going to cause a lot of distress in the economy. It would also throw off discount rates so valuations on stocks won’t make sense.
Are rising interest rates and inflation the top risks you see in the market right now?
Yes, higher rates and inflation are looming as big risks. As for what will pop the bubble, you never know. It could be some default of an institution for example. But there is not much room for error right now. Things are very tight, very fully valued.
Another factor is the amount of retail participation in the markets. It is very high and that usually happens when the market tops. There are a lot of things I see that could indicate that if we aren’t at the top — we are close to it. A lot of things could cause the train to go off rails.
What is the biggest risk you see right now?
Rising rates and inflation for sure. And the impact on bond yields. You have negative rates in Europe which is the craziest thing I’ve ever seen in my career in investments. Why would you give someone your money for 30 years and pay them to take it? It means you can take a substantial capital loss on bonds with only a small uptick in rates.
Any sage advice for people entering the pension space right now?
Think long term. I look at investor psychology because it drives what people do. Warren Buffett says that when people are greedy, be fearful — and when people are fearful, be greedy. It’s good advice. Because there are two factors that drive behaviour; fear of missing something and fear of loss. Right now people are overwhelmed by fear of missing something, and they should be fearful of loss. Last year at the bottom of the market, everyone was afraid of loss and that’s where the best opportunities are.
Investors have to balance two thoughts: how much could I lose if things go wrong? And what’s the upside if it goes right? And if the conclusion is a skewed distribution where your upside is way bigger than downside, then that’s when you want to be investing. That is typically at times when things look dire.
Also, valuations matter. In the long run, what you pay for something is the biggest, most important thing in determining your outcome. If you pay too much for something the odds are you will lose money on it. If you buy things at depressed valuations that’s where you are likely to make money.
I know that’s easier to say, but that’s what you need to do. I’ve only met one person in my career who could buy stocks on one day and flip them the next and make money. If you think you are going to be a day trader and make money you won’t. There’s a big difference between investor and trader.
For those interested in seeing Jim speak in-person in Vancouver, we can add you to a waiting list available for the Challenge of Change Forum from October 13-15.
This is a great interview with Jim Keohane, one of my favorite (now retired but still active) pension executives.
First, a quick note to let you know the Canadian Leadership Congress is holding its Challenge of Change Forum on October 13-15 in Vancouver at the Fairmont Waterfront.
If you're an asset owner still interested in joining, contact CLC Co-CEO and founder, Joanne Boccia, to be added to a wait list: jboccia@leadershipcongress.ca
Now, back to Jim Keohane and all the great insights he provides in this interview.
I actually reached out to Jim to talk markets and AIMCo and late this afternoon, he was kind enough to call me back.
Jim told me he sold his house in Toronto and moved with his wife to Ottawa where three of his four sons live and where he has a large family (seven brothers and sisters live there).
I was happy to learn he is in good form and in good spirits.
He was appointed to AIMCo's board of directors in late May and even though he only had one board meeting, he told me "it's a high-quality Board" (headed by Mark Wiseman who is the Chair).
On AIMCo, the thing that struck him is some governance issues which are "structural in nature."
What he means by that is at HOOPP and OTPP, it's basically one client (especially OTPP), so it's easier to set a common objective and focus.
AIMCo doesn't just manage pension assets, it also manages the Alberta Heritage Fund, Alberta Treasury assets and a couple of endowment funds. This leads to some "structural complexities."
Also, following the VOLTS blowup last year, there's "more friction" between clients and AIMCo.
The job of managing all these relationships now falls on Evan Siddall, the new CEO who was appointed back in April and started working on July 1st.
Jim told me "Evan is a great change management executive" and "he has extensive government contacts."
Indeed, his previous experience as CEO of CMHC will allow him to navigate all these relationships with clients and "refocus and get everyone in the same direction to achieve objectives."
In my opinion, this is crucial, AIMCo's clients need to put the entire VOLTS blowup in the past, move forward and trust the Board and senior leaders who Jim thinks very highly of.
There are a lot of risks across public and private markets and now is the time to focus and remain very disciplined, always focusing on the long run.
On markets, manias, tulips, bitcoins, bonds and much more!
This is where the conversation with Jim got very interesting.
Jim thinks there's a "huge disconnect between fundamentals and asset prices" and it has gotten worse over the last year.
As mentioned in the interview above, he thinks the biggest risk lies in bonds right now.
"With inflation running at 3%-4%, it's hard for central banks to justify keeping rates at 1% or 0%."
He didn't get into details about why inflation might be more permanent than transitory but he's right, if it's stickier, then central banks are going to start raising rates.
And going from 1% to 3% will have a material impact of highly leveraged funds and highly leveraged homeowners. "There's a lot of interest rate sensitivity in the economy right now."
"When I got a mortgage in the early 80s, rates jumped from 12% to 20% and I was lucky I was able to afford it back then but many people got caught and weren't able to make their mortgage payments and the housing market got hit hard."
He added: "I'm not saying it will happen but going from 1% to 3% on long bonds will have a material impact on mortgage rates and many homeowners will see their mortgage payments double akin to what happened in the early 80s."
Indeed, historic low rates have fueled all sorts of debt-taking activity, in markets and in the housing sector and if rates start rising fast, it will be catastrophic for interest rate sensitive sectors.
On bonds, he thinks there's a huge risk of capital loss on a 30-year zero coupon bond.
[Still, Jim did say "there's a role for bonds" in pension portfolios, and agreed with me that they serve their purpose for liquidity risk management.]
"Bonds are priced for deflation and right now, it's inflation that worries me. You're better off getting a 5% dividend on bank stocks even if they are more volatile in terms of share price."
I agree with one caveat: Canadian bank shares almost doubled since their March 2020 lows and many banks took huge provisions in the first quarter of last year. Since then, they put that money back in their balance sheets, grew their top line but the bottom line remains anemic.
Of course, big banks and insurance companies want rates to rise materially so their net interest income rises.
Who else wants rates to rise a lot? Pensions and fixed income retirees looking to lock in higher rates.
Interestingly, I asked Jim what happens if rates keep dropping? Won't that have a huge negative effect on Canada's large pensions?
He said "not as much as you'd think because they're fully funded so even if rates go to zero, I'm pretty confident they will remain fully funded." (worth noting that even though they are fully funded, all the large Canadian pension plans have lowered their discount rate in recent years to increase their reserve cushion in case something goes wrong).
He wasn't as kind when it comes to many underfunded US state plans that are 70% funded or worse: "Many of them will run out of money in 20 or 30 years, it's only a matter of time" (true, unless Congress or the Fed bails them out).
Another interesting topic we spoke about is valuations. Jim thinks there's a "valuation gap" between traditional energy companies and renewable energy where valuations are driven by "massive capital" flowing into impact investing.
"This creates opportunities where a sector is historically cheap in terms of valuations."
He expanded this to commercial real estate in Alberta: "Offices in Calgary have seen their share of cycles but the valuation/ appraisal method exaggerates the true value of these buildings because if something sells at distressed levels, all buildings get artificially marked down. They are not selling at those distressed values."
Good point, maybe now is the time to go long Alberta commercial real estate.
What else? We talked about manias going on right now.
He told me flat out: "There's no intrinsic value in bitcoin or any other cryptocurrency, it's just like the tulip mania."
I told him there are two big risks with cryptocurrencies that I never felt comfortable with:
- Whale risk: Billionaires buying cryptocurrencies can pull out, which leads to massive volatility
- Regulatory risk: Central banks can start regulating these digital currencies and then what?
The whole thing feels like a massive Ponzi scheme where the first investors get out with huge gains and the last ones lose their life savings.
I did differentiate between blockchain technology and cryptocurrencies as I do think the blockchain is here to stay and leading to great financial innovation.
I also noted that central banks have unleashed many bubbles at once, it's not just bitcoin, it's SPACs, it's meme stocks, it's credit, and the list goes on and on.
Jim agreed and gave the example of Tesla where he thinks valuations don't make sense: "They'd have to sell electric vehicles to everyone for those valuations to make sense."
He added: "It feels a lot like JDS Uniphase during the dot-come era, people were saying it will grow earnings at a compounded rate of 40% a year which no company ever did."
He also gave other examples like McDonald's shares in the 80s and Walmart shares, there where periods where valuations didn't make sense and share prices got hit hard in subsequent years.
Of course, Jim is right valuations matter in public markets and in private markets.
I told him I spoke with Jo Taylor earlier this week and he told me they are not chasing deals where valuations don't make sense, regardless of whether it's logistics properties or renewable energy in infrastructure.
Jim stated: "I agree, you need to stay disciplined on every deal."
By the way, that included private debt where many fixed income managers are turning their attention., squeezing blood from fixed income stones.
"Valuations are rich there too, a lot of traders are front-running the Fed and other central banks but if they raise rates, all the speculative traders will disappear."
Great insights, I love talking to Jim Keohane, he's too generous with his time and I can literally talk hours about markets and risks with him.
Lastly, before I forget, Sebastien Betermier sent me the latest Bank of Canada study he co-authored on the reach-for-yield in the context of Canadian private pension plans between 1998 and 2018. You can read it here.
Among his findings:
Our findings provide a new and complementary explanation for pension plans’ inclusion of more alternative assets in their portfolios. In the standard reach-for-yield explanation, plans respond to lower yields by increasing their overall risk exposure so they can meet their return targets.
We turn this explanation on its head. It is true that, in isolation, investing in alternative assets and corporate bonds or using financial leverage means taking specific risks in exchange for higher returns. But we show that these investments are part of a broader strategy that aims to reduce overall solvency risk.
We find that the likelihood of a portfolio shift increases with plan size, presumably because large plans have greater ability to invest in alternative asset classes than small plans do. In our sample:
- 85 percent of plans whose assets under management (AUM) exceeded $0.5 billion shifted
- 52 percent of plans with AUM below $0.5 billion shifted
Plan size is not the only factor, though. We find that exposure to solvency risk is another key predictor of shifting portfolios.
Plans that do not shift may face more solvency risk. These plans may have good reasons for maintaining the 60/40 portfolio mix but doing so leaves them exposed to short-term fluctuations in asset values and interest rates. Keeping the traditional mix therefore means that plan sponsors must stand ready to make special payments to the plans if solvency deficits persist.
I know Jim Keohane would agree as he told me the traditional 60/40 portfolio doesn't make sense with rates at historic low levels and inflation rising and looking stickier by the day.
We shall see, I remain very skeptical that inflation is sticky or permanent but remain open that it might be around longer than most investors think.
Below, an older interview where Jim Keohane spoke to Real Vision's Ed Harrison about the remarkable obstacles pension funds face and how they can survive and thrive in the face of these challenges. Take the time to watch this, it's excellent and packed with insights.
And Mark Wiseman, chair of AIMCo and former CPPIB CEO, joins BNN Bloomberg to discuss what he believes political leaders need to address when it comes to building back Canada’s economy. He notes so far, no party leaders are discussing long-term growth plans ahead of the fall federal election.
Great interview, take the time to watch it here is it doesn't load below. I totally agree with Mark, Canadians need to ask politicians: What type of recovery do we want and what are we going to do to improve long-term productivity growth? (productivity gains are the key to have a long-term sustainable recovery). Take the time to watch the entire interview, he really touches on all the important points.