2014 was another successful year for OPB’s Investments team. The team adjusted its Strategic Asset Allocation, advanced its Tactical Asset Allocation strategy, expanded its investments in private markets, repositioned its fixed income strategy, and upgraded its information technology systems – all while managing through challenging markets. In the following interview, Chief Investment Officer (CIO) Jill Pepall talks about OPB’s successes and challenges for 2014, as well as its outlook for 2015.

The Plan generated an investment return of 8.4% in 2014. How satisfied are you with this result?

Our primary objective at OPB is two-fold: protect the long-term sustainability of the Plan and keep benefit and contribution levels stable and affordable. We achieved a solid investment return for 2014, exceeding the assumed long-term rate of return (5.95%) used to calculate actuarial liabilities. The result was a positive impact on the funded status of the Plan. Our target is to achieve strong risk-adjusted returns that exceed the benchmark over a rolling four-year period and, if we look at a four-year average, we are well ahead of the benchmark by 76 basis points (bps). (A basis point is 1/100 of a percent.) That’s a significant value-added return. Because our focus is on capital preservation, we expect our annual return to slip below the benchmark from time to time or trail our peers during periods of strong, rising markets; however, we also expect to preserve capital and outpace both our peers and benchmarks during periods of steep market decline. It’s an approach that exposes the Plan to less market volatility and lower absolute risk.

What were the key factors affecting OPB’s investment results in 2014?

On the positive side, an overweight position in equities and strong results from our Infrastructure and Private Equity portfolios combined to bolster returns. On the other hand, while OPB’s Fixed Income portfolio had strong absolute performance, the Plan’s investments in short-term bonds underperformed relative to the benchmark, which is based on longer-term bonds. Also, the Plan has an internal investment policy of hedging a fixed portion of foreign currency exposures; as a result, our foreign asset returns did not get the full benefit from the increase in the value of the foreign currencies (such as the U.S. dollar and G.B. pound).

OPB adjusted its Strategic Asset Allocation (SAA) in 2014. What changed and why?

We completed an asset/liability study during 2014. The purpose of this study was to determine if our assets are a good match for our liabilities and, if not, determine what adjustments are required. The results identified a need to adjust our SAA so that it places less emphasis on public equities and more emphasis on private markets, such as real estate, infrastructure and private equity. Real estate and infrastructure investments help insulate the Plan from public market volatility and enable us to generate a larger proportion of returns from cash flow while we expect private equity investments to enhance long-term returns. In the wake of the adjustment, we began shifting an additional 5% of the Plan’s assets from public markets to private markets. This shift will be phased in over five years, giving us time to source quality investment opportunities. Once the shift has been completed, private markets will account for about 38% of the Plan’s total assets.

You continue to advance your in-house Tactical Asset Allocation (TAA) capability. How did that go in 2014?

It went very well; we made significant advances with our TAA. Just to recap, TAA is a strategy used to quickly and efficiently change the Plan’s risk by increasing or decreasing the Plan’s exposure to certain public market asset classes. This flexibility enables us to take advantage of short-term changes in the market. We can effectively preserve capital by reducing our risk exposure during volatile or declining markets and then quickly increase risk again when the time is right – generating value-added returns. During 2014, our TAA team also completed an analysis of OPB’s currency hedging policy. Based on that analysis, we changed the approach we take to managing foreign currency. We will be moving from a static 50% hedging policy to an active strategy. This move is expected to generate value-added returns.

OPB has enjoyed success with its Private Equity and Infrastructure portfolios right from the get-go, which is very unusual. To what do you attribute that success?

We’re very proud of our success. Many investors who enter into private equity and infrastructure markets experience negative returns during their initial years. We’ve avoided that, generating profits right from the early days of the programs. Our success can be attributed to three key factors. One, we carry out strict due diligence to ensure we buy only those investments that offer good value for the price and that are likely to provide steady cash flow or capital appreciation. Two, we are very good at negotiating the best possible investment fees. And three, we strategically invest alongside knowledgeable partners in secondary (already-established) funds and fund co-investments that provide visibility to the underlying assets being acquired. In this way, we are able to avoid the initial negative returns typically associated with new funds.

OPB is actively working to increase its holdings in private markets. What’s your strategy for 2015?

The environment for quality private markets assets is both competitive and pricey. With that in mind, we will continue to focus on high-grade assets that we can acquire through direct acquisitions and co-investments and that fit our strict policy parameters and underwriting criteria. We will leverage both existing and new investment relationships, investing alongside a wide range of “best-in-class” partners. As in the past, direct investment in prime Canadian properties and value creation from existing rental properties will be the focus of our Real Estate portfolio. That said, we will continue to make investments where we see an opportunity to create value and to enhance returns in real estate funds and co-investments. While we expect there will be opportunities to invest in infrastructure in 2015, we anticipate challenges related to pricing. Notwithstanding these challenges, we will continue to focus on core infrastructure assets (those that provide ongoing cash yield), mainly through direct acquisitions and co-investments. On the private equity side, we will continue to concentrate our efforts on finding private companies that offer consistent revenue and earnings growth, like-minded investment partners, and first-rate fund managers. Due to economic challenges in Europe, we expect North America to provide the best opportunities for private equity investments – at least in the short term.

OPB reviewed its fixed income strategy in 2014. What was the outcome?

When the credit crisis occurred in 2008/2009, credit spreads (the difference between the return offered by a government bond versus a corporate bond) were four times normal ranges. Many investors rushed to sell – or had to sell – their corporate bonds. OPB seized that opportunity to pick up corporate bonds at extremely low prices – a move that has added significantly to our returns over the last five years. In 2014, we saw a return to very narrow credit spreads and higher bond prices as a result of investors chasing higher yields (bond returns). This has created a current environment where investors are paid less while taking on more risk. At this point in the bond cycle, we believe a cautious approach that slowly reduces our exposure to corporate bonds is the best option and that lower exposure will help preserve capital in the event credit spreads widen significantly. With this in mind, we began to transition our Fixed Income portfolio in 2014 – from universe bonds to long bonds.

OPB has made a significant investment in technology for the Investments area. Why?

Over the past few years our investment strategy has evolved and become much more sophisticated. To keep pace with and support our new investment activities, we’ve had to update our information systems. Updated systems ensure we have the information needed to make informed investment decisions and manage investment risk on a holistic basis. These systems provide the ability to collect, store, filter, process, create, manage and distribute data. We use this data for: performance measurement, attribution that identifies key drivers of investment performance, trade capture and portfolio management, tracking private markets deals, managing key documents, and supporting internal management of equities, fixed income, currency and derivatives.

How does emerging markets fit into OPB’s investment strategy?

OPB has a benchmark weight of 15% in emerging markets. This is relatively high versus other plans’ average of 5%. OPB identified emerging markets as a global growth story back in 2008. We saw the opportunity to access higher-growth economies due to urbanization and the growth of the middle class. We are still committed to this investment thesis and believe that over the longer term, the Plan’s investments in emerging markets will provide a good return-enhancing complement to the assets and strategies currently employed in the Plan. Given the potential volatility of emerging markets, OPB utilizes two approaches to manage volatility:

1. OPB approaches investing in these markets with a focus on capital preservation – we employ investment strategies that evaluate companies on a fundamental basis.
2. OPB uses its TAA capability to manage its exposure, reducing it during expected market downturns. In 2014, our emerging markets strategy returned 10.1%, providing a positive contribution to the total Plan return.

What is the investment outlook for 2015?

There is no doubt that we are in for another challenging year. The global economy appears to be continuing on a slow growth path with central banks providing new forms of liquidity. However, the strong performance of risk assets, such as stocks and riskier bonds, is driving the price of those assets higher. Equity markets should gain ground, but advances may not be as high or as steady as in recent years. With geopolitical uncertainty running high, we expect the market volatility that resurfaced in the latter half of 2014 to continue into 2015. Likewise, the steep decline in crude oil prices that we’ve seen since June 2014 will likely have an impact on both Canadian and global economic growth – oil importing countries such as Japan, China and India will benefit but at the expense of oil exporters such as Russia and the Middle East. Add to this the fact that interest rates are still relatively low and credit markets are approaching their peak and the stage is set for an interesting year. There is, however, some room for optimism. Economic growth in the U.S. is expected to remain solid, while economic growth in Europe, although low, could see gradual improvement.