How a University Pension Plan Delivers Absolute Returns

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• Pension plans have gradually moved assets away from equity and into debt and cash investments over the past few years. Ontario’s University Pension Plan (UPP) uses a diverse allocation strategy focused on absolute returns.
• When equity beta — a measure of a stock’s volatility — increases in a stressed market, managed futures can contribute to a positive return known as “crisis alpha.” A balanced portfolio can perform well throughout market cycles.
• Why UPP recommends choosing managers based on a belief in their investment processes rather than their historical returns.

Pension plans are supposed to offer financial security after retirement, but in the past several years, employees have had reason to doubt they’ll see their full benefits.

Headlines about underfunded pension plans and market volatility have been particularly concerning for public sector employees, including city workers, emergency responders and educators. In 2021, in response to the funding crisis, Ontario’s provincial government created a jointly sponsored pension plan for eligible university employees.

University Pension Plan Ontario (UPP) now has approximately 39,000 members and 11 billion Canadian dollars ($8.1 billion) in assets under management. UPP’s Managing Director, Head of Public Markets Christophe L’Ahelec is responsible for a global investment strategy delivering stable retirement income regardless of uncertainty in the financial markets. For Christophe, the focus is on sustainable growth.

“Our ambition is to attract all the universities in Ontario,” he says. “We invest across all asset classes, including public and private equity, the fixed income sector and real estate.”

Christophe joined host Alan Dunne for a Top Traders Unplugged Allocator episode to further discuss how UPP pursues absolute returns in a volatile market. The conversation also touched on Christophe’s philosophy for investment manager selection. For investors committed to sustainable long-term growth, strategy matters more than recent portfolio performance.

The main objective

In the decade following the global financial crisis of 2007-2009, central banks did just about everything they could to stimulate economic growth through loose financial policies and low interest rates. It was one of the greatest bull markets in recent memory, a decade that some analysts termed a golden age for growth stock investment. Frankly, passive management had great returns, so investors didn’t need to be particularly strategic.

“We believe that this era is over,” Christophe says, “and that the next few years will be characterized by heightened levels of volatility.” This calls for more active hedge fund management and diversification with a focus on absolute returns in the short term. Especially in the context of a pension plan, consistent income is the primary goal.

“Our main objective is to remain fully funded and to manage the funding ratio to mitigate its volatility,” Christophe adds. A pension’s funding ratio is a comparison of the plan’s assets to its obligations — essentially, a 100% funded plan has enough assets to pay the full retirement benefits to all plan members.

To satisfy this objective, UPP pursues high-quality assets with risk-adjusted value. In other words, the fund seeks investments with a high expected return relative to the risk associated with it. The plan also considers environmental, social and governance (ESG) factors in asset selection for ethical, sustainable investments for their members. Last year, UPP committed to invest CA$1.2 billion in climate solutions by 2030.

Member-focused allocation

In terms of allocation, what does this ESG-conscious absolute return plan look like? Christophe breaks it down:

• 52% to equities, credit and absolute returns
• 32% to government and inflation-linked bonds
• 16% to real estate and infrastructure

It’s a traditional 60/40 portfolio with an 8% slice carved out from both stocks and bonds to fund the real estate and infrastructure investments. Alan asks, “Is that based on research that these are the most durable kind of assets to withstand inflation?”

Christophe explains that because inflation indexing is a core characteristic of the pension plan, the fund has to account for it. “It’s very important to be able to hedge that inflation indexing by investing into assets that will provide some kind of inflation protection,” he says.

An inflation-indexed pension will periodically increase retiree payouts relative to changes in the consumer price index. If inflation is up 3%, the pension plan can mitigate risk by holding assets that are likely to rise in value with inflation.

Alongside property and utilities, commodities are often suggested as an asset class to hedge against inflation, but Christophe notes that holding certain commodity futures, such as fossil fuels, could conflict with the fund’s ESG goals.

“We ultimately want to build a framework that will be focused on risk factors,” Christophe adds, but also manage a portfolio that reflects the expectations and values of UPP’s members.

Trading convergence

Once the allocation is decided, how does the fund pursue its goal of absolute returns? For Christophe, the underlying principle is a convergence strategy.

A convergent investment strategy perform best in normal times, when fundamentals prevail and investors act rationally. Expecting mean reversion, traders act on mispricing and deviations from fair value, arbitraging away inefficiencies and profiting handsomely in the process.

Divergent strategies, on the other hand, perform best in turbulent times, when uncertainty prevails and investor psychology tramples fundamentals. Instead of reverting back to intrinsic value, price deviations develop into full-fledged and well pronounced trends. Traders who successfully anticipate and ride these trends deliver outstanding performance, both in absolute terms and relative to convergent strategies. An example is the so-called crisis alpha, referring to a positive return in a period of market stress.

Here’s how it works. In a sharp market decline, beta (a measure of volatility) usually increases. But if investors are holding highly liquid, opportunistic positions, they can exploit this downward trend for a profit. Managed futures, for instance, tend to do well in periods of high volatility because active traders can capitalize on the trend movements.

Trend following isn’t foolproof, however. “And a good example is March 2020,” Christophe notes. “The market reaction [to COVID-19] was so sudden and so sharp, that the managed future and trend following strategy didn’t do well because it was a very short period of time,” not long enough or slow enough to find opportunities on the trend line.

Still, an outlier event such as the COVID-19 pandemic isn’t a reason to dismiss the approach. Christophe explains the importance of choosing a long-term strategy rather than focusing on recent market performance.

Buy the process

UPP has a large enough principal to invest in a variety of niche strategies to maintain liquidity and diversification. Christophe is in conversation with managers every week, some of whom he meets through banks or at conferences, and some who reach out to UPP directly. The fund maintains a database to quickly reference how a new risk-return profile is different from those strategies already in the portfolio. It’s a mindset of always looking for new opportunities.

Alan asks about manager evaluation and selection. “There’s always that temptation to be heavily influenced by their track record,” he says. Are the best fund managers the ones with the strongest recent performance? Christophe disagrees.

“You’re not buying a track record. You are buying an investment process that you believe will produce a risk-return profile for your portfolio going forward,” he says.

Christophe wants to avoid alpha decay, a nickname borrowed from nuclear physics that refers to a strategy’s gradual breakdown in its ability to outperform the market. “A manager should have the capacity to adapt to an ever-changing market environment,” he adds, without staying stuck in a singular mindset. Successful managers are agile and forward-thinking.

Of course, it’s much easier to look at historical rates of return than to make an informed assessment of a strategy’s potential in current market conditions. Christophe acknowledges that UPP’s selection philosophy requires a deep understanding of investment technicalities and market fundamentals.

A little T.L.C.C.C.

It’s fair to wonder, is active management worth the additional effort? Many pension plans use passive strategies such as investing primarily in index funds. But in support of UPP’s objectives to remain fully funded, diversified and capable of absolute returns, Christophe names five benefits of managed accounts.

1. Transparency

Transparency isn’t in reference to a fund manager’s trades, open orders or portfolio holdings. “It’s about being able to aggregate [all the risk exposure] across your hedge fund portfolio,” Christophe explains. It goes back to diversification. Even if active managers are beating their benchmarks, if there’s too much strategic overlap in the different slices of UPP’s portfolio, the pension plan could be overexposed to a particular risk.

2. Liquidity

A convergent, trend-following strategy relies on liquidity. Christophe notes that commingled funds — those mixing assets from several accounts — typically have limitations in terms of liquidity. By using managed accounts, UPP can maintain agility during market swings, ultimately preserving capital for clients. To that end, any managed strategy needs to have enough trading volume for quickly resizing a position.

3. Control

Managed accounts give the fund manager control of their assets, but the managers also have more direct contact with third parties such as audit firms or prime brokers. In many cases, this can simplify the auditing process and expedite any necessary changes.

4. Customization

“Being able to customize a strategy with the manager so that it will meet your needs for a given risk-return profile within your portfolio is very important,” Christophe explains. Related to the idea of transparency, sometimes changes need to happen in a few managed accounts to meet the risk tolerance of the portfolio as a whole.

5. Cash efficiency

Lastly, individually managed accounts don’t need to be fully funded. For example, a manager trading long-dated options doesn’t need the full amount of cash to cover those contracts, provided the cash is available elsewhere in the portfolio. With managed accounts, UPP can preserve cash on certain strategies and instead deploy it in other opportunities.

Never stop learning

Christophe’s advice to traders is to be curious and embrace the ever-changing investing landscape. Geopolitical shifts; the increased attention on sustainability and ESG issues; and the prevalence of automation and machine learning in investing tools will likely redefine best practices in the coming years.

“There are always new financial instruments, new ways to implement a given strategy and new tools at our disposal,” he says. Successful investors will be the ones looking ahead.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.