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.
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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.