The implementation of the new Basel Capital Accord (Basel II), the FTK regulations in the Netherlands, the introduction of European Commission’s Solvency II insurance regulations, and the changes in international accounting standards are all having a major impact on the future shape of institutional investors’ portfolios.
Liability-driven investment (LDI) has been around for some time, but it is only at this point in time that interest in these type of strategies is growing considerably. Even though the number of pension funds that have already made the move by implementing an LDI strategy in their portfolios is still limited, the figures are likely to increase in the near future. Indeed, many investors feel they cannot wait for much longer before looking at making changes to the way their funds are being managed at present.
Long-term investments
“If you are a pension fund you are looking at a 20-year horizon and long-term investment strategies,” says Yves Lehmann, director for global solutions for financial institutions at SG Corporate Investment Banking, speaking at a recent LDI conference organised by IQ Finance in Amsterdam. “But at the same time the regulator is putting you on a one-year horizon. It is funny how a shift has occurred from long-term return in the 1990s to nowadays where we are looking at short-term risk.
“I personally think the problem is that you have to manage both short-term and long-term horizons and the most important thing is that you have to stay simple and humble in your approach,” Mr Lehmann adds. For him, a simple solution to managing the duration mismatch is to structure a bond which, in the beginning, will absorb the excess cash flows received by the pension fund, and then pay them off with interest over time.
“This is a very simple way to implement duration matching and it can be quick and cost-effective,” adds Mr Lehmann. However, making a static picture of assets and liabilities is going to resolve only part of the problem. “Next year you are going to find out you have some new members and your hedge is no longer relevant. We have moved from a static hedge to a dynamic hedge strategy.”
Taking into account liability movements is a key factor in any successful LDI strategy and asset managers have been working on solutions that do just that to satisfy the demand from institutional investors across Europe. Many of them have now LDI teams or LDI solutions among their product range. However, as is the case in other many areas of asset management, the perfect LDI recipe is still to be found.
Christian Fendt, head of strategic marketing at Fortis Investments, describes the duration mismatch of most pension funds as “not an active asset allocation decision but an unwanted, and in the past often overlooked, effect of common investment policies”.
 | Christian Fendt, Fortis Investments |
Because liabilities are a moving target, he says, finding an exact match is neither necessary or desirable. For him, an approximate match will always be more efficient. Fortis, like many other investment management houses, has developed its own range of LDI solutions to meet the increasing demand from clients. “We target the small- and medium-sized pension funds that do not have the resources to go direct,” he says. With this in mind, the firm recently established a Luxembourg umbrella fund with seven duration-matching compartments that can be used as building blocks for LDI clients where the leverage is generated by the use of derivatives. For those investors that cannot, or are not willing, to invest in leveraged funds, a range of Ucits III funds can be used instead as building blocks for an LDI strategy.
Because of the potential growth in the market, managers are trying to differentiate themselves by developing innovative solutions. Because bonds can play a major role in LDI strategies, those with strong fixed income capabilities will always be top of the list when it comes to new mandate awards. Whether investors are looking for clever strategies to make bonds work harder or want to benefit from the liability and inflation-matching capabilities of long-duration or inflation-linked bonds, having a good range of fixed income solutions and a reputation to match will definitely make a huge difference when competing for new contracts.
Pimco, for instance, has managed to put its name on the list of preferred fixed income managers for those implementing LDI strategies in different European countries, including mandates from the Laurus pension fund in the Netherlands, and the Xerox scheme in the UK.
According to a recent publication by Pimco on LDI implementation using an active fixed income approach, pension fund portfolios have traditionally relied very heavily on market risk for return, with relatively high weightings in equities. However, equities might not be suitable for most pension funds in the long term because of their relatively high volatility and the resulting impact on the fund’s surplus.
For Pimco, portfolios should be built taking into account some basic concepts. Firstly, interest rate risk should be hedged to the highest extent possible. Secondly, beta risk should be added as a function of the overall risk tolerance of the portfolio, with alpha being the main engine for return. Finally, inflation should not be ignored, as it impacts on future cash flows. The company’s approach when it comes to constructing an LDI solution for a client starts by modelling liability cash flows, followed by the creation of a benchmark based on the structure of the liabilities. Once this is complete, the firm analyses the benchmark’s performance to assess mismatches between the cashflows of the benchmark and the liabilities. It then tries to optimise the portfolio to minimise these mismatches.
Generating and porting alpha is another crucial aspect in institutional investors’ portfolios and also an important part of any LDI strategy. According to Keith Patton, head of fixed income, Europe at Aberdeen, his team has changed its investment process to enable the porting of alpha. “We ask our portfolio managers to invest against traditional indices – alpha – and the LDI team swaps the traditional index to the LDI benchmark,” he says. “We compartmentalise each area of that alpha, we’ve got beta management in terms of making this portable, and then we’ve got our allocation team which looks at all the resulting risk, hedging corporate indices using swaps.
“What we don’t do is asset swap every single security back to the LDI benchmark,” he says, pointing to the huge transaction costs and administrative burden involved. “What we do is create duration buckets of the assets. That entails some curve risk but this can be managed.”
He explains that the appropriate benchmark to use should be the change in the present value of the liabilities, something that is not supported by traditional index providers. “You can create a proxy from liquid constant maturity swaps, combine the liabilities into duration buckets and re-weight them whenever the liabilities change.”
He adds: “Not every pension fund is big enough to [warrant] a bespoke service. So what we have done is to develop a pooled fund structure to create certain buckets of duration and clients can choose the risk profile they want.” By using funds like the Aberdeen Portable Alpha family, investors avoid documentation problems, custodian fees and administrative complexities. “It is a very flexible structure,” Mr Patton says.
Robert Waugh, head of the ALM solutions group at ABN Amro, thinks the next generation of derivatives can also help when it comes to implementing LDI strategies, by hedging pension funds and insurance companies liabilities over the long term.
“Their risk and pay-off profile can be tailored to suit the appetite and aversion of a particular objective of an individual pension fund,” he says.
He adds that new derivatives have complex pay-out structures based not only on future prices but also the path taken to get there. “This presents a problem in understanding whether the risk taken is appropriate for the liabilities you hold and the objectives you are trying to achieve.”
Mr Waugh explains that traditionally people have used risk measures such as VaR to understand the current state of their assets but he thinks this traditional method had significant short-comings when dealing with derivatives. He suggests an alternative approach to measuring risk that takes into account the objective a pension fund wants to achieve, which is not dependent on statistical assumptions of distributions, treats non-linear instruments in an accurate way, and incorporates the liabilities that must be honoured. “The alternative would be to use a conditional value-at-risk (VaR) approach – CVaR – which is the average expected loss under the condition that it exceed the VaR,” he says.
“The next generation of derivatives offer pension and insurance funds the ability to hedge more liabilities than ever before,” he explains. “Unfortunately, the structured nature of these products represent considerable challenges when measuring risk and understanding performance over the long term against a liability benchmark.”
He recommends optimising short-fall to the desired confidence level while minimising contributions to the sponsor: “Such an approach is required to not only capture the risk associated with derivatives but also their nature which can be complex,” Mr Waugh says. “We have also shown that sponsors objectives can be achieved by using hybrid derivatives which are suitable for the hedging of pension liabilities when passed through the balance sheet.”
The use of derivatives will continue to be critical to some types of LDI strategies. However as Mr Patton points out, such strategies provoke a certain fear among institutional investors. A lack of understanding of derivatives and complex administration still puts many investors off. However, the benefits of derivatives-based liability by using interest rates futures, swaps and FX forwards, include being able to target the exact duration on specific parts of the curve. Also it allows for the separation of alpha and beta and can exploit the full universe of cash investment for alpha potential,” he says, adding they can also be very easily adjusted to the changing liability structure.
It’s clear the LDI arena is still an evolving and rapidly growing market. So far some pension schemes – like the Dutch Laurus pension fund (see scheme spotlight page 12) have already made the move and are satisfied with the results obtained to date. In the months to come, we will see more LDI mandates being awarded and more and more asset managers trying to put their names on the list of preferred LDI providers for institutional investors across Europe.
Making the right choice to suit your needs and expertise
Investors seeking to implement an LDI strategy have different solutions they can use right now. Based on their size, their funding requirements and their investment restrictions they can choose from a variety of instruments ranging from direct investments in long-duration bonds or the use of derivatives, or look for a pooled fund solution. At Fortis Investments, head of strategic marketing Christian Fendt cites four possible solutions that investors could choose from.
- Use of long duration bonds. These instruments are the preferred choice for many pension funds, since most of them have long experience investing in fixed income and the asset class does not represent the threat of the unknown. “Pension fund boards are very comfortable with these instruments,” he says, noting however there are some disadvantages related to practical issues including the fact that the universe of available long-duration bonds is limited. Another problem is that duration matching requires assets to be equal to the net present value (NPV) of liabilities, so it is only suitable for fully funded schemes.
- Use of swaps in combination with bonds. When using swaps, liabilities can be matched by assets worth less than 100 per cent of the NPV of liabilities, which means other assets can be invested in higher yielding investments. Compared to using long-duration bonds, swaps come with lower long-term funding costs. But the news is not all good. First of all, for swaps to be used the pension fund’s investment guidelines must allow the use of derivatives, instruments that potentially could also require pension funds to go through a long and expensive set-up process. Swaps can also present operational challenges related to execution, confirmation and settlement, valuation, collateral management and counterparty risk management. “Only large pension funds can ensure efficient management and diversification of counterparty risk,” Mr Fendt explains.
- Use of unleveraged pooled funds. These could offer the same benefits as the use of long-duration bonds but allow greater diversification and cost efficiency. At a time where IFRS/IAS accounting standards represent a major challenge for investors, the fact that investment funds have simple reporting requirements will always be attractive. “However the closeness of the match between assets and liabilities depends on the available buckets covered by the pooled funds, but will generally be less close compared to solutions one and two,” says Mr Fendt.
- Use of pooled funds with leverage. This frees up assets for investment in higher yielding asset classes. “A pooled solution as opposed to a direct investment in swap is more acceptable to many pension fund boards,” he says. However, as pooled funds without leverage, the closeness of the match will also be inferior to the direct investment solutions.”
