Pointing out that pension fund cash flows were not certainties that could be exactly hedged away, Mercer advised against incurring unnecessary transaction costs or yield loss to achieve “spurious” cash-flow matching.
The firm said the extent of interest rate and inflation risk reduction should be commensurate with a pension fund’s overall strategy. Where risk mitigation could be achieved with less complexity, cost and loss of expected return, such as through reducing large equity exposure, this was deemed a preferable solution for the majority of pension funds.
Mercer also pointed to potential difficulties when seeking to hedge interest rate risk if the bond allocation is low or there is a funding deficit. While trustees could simply buy bonds with a longer duration than the liabilities, so that the average duration is achieved, this introduced yield curve risk. Although the desired interest rate exposure could be achieved using swaps, investors must be aware of the implications of using such instruments.
Where bond allocations are upwards of 50 per cent, managing interest rate and inflation risk should form a more significant component of investment strategy.
Mercer expressed doubts about liability-driven investment products which took a diversified alpha approach, arguing that some use hedge fund strategies which raises a capacity issue. The firm contended that many asset managers do not appreciate the need to offer diversified alpha sources outside their own range of funds.
Mercer has also warned that a shortage of skilled managers and increasing flows of money into hedge funds, unconstrained portfolios and portable alpha products that use market-neutral strategies are threatening return expectations.
The firm added that unless the high level of fees for such strategies came down, investor demand could fall.
HS
