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Liability Driven Investment

2. The ‘core’ element of such a structure

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2.1          In some respects LDI can be thought of as a variation of the core-satellite investment paradigm that was common some years ago. This involved subdividing the portfolio into a low-cost (often passively managed) core element that provided the bulk of the exposures the investor wanted, together with a higher-cost, actively managed satellite element that would hopefully deliver better returns (sufficiently better to justify the extra expenses).

 

2.2          An important advantage of using an overlay element structure within the structure is that it divorces the managing of the ‘core’ (physical) asset base from the ‘bespoke-ness’ needed to achieve a close match to the investor’s own liabilities. The ‘core’ can then be managed in a practical manner, e.g. along the lines of a manager’s standardised investment process against some relatively standard benchmark, offering potential economies of scale.

 

2.3          The precise structure of the core element can still express investor preferences, but these preferences can now primarily refer to the assets in isolation, rather having simultaneously also to cater for the precise shape of the liabilities. For example, the core element might eschew gilts in favour of a greater proportion of less well-rated credits. This might be because the yield spread of such bonds over gilts is believed by the trustees to over-compensate the holder for the likely future default loss experience on such bonds on the grounds of liquidity criteria, but see Kemp (2009).

 

2.4          It also ceases to be necessary for the core component to be exclusively bond orientated, even merely the protection element of the ‘core’. Instead, the core could make use of portable alpha. Nowadays swaps come in a very wide variety of forms. It is now possible to swap almost any sort of return stream, property-like, equity-like, bond-like, cash-like or inflation-like, into any other sort of return stream, embedding into the swap, if we so wished, caps, floors and other option-like characteristics. So, if an investor has confidence in a given active manager’s skill at adding value then this skill can be in any asset class we like with the added value ported onto a liability orientated benchmark merely by swapping the return on the relevant active manager’s benchmark into the return on the benchmark set by reference to the liabilities.

 

2.5          But whether such refinements are likely to be appreciated by most sets of pension fund trustees is less clear. A few asset managers do offer portable alpha products, but take-up to date has been relatively limited, perhaps because of the difficulties involved in educating trustees in the concepts involved (or in being sure that there is no leakage of value by the porting process). Also, one can argue that the swap contracts might be more keenly priced if they are swapping similar sorts of return streams. So, all other things being equal, if our desired cash flows are akin to fixed or inflation-linked bonds (just rather longer than is easily available in the physical market place) then starting with similar sorts of cash flows may be preferable.

 


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