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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