Embracing LDI? Don’t Forget Your Free Lunch

Why diversification still pays — even when you’re de-risking

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free stuffLDI is gaining more traction in Canada, and managers are changing their main question from “What is LDI?” to “How is LDI implemented?”  Here are some key considerations to take into account when looking to implement an LDI strategy.

Measuring the success of your de-risking program

A critical component of a dynamic risk management program is selecting a benchmark against which to measure the performance of liability hedging assets. The right benchmark for a hedging strategy evolves with the plan’s glide path positioning.  At a high level, a typical de-risking journey and its associated benchmarks can be divided into three broad stages:

  1. Early – At the journey’s early stage, the long duration fixed income allocation is relatively low. In this case, traditional long bond indices are likely to be adequate benchmarks.
  2. Mid – The journey’s mid-stage is where a sizable portion of assets are invested in long bonds.  At that point, it is appropriate to introduce a benchmark that accounts for the shape of the liability.
  3. Late – The late, or end, stage occurs when the plan is near or at full hedging.  At this point, using the plan’s liability as a benchmark will allow the sponsor to track the true performance of its hedging program.

Active management key

Many believe the objective of active asset management is to increase portfolio returns, and that this quest for alpha comes at the price of additional risk taking (active risk). While this conventional wisdom is true for most asset classes, active risk actually reduces funded ratio volatility as it relates to long duration mandates, in addition to increasing portfolio returns. This is due to a few important factors.

First, long bond indices are particularly concentrated. For example, the top 10 issuers of the FTSE TMX Canada Long Term Corporate Bond Index comprise almost 40% of the index.  Thoughtful active management will allow for greater diversification, thereby reducing portfolio risk. Second, long bonds tend to have lower liquidity and higher transaction costs.  Tactical active trading will reduce costs both at purchase and at selling. Third, liability discount curves are magically unaffected by bonds that default or are downgraded – a luxury that portfolio managers obviously don’t have.  Therefore, fundamental research and active management will help avoid defaults and downgrades; arguably, the most important objective when attempting to keep pace with liability growth.

Finally, past performance analysis suggests that active management has worked. More than 75% of active Canadian long bond managers have beaten the FTSE TMX Long Term Bond Index over a five-year annualized period.

Even for large Canadian plans, empirical evidence suggests that long bond assets are very concentrated, and are often invested with only one or two LDI managers.  But, there are many reasons why the increased diversification of LDI managers would benefit both sponsors and plan participants. The most obvious argument is that diversification limits the idiosyncratic risk of a manager’s operational failure.  Another valid reason is the fact that hiring managers who have complementary management skill sets is likely to provide smoother overall performance over time. Lastly, adding a few LDI managers to a plan’s roster is not very difficult to do, and it provides the sponsors with additional LDI think tanks and resources.

Summarized simply, the same arguments that are valid for diversification of equity managers hold true for LDI managers.  After all, diversification is still the only free lunch.

François Pellerin FSA, EA, CFA, CERA, is LDI strategist, Pyramis Global Advisors

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