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The Risk Whisperers

From aiCIO magazine's November issue: How leading-edge managers have cut across silos, making risk factors the lingua franca of liability management. Leanna Orr reports.

To view this article in digital magazine format, click here.

There is an official story and a real story behind how three managers linked two of investing’s biggest trends in a paper and, instead of getting laughed at, won broad acclaim. Because the notion of applying a risk-factor framework to liability-driven investing (LDI) may seem like the coupling of Kim Kardashian and Kanye West: pretty arbitrary, except for their respective hotness.

The official origin story of “LDI in a Risk-Factor Framework,” as told by Andy Hunt, a BlackRock managing director and one of the three authors, goes like this: “To understand liabilities for risk management purposes, you have to start by knowing what those liabilities are and what risks they’re giving you,” he says. “And fixed income has always been very good at serving up risk factors.” Hunt and his team had been working in the LDI and risk factor spaces for years, he points out. “It’s very natural to try and find a common language between the two sides of the balance sheet for the purpose of holistic risk management.”

And this is what actually happened: “In reality, we were asked to write an article about liability-driven investing as well as one on risk parity. We thought, ‘Why not put them together under this new banner as they fit ever so well together?’” One suspects that the efficiency of one paper versus two also appealed to the authors. So, like any successful turn in evolution, “LDI in a Risk-Factor Framework” was by and large a happy accident. The paper won the 2013 Redington Prize—a biannual award for the best investment research authored by an actuary. It also defined the paradigm behind a decade of LDI innovation: the risk-factor approach.

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It all started with one. Ten or so years ago, before the 2006 Pension Protection Act compelled most plan sponsors to LDI or die, “duration” was the watchword in cutting-edge corporate pension risk management. It was a rough, if simple, measure of a liability’s lifespan, according to Callan Associates Vice President Eugene Podkaminer. He and the BlackRock trio—Hunt, risk parity head Phil Hodges, and strategist Dan Ransenberg—all know one another well. If the risk parity and LDI sectors were on a Venn diagram, these four reside in the overlap. It’s a young, research-driven space that seems more collegiate than cutthroat… at least for now.

“Back in the day, we would talk about liability duration as one number—11.5 years, for example,” Podkaminer says. “Pretty quickly, that evolved into key-rate duration,” a technique to measure a liability’s duration at multiple points across the yield curve. Then came the integration of the spread between corporate bond yields and US treasuries. “For the last four or five years, sophisticated asset management shops and consultants have been applying different factors and metrics to ever more granularly define liabilities: convexity, default risk, et cetera. This goes hand in hand with the research done on risk factors in years prior.”

Perhaps four or five asset managers and a handful of investment consultancies operate and innovate at the forefront of factor-based LDI. Each has its own secret sauce. These much-tinkered-with proprietary risk models diverge at the margins, but they share a core of fundamentals. “There is a certain level of consensus on some of the key factors,” says Joe Nankof, a partner at Connecticut-based Rocaton Investment Advisors. “Virtually everyone is looking at either nominal interest-rate risk or its two building blocks: inflation and real interest-rate risk.” Rocaton chooses to break it down. The second agreed-upon factor is spread risk, as both corporate credit yields and treasuries contribute to the not-so-secret funding status methodology used by US regulators. “The third which everyone would agree on is equity risk,” Nankof continues. “Beyond that there’s certainly difference in opinion.”

The BlackRock paper supports Nankof’s take on the industry fundamentals. It considers “simplified versions” of four of the firm’s in-house risk factors: equities growth, credit growth, real interest rates, and inflation. Neither BlackRock nor Rocaton would divulge the total number of factors in their models. However, Nankof’s colleague Matt Maleri, the consultancy’s director of asset allocation, gives reassurance that risk-factor modeling wouldn’t follow the razor blade industry’s approach to innovation: Just add one more. “We know that there is a limit,” Maleri says. “It’s not helpful for anybody to look at 10 or 15 or 20 risk factors.” Plus, he adds, the three core elements—nominal interest rates, spread risk, and equities—account for roughly 80% of a portfolio’s total exposure. “But that doesn’t mean we’re giving up on the other 20%.”

As risk models have become more comprehensive, so too has their utility for corporate defined benefit plans. Ten years ago, enhanced estimates of duration gave plan sponsors better insight into one angle of their liabilities. Now, the top-end risk models only fully deliver when applied to an entire portfolio and the sponsoring organization’s own exposures. But then again, that’s their selling point.

“You can look at your entire portfolio in risk-factor terms or cleave it into halves: liability-hedging assets and return-seeking assets,” Podkaminer says. When introducing the concept of risk factors to his clients, he’s found the best approach is a simple example: “In your liability-hedging portfolio, you probably have an exposure to credit. In your return-seeking assets, you also have credit exposure. But there is no crosstalk, because they can’t connect. At the most basic level, there should be crosstalk with factors from one side of the portfolio to the other.”

Holistic portfolio management is a lovely and intuitive theory, and Podkaminer’s clients typically respond with interest. But communism and global governance sound just fine on paper, too, and implementation brought us the USSR and League of Nations. Unlike those, the practical complications of applying risk factors to LDI seem to be surmountable. But they do exist. For one, developing a sophisticated risk-factor program would—for most corporate funds—mean hiring an external provider. At present, only a large handful of organizations are on the leading edge of the approach, and they’re all asset managers and consultancies. Education presents a barrier, too, as any of these managers, consultants, or savvy CIOs can attest. Risk factors are a whole new language, and resistance to change can come from any level. Holistic portfolio management runs counter to the common approach of substantially outsourcing assets across many specialized managers.

“I do believe there’s a world of specialization that consultants have driven into asset management,” Hunt says. “But these specialties aren’t necessarily engineered by anyone to fit together very well or be monitored holistically on an ongoing basis. Absolutely people tend to focus on their own piece of the puzzle without much care to what else is going on. With these kinds of siloed managers, if specific risks pop up, they go unmanaged.” Whether or not consultants created the problem of ever-narrowing manager mandates, Podkaminer sees his profession as part of the solution. “Implementing and monitoring a risk-factor approach falls pretty cleanly in the consultant mandate,” he says. “It’s our job to be thinking at a high strategic level about the whole portfolio, and it’s imperative that consultants do so.”

Still, funds need not overhaul their operational structure to work in risk factors. It’s up to CIOs—and perhaps their consultants—to align the fund’s various managers towards one portfolio-wide goal. “CIOs can ask LDI managers, ‘Are you incorporating what I’m doing on the other side of my portfolio in what you’re doing?’” Podkaminer suggests. Those on the return-seeking side also benefit from questioning, he says. “For example, ‘Of all of the capabilities that you have in your shop, Mr. Equity Manager, is this the right product or strategy to implement my objective? Is the flavor of the strategy in which I’m invested consistent with meeting my objectives in terms of high-level goals?’ These kinds of questions can show a lot about a manager’s willingness or capability to work in a risk-factor framework.”

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So how many corporate CIOs are asking these questions? In Hunt’s experience as US head of LDI for BlackRock, “implementation of risk factors with LDI has physically lagged the theory.” This aligns with the broader institutional uptake of risk-factor investing—or lack thereof. Most forward-thinking CIOs tend to agree that asset classes aren’t all that useful for building and optimizing portfolios. Nevertheless, only a handful of investment offices -allocate primarily by priced risk exposures. Norges Bank Investment Management, marshal of a US$800 billion pool of assets, is one. Indeed, its mandate declares that alpha “shall be achieved in a controlled manner and with limited systematic exposure to priced risk factors in the markets.” The New Zealand Superannuation Fund is another adherent. It’s likely no coincidence that these investment teams have substantial resources and answer chiefly to professional boards, not politicians or members. 

But risk-factor investing, like LDI, exists on a gradient. A plan sponsor that begins hedging a portion of its liabilities by extending fixed-income duration pursues a modest degree of LDI. Likewise, a public pension that adds a risk parity allocation detaches a bit from the asset-class model. Almost no one would argue with Hunt that, among corporate pension funds or any other institutional facet, there’s a lot more conversation than action on risk factors. But his reasoning might be more controversial.

“You need to embrace or facilitate leverage if you’re going to do LDI in a risk-factor framework,” Hunt says. “That has been, in our opinion, one of the greatest hurdles. Don’t buy the theory and give up on the practice.” Clearly, one man’s risk-factor framework is another man’s risk parity. Neither Podkaminer nor the Rocaton consultants define leverage as a real-world lynchpin of factor-based LDI. As columnist Angelo Calvello has vented in these pages many times, definitional issues hamstring this topic. It’s no wonder, then, that risk factors have given rise to so much discussion: Conversations may be going in circles as everyone tries to figure out what the hell they’re talking about, exactly.

From another perspective, LDI itself is an act of basic risk-factor investing: The target is a certain level of interest-rate exposure, while the asset class—say, 10-year treasury bills—is just the vehicle to get there. In other words, LDI compels an investor to be factor-oriented and asset-class agnostic—a mindset some define as risk-factor investing.

Unlike any other breed of asset owner (except perhaps insurance CIOs), corporate plan sponsors have a tangible motivation to embrace risk factors. Regulators have pushed them into it. That shove has been enough to overcome some barriers to implementation that still block other types of institutional funds. Take, for example, board education. Experts or not, trustees will get up to speed on nominal interest-rate hedging if it promises to tame a funded status that’s gone wild—and thus lower the CEO’s blood pressure during earnings season. Corporate asset owners, managers, and consultants have been singled out in the industry and incentivized to think factors. LDI has become the norm; most thoughtful plan sponsors will by now conceive of at least one portfolio target as a risk exposure, and of asset classes as the tools to reach it. And if not, it won’t be for lack of understanding. While the impact of interest rates on their funded statuses may no longer surprise corporate CIOs, a few probing questions to their managers and consultants might. A plan that appears no more engaged in its risk profile than hedging nominal interest rates may have a high-level puppet master overseeing half a dozen secret factors. Or it might not.

Before BlackRock put names to the converging trends, they had spent years in good company building out the middle of the LDI/risk-factor Venn diagram. The extent to which that research trickles up depends on the CIOs. Every risk guru interviewed here knows its bad business to bore or confuse clients with third- and fourth-order discussions of convexity. While they’re loath to reveal their bespoke models, each is keen to prove how busy they’ve been below the surface. For these select asset management nerds, LDI and risk factors have been a fated pair all along.

“Risk management is near and dear to corporate pension plan management, and it’s made more so because of all the regulation that has encouraged LDI,” Podkaminer says. “Risk-factor frameworks are just the next step. It’s not revolutionary—it is an evolutionary step.”

Home > News > Newsmakers > Coming To America
Newsmakers

Coming To America

From aiCIO magazine's November issue: Why Europe’s asset managers want America’s liabilities. Charlie Thomas reports.

To view this article in digital magazine format, click here.

Can you hear that distant rumble of hooves, bugle calls, and battle cries? It’s Europe’s biggest liability-driven investing (LDI) providers—and they’re charging towards the US.

America currently has corporate pension liabilities totalling $2.3 trillion—almost twice the size of the UK market. And that’s before you consider the public sector pension market, which has another estimated $3.5 trillion. There’s a lot to play for.

BlackRock, Insight Investment, and Legal & General Investment Management (LGIM) dominate the UK LDI market. Collectively, the three firms manage 90.9% of the liabilities hedged with these strategies. LGIM takes the crown with 43.3% of the market, according to KPMG’s last LDI report.

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These champions of LDI’s round table have overseen its evolution in the UK. No longer is it just a way of matching assets to liabilities: Today, LDI is a more rounded framework for working out the risks. It hedges out the ones you don’t want, and makes sure the risks you choose to retain pay a good premium. It’s about making your assets work harder, not locking them in.

In the US, meanwhile, LDI has started to gain traction. After years of talking about it and putting plans in place, mandates are accelerating. As they are predominantly corporate bond management strategies, most of those mandates are a simpler form of LDI than the British would recognize.

And this is where the UK’s shining LDI knights want to shake things up: The US is ready for LDI 2.0, and they believe they’re the ones to provide the LDI of the future.

BlackRock and LGIM first established their LDI businesses in the US in 2006, but it’s fair to say take-up had been slow until recently. Insight Investment began having conversations with plan sponsors six years ago, but only this year that has it opened a New York office with plans to offer LDI to a US market in the next 12 months.

So why are they crossing the Atlantic now? In short, because two big chickens are coming home to roost. 

In 2006, the US underwent two major changes. First, FAS87—the long-standing accounting measure—was abandoned in favor of Corporate Balance Sheet 158, meaning companies recognized the dollar value of pension fund deficits and were forced to calculate liabilities on a mark-to-market basis. In turn, this limited companies’ abilities to borrow money, as well as make some other business decisions, putting pensions at the top of chief financial officers’ to-do lists for the first time.

Secondly, the Pension Protection Act was introduced, bringing changes to funding rules and contribution requirements. In a nutshell, deficits had to be made good in a seven-year period, and while an element of smoothing has been allowed due to the financial crisis, today’s landscape has a much clearer view of the value of assets and how they and pension fund liabilities dictate contribution requirements. Both of these changes are only now really starting to have a profound effect on US pension funds—and these funds want help.

“When these things happened, that gave the impetus for de-risking and LDI,” says Andy Hunt, head of US LDI at BlackRock. “There was lots of planning and preparation, but it’s only now that people are pulling the trigger.”

Andrew Giles, CIO of solutions at Insight Investment, agrees that going out to the US market six years ago was tough. “They told us: ‘We did all this in the 1970s, and it was expensive—and we missed out on a big part of the equity rally’, and they weren’t very keen,” he says.

But after the credit crunch, everything changed. “In 2006, everyone was talking about it, and there were conferences held on it, but in 2007 the cash crisis crept up, and then you had the credit crisis and the full-blown economic crisis. And then funding levels fell off a cliff,” Hunt says.

LGIM’s Global Head of Solutions Aaron Meder believes the economic crisis kick-started interest in LDI, with the first steady flow of assets coming in around three years ago.

“During the credit crunch, credit spreads blew out to record levels, giving plan sponsors an opportunity to invest in long-duration corporate bonds at an absolute yield of 7% or 8%. That was the first time that opening had come since LDI opportunity had taken place,” he says. “The second reason is that the credit crunch was the second, if not the third, time that decade that pension funds had seen significant drawdowns as equity markets fell. Interest rates also fell, and there was this realization that there’s a lot of risks in these pension funds.” What happened next was a raft of fixed-income managers offering LDI solutions for an American audience—long-duration credit, in some cases actively managed, to match the liabilities.

So why does America need BlackRock, Insight Investment, and LGIM?

“If you asked any fixed-income manager in the US if they do LDI, they’d say yes. But we think there’s a big difference between long-duration fixed income and managing the physical securities and/or derivatives relative to a liability benchmark and being accountable for performance and reporting attribution,” argues LGIM’s Meder. “That’s where you need to invest in a dedicated LDI team, and there’s very few people in the US that have invested in that. Fixed-income managers have been able to get away with that so far, and there will always be a demand for just long-duration fixed income. But over time there will be increasing demand for customized management against liability benchmarks. Those true LDI providers will become increasingly separated from those managers who just ‘do’ LDI.”

Others are less aggressive about their competition in the US. BlackRock’s Hunt believes there’s room for everyone. “We talk about there being a quarterback role, or a completion manager role,” he says.

As up to 80% of an American pension fund’s assets could be in corporate bonds, it’s rare to select just one manager. Many pension funds have three or four to spread the manager and alpha risks. “That means there’s an increasing need for one of those managers to act as the hedging manager and provide the coordination, running overlays across all of the portfolio, and possibly providing an aggregation of reporting data for the plan sponsor,” Hunt explains. “Fixed-income managers are a part of the solution, but they’re not enough on their own.”

Insight Investment, meanwhile, believes its more holistic attitude to LDI merits a push across the Atlantic. “We differentiate between liability risk management and LDI, which is as much about the asset side of the balance sheet as it is about the liabilities,” says Giles. “One of the things that has worked well for clients in Europe is to separate the decisions into ‘What do I want to hedge?’ and ‘How much risk do I want to take on the asset side of my balance sheet?’” He continues: “The beauty of using the UK approach with derivatives through overlays is you can hedge whatever you want, but what you do with your assets is a completely different decision, driven by how underfunded you are and how much risk you want to take.”

There are a number of obstacles for these European gallants to overcome if they’re to make it big in the US market. Fundamentally, the two types of LDI (European and US) are different—largely because the liabilities, and the way they are discounted, are different.  

In the UK, liabilities are inflation-sensitive, and matching assets tend to be long-duration gilt-type bonds. Liabilities have durations of around 20 years, and UK-based plans hedge on an economic basis using a combination of derivatives, including swaptions and overlays.

In the US, duration is shorter—more like 15 years—there is typically no inflation-linking, and discounts are calculated using corporate bond yields. Their primary concerns are hedging interest rate and credit spread risks.

Financial markets are different, too: There’s a much deeper long-duration credit market in the US and a relatively liquid traded derivatives market. In the UK, gilt futures are not as liquid, and there’s not much around that is longer-dated than 10 years, forcing investors into over-the-counter derivatives for synthetic exposure to interest rate and inflation hedges.

The big shift, therefore, will be to convince a US market that it wants to move away from simply actively managing corporate bonds and towards taking those long-duration securities and adding in derivatives, a liability benchmark, and possibly overlays.

There is evidence that this starting to happen. At LGIM, Meder says his US clients are currently split: 65% opt for the simpler LDI, and 35% choose the derivatives and benchmark variant. He predicts that will move closer to 50:50 in the medium to long term, and that the majority could even reverse.

Insight Investment is trying to encourage the US market to synthesize elements of the portfolio outside of the credit portion in order to free up other assets to invest in return-seeking strategies.

Another major difference, and potential setback, is the lack of consultant influence in the US compared to the UK market, the managers say. Insight’s Giles is the most candid: “Consultants’ influence is less pervasive in the US than in the UK, which complicates the problem for us. In the UK, we can talk to a relatively small number of people and gain a huge market coverage. In the US, it’s more dissipated.”

The only way “in” will be to build a personal rapport with the CFOs, plan sponsors, and investment committees of those US pension funds. Having a well-known parent company (Insight’s BNY Mellon) or a well-known brand (BlackRock) will open some doors, and having existing LDI business with US companies’ UK or Dutch arms will also help (all three).

Staff on the ground will be crucial, however. All three now have offices in the US, although Insight is a relative late-comer, moving in just this year. All three plan to recruit domestically—while the risk management and tools imported from the UK are useful, they know the implementation doesn’t necessarily translate.

BlackRock arguably has the strongest presence, with a reported $220 billion global LDI book, $48 billion from 161 US clients. That compares to £82 billion in the UK and £36 billion for 32 European ex-UK clients, predominantly from the Netherlands.

LGIM has $40 billion in US LDI assets across roughly 60 to 70 clients, while Insight Investment has no clients in the country, as of our print date. In Europe, its liability hedging book tops £205 billion, more than half of which comes from the UK.

 

The one advantage these heavyweights have over their US counterparts is the length of time they’ve operated in LDI. LGIM transacted the first LDI strategy with UK pharmacy Boots in 2002. With all of that knowledge, they should be able to spot the future trends of the LDI market and where it will go when the corporate defined benefit books are sewn up.

All three are adamant there are no fat ladies singing in London: There are still plenty of UK LDI mandates. “Even those pension clients which have implemented hedging strategies may only have a hedging ratio of 40%,” says Insight’s Giles. He also thinks the public sector market in the US is worth considering at a later stage.

BlackRock’s Hunt thinks the next evolution could see other institutional funds with softer liability pledges adopting LDI. “LDI as a broad concept is totally applicable,” he says. “It works for endowments or foundations which have a desire to pay for future uses of money. If you have a spending pattern and want to commit to a certain amount of money, that becomes a stream of income, and you could argue that you could match your assets to naturally pay those payments when they fall due.”

Defined contribution (DC) funds are another fertile ground for LDI, Hunt continues. “DC isn’t just a wealth accumulation fund, it’s a provision for retirement. The needs of retirees and what income they can draw for their healthcare and cost of living is a structured need.”

And it doesn’t stop at the US. Up next: investors in Canada, Japan, and Australia. The knights have you in their sights. 

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