Coming Soon to Your LDI Plan: Equities | Chief Investment Officer

Pension funds are beginning to incorporate equities into their liability-driven investing (LDI) strategies in an effort to protect funding ratios when interest rates start to rise.

“When short-term rates rise, the long-term ones may follow suit, undermining the worth of LDI.” —CREATE-Research investor surveyA survey of institutional investors, consultants, and fund managers by forecasting centre CREATE-Research showed a more “dynamic” approach to de-risking glide paths was emerging, including re-allocating to equities.

Private sector plans have begun creating dynamic LDI glide paths that favor rebalancing towards equities when bond allocations exceed their pre-set levels, the survey’s author and CREATE-Research founder, Professor Amin Rajan, wrote. “Some plans are wary of sticking to their original risk immunisation strategies, which never anticipated that yields would drop so low as to undermine bond investing.”

Rajan added that low rates and higher aging demographics “have sparked a downward spiral of rising liabilities, rising deficits, rising insolvency risk, and rising negative cash flow”. Extra contributions from plan sponsors “have eased the spiral, not reversed it,” meaning some pensions would have to take on more equity risk to improve their funding ratios.

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One global consultant cited anonymously in the report said many pension funds adopted traditional LDI strategies when discount rates were between 5% and 8%. “As rates declined, more and more plans found LDI an unattractive option,” the consultant said. “When short-term rates rise, the long-term ones may follow suit, undermining the worth of LDI.”

Investors were “willing to give equities the benefit of the doubt”—despite some indexes hitting record valuations—because they believed recoveries underway in Japan and Europe would lead to improvements in company earnings that can support the high valuations.

The consultant said pension funds in Germany had increased equity allocations from 22% in 2008 to 26% in 2013. Public sector plans in Japan are dramatically expanding their traditionally low exposures to equity in the wake of a similar move by the country’s Government Pension Investment Fund.

CREATE-Research’s report—“Pragmatism Presides, Equities and Opportunism Rise”—covered 705 institutions from 29 countries overseeing $26.8 trillion in assets, and is available from the group’s website or from Principal Global Investors, which commissioned the report.

Separate research conducted by the CFA Society of the UK revealed a record proportion of its members believed developed market equities to be overvalued. Some 61% of respondents to CFA UK’s survey said developed equity markets were either “very overvalued” or “somewhat overvalued”—the highest level since the survey was launched three years ago.

Will Goodhart, chief executive of CFA UK, said quantitative easing and other market stimulus programs from central banks have driven valuations “well ahead of fair value”.

“The fact that a significant majority of respondents now regard developed market equities as overvalued means that there may be limited support for both equity and debt valuations in the face of potential increases in interest rates,” Goodhart added.

The number of hedge funds available to investors has remained largely constant since the crisis, while performance has become more dispersed and fees are falling, research has found.

Since 2011, there has been an annual average 1,080 new hedge funds opening around the world, with an average 854 closing up shop, according to Hedge Fund Review (HFR). This cycle has led to an average net 226 increase in the number of funds available, compared to soaring figures in the first half of the last decade.

In the first quarter of 2015, the sector saw 264 hedge fund launches and 217 liquidations, putting it on target to sit in line with last year’s overall result, should it continue in a similar pattern.

“The environment to launch new funds continued to be challenging, with managers balancing increased demands for performance, transparency, liquidity and complex regulation.” —Kenneth Heinz, HFRBetween 2001 and 2005, the number of annual hedge fund launches grew from 673 to a record 2,073. At the start of the decade, closures were much lower than the present day with 92 closing in 2001. This grew to hit 848 closing in 2005, and after a spike in 2008, has remained relatively consistent around that number.

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The slight difference between the newly opening and closing funds in the recent past has pushed the number available to investors to a record high, HFR said. At the end of March there were an estimated 10,149 funds operating around the world and managing a record $2.94 trillion.

“The environment to launch new funds continued to be challenging, with managers balancing increased demands for performance, transparency, liquidity and complex regulation,” said Kenneth Heinz, president of HFR. “While allocating to newly launched emerging managers requires investors to bear incremental, firm-specific risk, investors are compensated for these idiosyncratic risks through innovative strategies, access to capacity and dynamic, early-stage fund performance.”

Dispersion in performance between the top and bottom quartiles grew wider in the first quarter of the year. The best funds gained an average 12%, while the worst lost 7.6%. Added into a 12-month rolling average, it pushed the top decile to a 35.5% outperformance and the bottom to a 20.7% loss—amounting to a 56.2 percentage-point dispersion.

These numbers showed a greater dispersion than in the calendar year 2014, which saw top performers grow 27.4% and the bottom lose 19.5%, resulting in a 46.9 percentage point dispersion.

Despite a fairly consistent level of launches in the sector, funds opening in 2015 priced themselves slightly lower than their comrades did in 2014, HFR found. The 2015 vintage has demanded an average management fee of 1.52%, representing a five basis point fee reduction over those launched in 2014.

Average management fees have also fallen to 17.04% for launches in 2015, representing a 31 basis point decline over the 2014 set.

HFR launches Q1 2015 Source: HFR