LDI: Does It Make the CAPM a CRAPM? | Chief Investment Officer

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The portly G.K. Chesterton once remarked to the slim George Bernard Shaw that if folks saw Shaw they would think there was a famine in the United Kingdom—to which the quick-witted Shaw replied, “And if they saw you, they would know why!”

The Capital Asset Pricing Model (CAPM) did a similar injustice to effective asset management as Chesterton did to the food supply of the UK—it sucked up all the oxygen. Many naïve proponents of liability-driven investing (LDI) extend CAPM to develop LDI approaches and try to ground their products in finance theory. But if everyone invests based on LDI, CAPM would be wrong and extensions of wrong models are rarely right. The global investment industry is based on CAPM/Mean-Variance Optimization (MVO). Is this the cause of the declines in solvency and potentially of future crises?

MVO and CAPM make two assumptions that should cause any reader of this magazine, who are meant to be represented in CAPM, to sit up and pause. First, every investor seeks to earn the highest absolute return per unit of volatility. Second, they make all investment decisions themselves (i.e., they function as “principals”). While heavily divorced from our reality, along with other simple assumptions, this allowed theorists to develop the CAPM, which is elegant and easily learned by even my undergraduate students. For example, the expected return of a risky asset is easily discerned by its beta and the expected return of a “market portfolio” and everyone allocates between a risk-free asset (cash) and the risky market portfolio—no mention of liabilities here. Yet CAPM is silent about the return of bonds; bonds account for a reasonable share of total financial markets and portfolios, and are a core asset in any LDI approach. The massive decline of rates led to meaningful solvency declines globally, yet CAPM has little to say on the expected return of bonds, factors impacting it, and hedging liabilities. LDI proponents are seizing this opportunity to market products as opposed to fixing the original problem—the flawed CAPM theory behind the portfolio allocation decisions.

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Every investor, whether institutional or retail, sets aside money to service some future consumption or expenditure (termed the “liability”), as shown by the late Nobel winner Franco Modigliani. Investment decisions need to be made on this pool of savings. These decisions need to be made relative to the liability, however defined, and not on an absolute risk-adjusted return basis as assumed by CAPM. While common in pensions, Mark Schmid, the CIO of the University of Chicago endowment, demonstrates how even an endowment can apply LDI concepts, moving away from the CAPM-anchored “endowment model.” In short, investment portfolios must be highly positively correlated to liabilities to prevent future solvency declines. Many of us who used the CAPM approach overallocated to equity/hedge funds (negatively correlated to liabilities!) as opposed to the liability hedge, and paid the price from 2000 to 2012. Given current underfunding and equity allocations in portfolios, a smart investor needs to invest in strategies that earn a return greater than the liability (to grow solvency), and correlate positively to liabilities, and negatively to equities (to lower solvency risk and provide a tail risk hedge).

The second area of relative decision making is that very few investors manage their own investments. Boards (“principals” in CAPM) typically hire CIOs and consultants who then hire external managers (“agents”) to implement the investment decisions. CAPM misses the nuances that follow. The principal is unsure whether the “highly paid” agent is lucky or skillful. High relative risk conveys low confidence that the agent is skillful. To preserve the fee annuity, agents manage portfolios to correlate closely to the benchmark (low relative risk), however flawed the benchmark might be in replicating the liability or in minimizing drawdowns (e.g., in 2008), thereby hurting investors.

A new and different model—let’s call it the Relative Asset Pricing Model (RAPM), which academics need to develop—would price all assets relative to the value they provide to hedging the liability and not just a market portfolio, and this pricing would be affected by how much relative (or correlation) risk one can bear relative to the liability. Every investor would allocate between the liability hedge, cash, and risky assets. Using RAPM, the decline in interest rates from 2000 can be attributed to changes in regulator-imposed constraints on relative risk to liabilities in Europe and the US (because of PPA), leading to a greater demand for nominal bonds/liability hedges. When the regulators in Europe relaxed this constraint in June 2012, rates backed up as RAPM would predict. CAPM is just a very specialized/constrained case of a more realistic RAPM and assumes no liability and no delegation. Noting the flaws of CAPM, innovative funds are dispensing with a strategic asset allocation that is produced from some CAPM-based models, benchmarking themselves to the liability, and ensuring that they are empowered by the board to make investment decisions as opposed to being encouraged to delegate to third parties.

Rather than try to flog LDI products, our focus should be on helping investors think about using RAPM to rethink asset pricing, portfolio structuring, rebalancing, and manager compensation. Otherwise, agents will earn good fees, but client portfolios could end up in a pile of CRAPM.

Arun Muralidhar is Chairman of Mcube Investment Technologies LLC (www.mcubeit.com), and CIO of AlphaEngine Global Investment Solutions (AEGIS).

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The elephant in the room for institutional investors is whether target return assumptions of over 8%—established in times of rosier equity risk premia—are achievable in the future. To posit that the median plan will reach 8% is, at best, greatly optimistic, especially in the “risk-on/risk-off” environment post-2008.

However, after what the industry has gone through over the decade, it is not surprising that fund sponsors are evaluating alternatives to the equity-centric policy standard.

How Low Can You Go?

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Interest rates are at historic lows, but for plans approaching fully funded status, lengthening durations and increasing fixed income is high on the list of risk and volatility management.

A number of institutions have switched from an equity-biased asset allocation model to a liability-driven investment (LDI), risk-parity, or factor-based approach. Typically, addressing the asset/liability mismatch includes combining long corporate (10 years+) and government credit (two to three decades+) with options and derivatives to hedge certain exposures.

Large corporate and defined benefit (DB) plans are moving to LDI to reduce market and balance sheet volatility. Compared to their five-to-ten year brethren, multi-decade credit looks more like a liability than an asset.

Plans that are not fully funded—and there are many of them—potentially face significant risks if they lock in low yields now, since shorter duration bonds could improve their funded position should rates rise. According to Aon Hewitt (which by the way has one of the best apps in the industry, “HRevolution”), 86% of DB plans were underfunded as of January 2011.

While long duration bond funds are a possible solution, the strategy faces a number of challenges: the possibility to lock in losses by going long now, convincing trustees to approve the necessary portfolio changes, and the overall question of supply for long duration bonds in the marketplace.

How Long Can You Go?

The UK, driven by the depth of its pension market and regulatory impetuses, in 2005 started with a 50-year gilt. This summer, the UK’s debt management office reported sales of long-dated government bonds of £11 billion in under an hour (50-year gilts accounted for £4 billion), which prompted the chancellor to put forth the idea of a 100-year “Osborne bond” or a perpetual gilt, similar to bonds issued after the South Sea Bubble and WWI.

On the emerging front, Mexico—encouraged by the success of Rabobank and Norfolk Southern—issued 100-year debt at a 6.1% yield, while Peru post-2008 sold 40-year sovereign bonds. Often, such issues have been a result of specific requests. For pension funds, the longer, the better.

For the US markets, getting longer exposure has been an uphill battle.

Going beyond the existing 30-year offering, the discussion by the US Treasury to create 50- and 100-year bonds as a sensible thing to do in this environment is built around $2.5 trillion+ in possible demand in the next few years as a result of financial and pensions regulation.

The 2008 crisis forced the US government to issue $800 billion in Treasury bills, along with some $500 billion in short-term financing to deal with the financial crisis. Since then there have been efforts to transition to longer term financing with auctions of 10- and 30-year bonds, alongside 10-, 20-, and 30-year TIPS for a total of more than $2 trillion in various instruments with long maturities.

Still, the average maturity in the UK—close to 15 years—is three times longer than in the US.

As a result of the limited long-term supply, asset holders have been stacking up on long-term corporate debt instead of US Treasuries. 2012 is already a record year for 30-year corporate bonds. Halfway through the year, long-term corporate debt sales had already surpassed the $85 billion 2011 full year totals, capitalizing on the low-yield environment and institutional demand for alternatives to government debt. For example, the University of Pennsylvania issued $300 million in 100-year bonds at 4.64% (lower even than the California Institute of Technology last November) in a strategic move to take advantage of low borrowing cost.

So while LDI implementation and long duration bonds are a risk management solution for some well funded plans and a good way for corporations and schools to raise money, most institutional investors must first decide whether rates could potentially go lower or remain low, and then perform a balancing act of risk allocation, interest rate assumptions, and board education around new investment policies and implementation triggers. Moreover, as Callan Associates speculated in a recent risk parity research study, “Given the underperformance in the 1990s and the practical difficulties to implement a levered policy portfolio, it is unlikely that the levered risk parity approach would have survived at any major institution.”

And assuming this communication conundrum can be solved, good luck with breaking the news that future returns might be closer to 5% than 8%.

Daniel Enskat is Senior Advisor to Asset International and Founder of Enskat & Associates.