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A “perfect number” exists in mathematical theory. In liability-driven investment (LDI), it does not. On one side of the Atlantic, investors are suffering an embarrassment of riches; on the other, it’s slim pickings. This uneven spread is failing both sets of investors—but it might be about to change.
In the UK, the market that arguably led the LDI charge, there are 14 providers offering services to pension funds, according to KPMG’s calculations. But with rates continuing to edge downwards, many investors are loathe to lock in and instead avoid these strategies. Does that mean there are too many providers? And how many are “me too” brands rather than real innovators?
The UK market has traditionally been dominated by three players: Legal & General Investment Management (LGIM), Insight Investment, and BlackRock. But there has been a flurry of new entrants who are themselves fund management heavyweights: Schroders, AXA Investment Managers, and F&C Investments.
There might be even more pretenders to the throne, except for a controversial barrier: the consultant market. TC Jefferson, senior consultant at London-based executive search specialists Plenum Group, tells aiCIO some consultants only give airtime to providers with a sizable and dedicated LDI solutions team. This means less-established players who want to grow organically can find it a tough market to penetrate.
“There is a serious catch-22 in that consultants, while wanting more choice for their clients, stand accused of exacerbating the problem in reinforcing barriers to entry for new and smaller LDI providers,” he says. “This capacity issue is made worse by the conservative nature of trustees themselves, many of whom may lean towards a household name. The current LDI landscape is a reflection of the fact that, as a relatively low-margin business, the success of LDI can be a question of scale.”
The state of the LDI market is seen completely differently on either side of the Atlantic, however. Russell Investments told aiCIO that demand is outstripping supply in the US, while the UK market is ripe for consolidation.
Marty Jaugietis, Russell’s head of LDI for the Americas, notes that there is a huge appetite for the strategy that has yet to be sated stateside. “The average allocation to LDI fixed income of our US consulting client base has risen from 25% to 43% over the past six years,” he says. “However, this is still regarded as the relatively early innings in terms of the amount of interest-rate risk being hedged, which results in material differentiation in solutions.”
Some feel there still isn’t enough variety on offer in the US. Dave Wilson, managing director at Cutwater Asset Management, says there’s plenty of room for more entrants into the US LDI space because there are too few providers offering bespoke products. “While there are many investment managers in the US that offer LDI, there are very few that are truly committed to providing customized, solutions-based investment programs for their clients,” he explains. “Too often, US plan sponsors are presented with a one-size-fits-all recommendation of extending duration, which may not be appropriate for some or precise enough for others.”
Kimberlee Lisella, senior client portfolio manager at LGIM America (and formerly of Cutwater) agrees; she says the US LDI market is split into fixed-income providers who “do LDI” and what she calls true LDI providers.
Most managers offer LDI in terms of managing a single, long-duration strategy benchmarked against a standardized market index. The exciting ones might also offer blends of standard market benchmark long-duration strategies, but there aren’t many who offer a tailored experience for pension plans and their liability benchmarks, she claims.
But are those bespoke tailors worth the extra money? Lisella argues (perhaps unsurprisingly, given her employer) that they are, as they manage credit and develop LDI strategies while understanding that pension liabilities are un-investable and do not have default risk. “Essentially, these LDI managers recognize that outperforming a market benchmark does not necessarily mean the client has achieved success relative to their custom liability benchmark,” she says. “A customized liability benchmark holds the LDI provider accountable for performance against the client’s actual liabilities, and provides a detailed attribution which quantifies ‘un-investability’ and how the manager has added value.”
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Meanwhile, back across the pond, David Rae, the head of LDI solutions for EMEA at Russell Investments, believes we’ll see the number of providers shrink. Any future flows to LDI will to go to a concentrated number of providers, he says. “In recent years, a number of providers have entered this market to challenge the dominance of the small number of players at the top, but it is unlikely that the market can sustain all of the new entrants. The success of these new entrants will depend on their ability to offer a differentiated product and attract scale to compete with the early movers in the marketplace.”
Howard Kearns, head of LDI for EMEA at State Street Global Advisors (SSgA), also says 14 players in the market was “clearly too many.”
Predictable statement warning: The UK’s big guns believe there’s enough capacity in the LDI market, and that the need for new entrants is slim. But there may be more to their claims than just self-preservation. Mike Walsh, head of solutions distribution and management at LGIM in the UK, says pension funds need to align themselves to a manager who is in the LDI game for the long term—and that having more managers offering products could actually be detrimental for pension funds. “In addition, clients are looking to access inflation protection, and the inflation market is very much driven by supply.
Merely having more managers chasing the same inflation supply will not provide a better outcome for clients,” he adds.
Steve Aukett, director of financial solutions at Insight Investment, also believes there are enough players in the market, although he did welcome the recent influx of managers into the LDI space. Established managers have been challenged to justify their value propositions by the new competition, he says.
“A broader range of providers gives clients greater choice and a better means to assess the quality, risk, and value of different offerings,” Aukett continues. “However, new players should not underestimate the investment and level of commitment required to meet client objectives. “The effective management of operational risk, counterparty exposures, and representing clients’ interests in the move towards central clearing are just some examples of the many areas that require significant investment in both people and operational infrastructure.”
Not everyone is convinced by the less-is-more argument though. SSgA believes the market will grow, and has invested heavily in its LDI offering. Many of the smaller LDI managers also tell us that new entrants would be a welcome development to shake up the status quo.
AXA IM is one of the newest players in this space: After winning a UK public-sector client, it suffered a setback in the loss of its head of LDI to his homeland of South Africa—but a replacement is on the horizon. In the meantime, the firm is planning on expanding its LDI team in direct response to interest from its clients. “We see significant demand both in terms of the number of schemes as well as the assets under management,” said Madeline Forrester, head of UK institutional business development at the fund manager. “There is a need for new entrants and competition in the marketplace to ensure that providers offer the training, support and bespoke approach that schemes require.”
Other than dastardly consultants, what other barriers to entry are there for new providers? The fixed costs of setting up a suitably staffed derivatives trading desk, the operational infrastructure to support a derivatives business, and the necessary deal flow in the market to ensure best pricing from banks, to name but a few. Julian Lyne, head of global consultants at F&C, explains: “Entry into the LDI market will require a sustained investment for several years, partly explaining why several providers have failed in recent years to sustain their commitment to the LDI.”
Maybe there is no “perfect number” for LDI providers, but it is clear there are some additions and subtractions to come—and soon. —CT