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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.
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.”

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.”