Who Knows Best about Hedging?

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If you had a view on interest rates and inflation, would you want to be in control of hedging them out of your portfolio—or would you let someone else do it?

The answer, at least from investors responding to a survey by liability-driven investing (LDI) and outsourcing group SEI, is that many think someone else might do a better job than those who have fiduciary responsibility for the fund. One-third of respondents said they had views on the movements of these essential rates, and putting aside the fact that two-thirds did not, just over a quarter said they outsourced the decision on the amount of hedging implemented.

Potentially, a more understandable number might be the 40% who said they would hand over the reins to someone else to pick hedging instruments. Some smaller pension funds might not feel comfortable choosing from a large arsenal of derivative products, for example. Similarly, changing where investments sit on an inflation curve is not something for an investor with just a rudimentary grasp of markets to grapple with.

But to hedge inflation and interest rates at all—and to what extent? Surely that is one of the basic decisions for pension boards.

The reason behind this view has been the rise in outsourcing investment decisions to third parties. In the UK, consulting and auditing firm KPMG found there had been a 40% increase in the growth of fiduciary management in the last year alone.

The push into this delegation of investment responsibility has come about as pensions—and other large institutional investors—feel they are not equipped to carry out their duty to the level required by those who will benefit from the funds.

Again, this is understandable, but even David Hickey, director of European pensions advice at SEI, thought the number of investors farming out a decision as integral to a fund’s health as interest-rate and inflation-hedge setting was high.

“Although pension funds are taking views themselves, the amount of them saying ‘there must be someone who knows better’ is surprising,” Hickey tells aiCIO. “But it shows the flexibility available. These investors are really only going to outsource these functions if they truly believe the person they are giving the reins to actually does know better.”

Another reason may be to do with the instruments that are being used. Rather than sticking to conventional bonds, government bonds, and swaps, investor portfolios are being hedged using a wider range of complex instruments. (Don’t forget the 40% who said they outsourced the decision on what instrument to use.)

Some 19% reported using synthetic gilts, with another 19% agreeing to use alternatives and a further 15% saying they were using options to get rid of their risk. Given the rise of these instruments, combined with a large number of investors lacking proper understanding of what results they may be able to produce, it might be advisable to leave them in the hands of the experts.

There are still investors paddling their own canoes, though. In the UK, SEI found that 50% of investors retain all control of their LDI decisions—but this number might start to dwindle, too.  

“I would never expect to see everyone delegating the minutiae of LDI decisions, especially on how much to hedge,” says Hickey, but he adds that the detail of the complex hedging products may be too much for some smaller schemes.

However, these numbers may soon be altered again by the 29% of respondents who said they had no LDI strategy at the moment, but planned to implement one. Let’s check back in a year to see if they ploughed their own furrow on interest rates and inflation—or left it to someone else.