When LDI Wins, Who Loses?

To view this article in digital magazine format, click here. 

With liability-driven investing (LDI) gaining traction on both sides of the Atlantic, one has to ponder: Where have all those funds in LDI structures been moved from?

The obvious answer is equities. As pension schemes seek to diversify risk, most have divested some of their equity allocation and increased the proportion of liability-matching components—largely fixed-income instruments. But there are other strategies that lose out. David Rae, head of LDI solutions EMEA at Russell Investments, says there’s a strong argument for why domestic corporate bonds could be dropped by European funds.

“Corporate bonds are inferior to an LDI strategy when it comes to hedging the liabilities, and inferior to a more diverse portfolio when it comes to adding value,” says Rae. “You can get far more interest-rate exposure to hedge your liabilities with an LDI strategy, and a more efficient return-seeking portfolio by allocating to global credit, high yield, emerging market debt, mortgage bonds, and active absolute-return bond strategies.”

Traditional property could also be due for a chop, according to Redington. Dan Mikulskis, co-head of ALM and investment strategy, said: “A pension fund that has adopted LDI is more likely to focus on assets that can be used for both return generation and liability matching, like illiquid credit assets such as infrastructure debt, and away from more traditional property and private equity. Schemes will have a limited liquidity budget and will focus on using this most effectively.”

Others argue that the sophisticated nature of LDI in Europe, where the use of derivatives and leverage is commonplace, means investors are not forced to sell anything in order to lower their risk levels. “There are limits, but it’s quite commonplace to have a strategy that is, say, 75% hedged to interest rates and inflation, while simultaneously being 50% to 60% invested in growth assets,” notes John Belgrove, senior partner at Aon Hewitt. “There doesn’t have to be a ‘loser’.”

In the US, Erik Knutzen, CIO of NEPC, says anything in the growth bucket can suffer if LDI wins. “That could include credit strategies, risk parity, hedge funds, and an array of private market strategies,” he notes.

Indeed, risk-parity strategies that don’t use leverage or derivatives could become particular casualties, especially given the threat of rate rises in the near future. The $25.1 billion Iowa Public Employees’ Retirement System has just rejected a move to a risk-parity whole-portfolio approach for exactly that reason.

Belgrove believes this decision may require a second look, however. For that decision to pay off, rates would have to rise by more than the market expects, he argues, as bond prices—the typical loser from rising rates—are derived from market expectations of the yield curve. And as many an LDI investor knows all too well, the market already expects rates to rise quite a lot.