Column: The European (LDI) Experience
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Liability-driven investment was introduced to me via a presentation in 2003. At that time I was CIO of PME, a Dutch €10+ billion fund. The markets had just started to recover from the dot-com crisis, and we had added 7% equities to our portfolio. The S&P500 was around 850. So why did I listen to a presentation on bonds?
Well, when I started at Shell pension fund in 1985, we were 95% invested in bonds. After developing a Fixed Income Arbitrage Tool, which was profitably selecting deals for 18 years, I have a special er, bond, with this asset class.
The dot-com crisis made us focus more on risk than return. Patrick Groenendijk, my strategist, indicated two trends during 2003: Long-term yields were still relatively interesting around 5.4%, and institutions in the UK and Denmark had started to hedge their interest rate risk. Prudent investing means looking for value and avoiding risk by responding early to trends. We concluded that if mark-to-market valuation of pension obligations became the standard in the Netherlands and other European countries, the long end of the curve could easily drop one to two percentage points (as in the UK and Denmark). Patrick proposed hedging interest rate risk completely as the forward starting yield of around 5.4% fitted nicely in our ALM analysis. I hesitated: to propose a €10 billion swap deal to the board seemed too large a step to me. I went for an initial 30%, which—with hindsight—was the second largest mistake in my investment career.
The lesson to learn here: If a trend has value, being an early adaptor is more prudent than being an early wiseacre. The 2008 crisis was estimated to yield a loss of €100 billion for Dutch funds, and not taking LDI seriously since 2004 easily exceeds that amount. The only true winners are the Danish funds, which implemented LDI at proper yields. My tip would be to follow them closely, because when they start to unwind, we are probably near the bottom.
Having a well-thought strategy is not the only key factor of successful investment management: prudent execution is just as important. We decided to have one firm to execute the deal instead of shopping around and spoiling market prices. Our main question: How to get best execution without being ripped off? Our approach was to fix the profit, not to take a vague agreement based on ticks per duration-year. It worked. We were fully involved with the execution and afterwards completed a statistical evaluation.
When LDI became the buzzword with interest rates around 3%, I noticed (very) large deals were executed based only on trust. My statement was proven again: asset management is mainly a highly rewarding business due to the clients’ behavior, and less an effect of “extraordinary talent.” (NB: I could not imagine that seven years later our fixed-price approach would be an argument for a forensic investigation.)
LDI is actually an old concept often applied at insurance companies where you have an environment with guarantees. The typical approach is to divide cash flows into year buckets, and to invest accordingly. However, Dutch funds do not provide guarantees, and the bucket approach is costly compared to the more liquid swap market. This revelation led to the idea of mimicking not cash flow but interest rate exposure via swaps. The yield curve is, according to the European Central Bank, a function of only six parameters such as the spot rate, the very long rate, and curvature. High school math shows you only need six different equations to find a matching solution. Buying six swaps is more cost-effective than buying dozens of bonds. One would expect that this development in cost-effective risk management would be applied everywhere.
Sorry to disappoint you, but governance is a part of the equation too. Another lesson to learn is that techniques that are too smart for board members to grasp have no shelf life. After the fall of Lehman Brothers, the regulator in several European countries demanded that the board should be able to understand in full detail how investments were structured. The swap approach—a combination of long and short positions—was too advanced, and the bucket approach was promoted again.
LDI comes in various flavors. Some influential advisors saw it as an active tool to enhance (their) returns by promoting the range-based approach. This fit perfectly with the widely-held opinion that interest rates had reached the bottom. The implementation rule is simple: at 5% yield you are 100% hedged, and at 3% the hedge is zero. As markets are volatile, the attractive selling point was that this strategy would deliver free alpha. You can guess what happened: not being hedged at 3% cost billions.
Looking ahead, I sincerely hope the governance climate will improve so that funds will have a thoughtful opting-out LDI policy when there is a market turning point.
Roland van den Brink is a senior pension fund lecturer at Nyenrode Business Universiteit in the Netherlands. Roland previously oversaw investments for Dutch pension PME and was a director at fiduciary consultants MnServices.