LDI: Portable Alpha’s First Cousin

On the family tree of modern investment management “LDI” and “Portable Alpha” are first cousins.  Unfortunately, familial affection doesn’t necessarily go both ways. Portable Alpha is beginning to play a critical role in LDI strategies. But LDI isn’t really a prerequisite for portable alpha. As a result, LDI is a topic that is often ignored by the financial media, or worse yet, obfuscated with actuarial mumbo jumbo.

On Monday, Aon Consulting released its latest study of UK pensions and its findings match those of a similar study conducted by Greenwich Associates (covered last month). According to the Aon study, British pension schemes turned toward alpha-generating alternative investments such as real estate, hedge funds and global tactical allocation in 2006. (ed: The British term “scheme” always gets a chuckle in the US where it takes on more nefarious meaning – one that may ironically be more appropriate for pensions that actually have no way in hell of keeping their promises to growing legions of retirees).

But the study also mentions that 11% of pensions adopted some form of Liability Driven Investment (LDI) strategy in 2006. Similarly, the Greenwich study said that a whopping 37% of pensions were “considering” Asset/Liability Matching.

For those non-actuaries out there, LDI (a.k.a. Asset Liability Matching or “ALM”) essentially recognizes that pensioners don’t give a hoot what the S&P 500 or FTSE did last year. All they care about is getting paid as promised after they retire. As a result, the benchmark against which pensions ought to be measured are specific streams of liabilities. For example, beating the market won’t help if long term rates (i.e. the discount rates applied to determine the present value of a pension’s future liability stream) fall, pushing up the pension’s payout requirements.

Cutting through the LDI hyperbole are two interesting reports published this month – one by Standard Life in the UK and the other by Integra Capital in Canada.

The Standard Life report does an excellent job of putting LDI in an everyday context by comparing it to retail financial planning. The report goes on to state that the challenge facing pensions, is that…

“Pension fund liabilities can be considered as a set of defined payments, or cash flows, due to be paid in the future. They are tricky to model precisely – because of the need for assumptions about pension scheme demographics, implied guarantees offered to clients and salary (and general) inflation. They can vary in value with the stroke of a pen: a change in assumptions can easily lead to a surprisingly large change in the value of liabilities, and thus a large swing in the asset liability matching position, often revealing a fund deficit.”

While this has always been the case, recent accounting standards changes in the UK require pensions to report both their assets and their liabilities – increasing the transparency into the pension underfunding problem. The trick is to exactly off-set the nature and characteristics of a customized “liability benchmark” with corresponding investments. That set of liability-matching securities becomes the new “beta” in the pension’s portfolio. So alpha/beta separation becomes critical to LDI success. Continues Standard Life:

“…the funds must have benchmarks which are close to established futures markets. This permits ‘alpha transfer’, allowing the physical investment to be disconnected from the market risks desired by the fund managers, by using the liquid futures markets to shed or acquire market exposure.”

While the Greenwich study showed US pensions were less concerned with LDI compared to the British, these accounting standards changes are making their way across the Atlantic. In time for the expected scramble, Integra Capital brings together the heads of pensions at Nortel, The Royal Bank of Canada and Hydro One, one of North America’s largest utilities for an LDI roundtable.

Integra’s Tris Lett sums up the advantages of LDI with long term rates fluctuating as they have over the past 5 years:

“A critical improvement with LDI is that you remove that question and simply do what is right relative to the liabilities and not relative to the market.”

Using a quintessentially Canadian metaphor, he expresses concern that pensions think rising interest rates will simply “skate their liabilities back onside”.

Royal Bank’s Adam Bomers ties portable alpha into the discussion:

“The concept of separating alpha from beta is coming into play in the LDI process, as well. A lot of people are talking about things like portable alpha, where they have synthetic exposure to their liabilities through long bonds, and then introduce a fund of funds that looks to generate alpha on top of that. So, it’s really the separation of the two.”

…and John Poos of Nortel reminds us of the family resemblance shared by LDI and alpha-centric investing:

“Alpha, in and of itself, is an interesting piece because we all talk about it as if it’s just there. It’s easy, just go out and buy it. However, investing is a serious game. Someone is winning and someone is losing. If everyone was winning, it would be an easy chore to add alpha. But that’s not the case. For every winner there has to be a loser.”

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