Putting liability driven investing into practice

Utilising the techniques of liability driven investment (LDI) can bring rich rewards and help counter many of the major problems which have beset retail or institutional investors in recent years, according to research published by fund manager, Standard Life Investments.

In the latest edition of Global Horizons, its regular look at long-term investment themes, Standard Life Investments examines how the techniques of LDI can be useful for both retail and institutional investors, setting out more sophisticated approaches which are increasingly required. Dr Julian Coutts, Head of Quantitative Analysis, Multi Asset Investing at Standard Life Investments, said:

“An LDI approach is appropriate whenever liabilities are likely to occur in the future, and savings are made with the purpose of meeting these liabilities. The process involves several stages: defining the liability, for example university fees or future pension payouts, assessing which assets best match these liabilities, whether in terms of regular cash flow or final returns, assessing risks and using tools such as swaps where practicable to overcome difficulties in matching, and finally optimising the various ‘alpha’ sources within an investment firm, including stock selection, market risk and overlays. The risk appetite of the investor will determine whether a conservative approach is employed or techniques to work assets harder are more appropriate. “At a retail level, such an approach is made when considering how to pay off an interest-only mortgage. Savings must be undertaken to meet a target level at a target time. Similarly, financial planning should take account of defined large outgoings connected with specific liabilities like college fees, or aspirations like a retirement round-the-world cruise.

“At an institutional level, LDI techniques have been developed for application in defined benefit pension schemes. They have also been applied in long-term mass savings vehicles with guarantees at maturity.”

“The risk appetite of the institutional or retail investor will determine whether a conservative approach is employed or techniques to work assets harder are more appropriate. For those clients who desire near certainty in their asset liability matching, a classic LDI approach using, for example, a conservative bond fund plus a swap overlay would generally be the preferred solution. However, this approach merely stabilises the situation.

“A more useful approach for, say, funds with small deficits, or for LDI investors with higher risk appetites, would be to make the assets work harder. A LIBOR +x% return engine can be employed with a swap overlay to achieve liabilities +x%. In such highly dynamic vehicles, all the return engines in an asset management house are harnessed together in an optimised way. More sophisticated investment techniques are required, covering stock selection, market risk optimisation, and a non-linear option overlay designed to manage risks in tune with fund specifications. Utilising all the sources of alpha generation in a global fund manager, in a carefully controlled environment, can bring rich rewards and help counter many of the major problems which have beset retail or institutional investors in recent years.”