May 2014

EDHEC: Liability practice

TruckIn the second of a two-part article, the Edhec-Risk Institute looks at further conclusions from its recent survey of the liability-driven investing practices of European pension funds. The purpose of the liability-hedging portfolio is to provide a hedge against unexpected changes in the risk factors that impact liability value. Because this value equals the present value of promised pension payments, the relevant risk factors are those that impact either the discount rate (typically interest rate risk and credit risk) or the cash flows (inflation risk, for instance). The results from the Edhec-Risk survey (Dynamic Liability- Driven Investing Strategies: The Emergence of a New Investment Paradigm for Pension Funds?) confirm that interest rate risk is perceived as the main source of risk by most participants, since the liability-hedging portfolio is dominated by a list including fixed income instruments, sovereign bonds, corporate bonds and interest rate derivatives. This perspective can be justified from a theoretical standpoint, because research has shown the long maturity of liabilities makes interest rate risk the main contributor to liability volatility, even if payments are indexed on inflation. Fixed-income instruments are, in reality, perceived as attractive not only for their liability-hedging properties, but also for their diversification and performance benefits, and 78.65% of respondents stated that they also hold fixed-income instruments in their performance-seeking portfolio. DURATI ON SURPRISE
A striking result of the liability-hedging portfolio is that only 40% of respondents seek to align the duration of the bonds that they hold in it with the duration of liabilities. This is surprising, given that duration matching is usually considered the first step towards the immunisation of the funding ratio against interest rate changes. Of course, this result may simply reflect that many participants do not actually hedge their liabilities, but even among those who do hedge, 32.50% do not seek duration alignment, perhaps due to the practical difficulties involved with having access to bonds with sufficiently long maturities. In this context, we also note that roughly the same proportion of participants match the asset and liability exposures to changes in the shape of the yield curve: in other words, there are no more participants who manage the risks related to first-order factors in yield curve changes (changes in level) than participants who manage the risks related to second- and third-order factors (changes in slope and curvature). Another important lesson from the survey is that the novel risk factor allocation approach is drawing significant interest among pension funds. This approach replaces the traditional focus on dollar amounts allocated to asset classes by a focus on the budgets allocated to risk factors. We find that 35.42% of participants have adopted this perspective, a percentage which is far from negligible. In other words, for a significant fraction of the total respondents, the potential benefits of a factor approach have outweighed the implementation challenges that it raises. For two-thirds of those participants who frame the allocation decision in terms of factor exposures – as opposed to asset class exposures – the main motivation is to question the performance and risk of the asset classes. This figure indicates that many asset managers are no longer willing to merely rely on historical performance and risk measures for standard asset classes, and are interested in understanding the sources of performance and risk: indeed, the knowledge of factor exposures gives more robust forecasts of the long-term performance of an investment strategy, as well as of the short-term performances across various market conditions. This result should be taken by the passive management industry as a clear invitation to place more emphasis on the disclosure of the factor exposures of their investable indices, not only when these exposures are explicitly sought, but also when they are side effects of the stock selection or weighting process. It should nevertheless be recognised that implementing risk factor allocation raises technical issues, which relate to the estimation of exposures of assets and to the translation of factor weights into asset weights. One-fifth of participants who have not adopted this approach say that they lack the necessary expertise, while close to 30% point out difficulties in mapping the factor allocation into realistic asset allocation. DIFFERING WAYS
Liability-driven investment (LDI) differs from static LDI in that it involves periodic revisions of the allocation to the performance-seeking portfolio and liability-hedging portfolio. From a theoretical perspective, these revisions can be motivated by changes in current risk and return parameters, and/or by variations in a risk budget. This is typically defined as the distance between asset value and some floor asset value (for example related to a minimum funding ratio constraint) and has to be protected at all times. The survey includes a series of questions aimed at analysing the reasons that motivate the adoption or non-adoption of dynamic LDI techniques by pension funds. At the aggregate level, dynamic LDI has been adopted, or is being considered for adoption, by slightly more than 38% of respondents. However, large geographical heterogeneity exists: countries such as the Netherlands, Denmark, the United Kingdom, Germany and North America display more interest than the rest of the sample for this technique. This result indicates a higher level of interest for advanced asset-liability management techniques in these regions. For half of the participants  who have adopted or consider adopting a dynamic LDI strategy, the use of derivatives is the preferred implementation approach, while cash positions are used by only one quarter. STRATE GIC ALLOCATI ON
The main motivation for engaging in dynamic LDI is the willingness to make the strategy responsive to changes in the economic environment. One third of those participants who express an interest in dynamic LDI say that they want revisions of the strategic asset allocation as a function of changing objective parameters, such as volatilities, correlations and risk premiums. A slightly lower percentage (27.78%) of the respondents invokes tactical considerations: they seek to add value by incorporating their subjective views on future returns in the allocation, which may lead to them temporarily deviating from the strategic portfolio. Downside risk management and the respect of floors through a dynamic adjustment of risk budgets are only cited by 27.78% of participants, that is, as many as those who are interested in tactical asset allocation. Overall, this risk management motive is not perceived as important as the considerations for market conditions, which is perhaps surprising given the presence of minimum funding ratio constraints in most countries. The lower importance given to risk management is also seen in the fact that a large majority of respondents (85.26%) do not impose any floor in their allocation process. It might be expected that those who face minimum funding regulatory constraints translate the minimum funding levels into floors, but surprisingly, this does not often seem to be the case. Indeed, the percentage of participants who impose a floor is barely higher among those who face regulatory constraints (16.98%) than in the sample as a whole (14.74%). A further source of concern is that more than half of those participants who set a floor consider an asset-only floor, without an explicit reference to liability value. Overall, these results show that dynamic LDI strategies are gaining acceptance, especially in northern European countries, but are not yet adopted by the majority of the pension funds. Among the reasons for the reluctance to adopt a dynamic LDI approach, the first reason cited by participants is the existence of implementation issues, particularly the lack of liquidity of asset classes. These results also suggest that dynamic LDI strategies are currently mostly adopted for asset management reasons, but not for reasons that have to do with the presence of liabilities. They also indicate that the market has not yet fully realised the usefulness of dynamic LDI techniques in the presence of minimum funding requirements. The research undertaken for this article was supported by BNP Paribas Investment Partners as part of the New Frontiers in Risk Assessment and Performance Reporting research chair held at the Edhec-Risk Institute. Saad Badaoui is senior quantitative analyst and Romain Deguest is senior research engineer at the Edhec- Risk Institute. Lionel Martellini is professor of finance at the Edhec Business School and scientific director at the Edhec- Risk Institute. Vincent Milhau is deputy scientific director at the Edhec-Risk Institute ©2014 funds europe

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