Last year, Russell described a new approach to liability-driven investing (LDI) that concentrated on longer-dated cash flows, rather than treating all liabilities as equally important. The approach is called “hedge long first,” or HLF. At the Russell Institutional Summit held last week in New Orleans, David Phillips and Marty Jaugietis expanded on this idea and looked at some of the implications for portfolio construction.
The presentation opened with David arguing that HLF is a new way of looking at something that has long been taken for granted (just like the best way of peeling a banana.) Specifically, that the most effective way to manage interest rate risk and to reduce the volatility of pension plan surplus may not be to simply hedge the duration of the plan’s liabilities but rather to extend duration further with an HLF strategy.
The main reason HLF is so effective at reducing the volatility of pension plan surplus is that it results in an LDI portfolio with greater sensitivity to interest rate movements. Pension plan liabilities are very sensitive to interest rates, so the first job of most LDI portfolios is to create that same sensitivity in the asset portfolio. Indeed, in the presentation, David and Marty introduced the concept of “extended HLF,” which takes the idea of extending duration one step further.
In loose terms, HLF and extended HLF might be summed up in the following philosophies:
HLF: “If I’m only hedging part of my liabilities—a hedge ratio less than 100%—then it’s more effective to hedge all of the longest-dated cash flows than it is to hedge part of every cash flow, because it’s the longest-dated cash flows that represent the most risk.”
Extended HLF: “I’m not even going to worry about the details of the cash flows until I have a hedge ratio close to 100%. Until that point, the more duration I can get into my LDI portfolio, the better.”
The potential value of the two approaches is perhaps best illustrated by an example that came up in the Q&A at the end of the session. Greg Henry of Southern California Edison raised the question of whether any of this applies in the case of a plan which has only dipped its toes into the water of LDI: a 40% fixed income allocation, one quarter of which (10%) is allocated to LDI.
That’s a situation where extended HLF might be a good fit: after all, with just 10% of the assets, it doesn’t seem worthwhile worrying about the finer details of the liability cash flows. LDI is simply about getting duration into the portfolio in that example. But as the allocation to LDI increases, it’s likely the approach can focus more on the specific liabilities, so the extended HLF strategy may evolve into HLF. All of which is a reminder that LDI—like every type of investment—needs to begin with a clear definition of what the objective is.
And a quick word about interest rates
As you might expect, another angle that came up was whether this is really the right time to be talking about ways to increase the duration of fixed income portfolios: if interest rates were to rise sharply, then more duration would just mean bigger capital losses.
On that point, there are two things we think are worth keeping in mind.
- Even if the goal is to be positioned for a rise in interest rates, most pension plans already have a very substantial exposure to that position. LDI is about reducing the risk associated with that position.
- It is possible to retain the same duration in the LDI portfolio by extending duration but, at the same time, reducing the size of the LDI portfolio. David and Marty illustrated how this can serve to free up assets for return-seeking purposes, without increasing the expected volatility of the plan surplus.
Obviously, the details of how HLF might apply in any given case would need to be thought through in the context a specific plan’s circumstances. But this really is an intriguing new take on the question of LDI.