What is the goal of an LDI portfolio? If you answered “to behave as much like the liabilities as possible” then you are not alone, and doing so can be a material first step toward reducing the volatility of the plan’s overall surplus/deficit (or “surplus volatility”.) But there is another possible answer to the question, and that leads to a different approach to LDI.
This approach is described in an article, “Hedge Long First: An Alternative Approach to LDI” by David Phillips, Jim Gannon, Mike Sylvanus and myself, that has just been published in Chief Investment Officer magazine’s latest LDI edition.
Hedge long first (HLF) is based on the idea that an LDI portfolio should not treat all liabilities as equally important but rather, as the name suggests, should start by concentrating on the longest-dated cash flows. That’s because those cash flows contribute a disproportionately large share of the volatility of the liabilities. So the HLF approach aims to get more bang for the LDI buck by targeting a subset of the total liabilities. Abandoning the goal of making the LDI portfolio behave as much like the liabilities as possible, HLF instead focuses directly on the goal of reducing the plan’s surplus volatility.
HLF raises some interesting questions for investors. First of all, what is the real goal (or goals) of the portfolio? Secondly, in the current environment, possible interest rate movements loom large in many LDI decisions. Tactical considerations will come into play on the timing of any change in the portfolio to the extent that the investor has specific expectations regarding a possible increase in interest rates or a steepening of the yield curve (these expectations do, of course, need to be considered in the context of what is already priced in to the market.) That may play into a third question: if it is indeed possible to get more bang for the LDI buck, is that better used to reduce the plan’s surplus volatility, or is it better to target the same level of surplus volatility with a smaller LDI portfolio and free up more assets to seek higher returns? Different investors may have different views about each of those questions.
So there are a number of issues to think through. Nonetheless, we believe that for plan sponsors eager to reduce the volatility of their pension funding without allocating additional assets to the LDI portfolio, HLF offers a potentially attractive new approach to LDI management.