Liability-driven investment managers could be made to do more for their money, says Paras Shah.
It is true that the falling and prevailing low interest rate environment has been difficult, but with the rise in popularity of liability-driven investment into the mainstream, now the question is whether the LDI industry could be doing more.
Key points
Include the LDI manager when deciding the shape of the mandate
Impose a clear and transparent benchmark for assessing performance
Ensure your adviser is getting the most from the LDI manager in all areas
Agreeing the purpose of the mandate
LDI managers work within bounds specified for them by trustees on advice from their consultants.
While all investment mandates need appropriate restrictions for prudent risk management, giving more freedom to LDI managers and expecting more from them when specifying mandates is the first stage in this.
It also provides more for the investment adviser to lead on.
Adding value
There are a number of considerations for trustees when specifying a mandate.
Usually trustees make the decisions under advice from their consultant, but an LDI manager can be more involved.
The typical decisions include:
Choice of instruments: including swaps, gilts, swaptions, gilt total return swaps, gilt repos;
Timing of building up the mandate: will the manager take into account market events or the general level of the market?;
Overall hedge levels: allowing the manager to become over or underhedged depending on what is more attractive at the time;
Hedge shape: decisions on where the most attractive levels of hedging are.
Further, where trustees are comfortable, providers should be given suitable levels of discretion since more rigid guidelines, for example those relating to funding level triggers, can lead to missed opportunities.
Clear and transparent benchmark
If trustees are going to frame the mandate in this way, the adviser must help specify a clear and transparent benchmark against which the manager can be assessed. This clear benchmark should be driven by the scheme’s overall funding objective.
For example, a scheme might be looking to achieve full funding on a swaps basis.
It follows that the LDI benchmark should therefore be the change in value of the liability cash flows on this chosen basis.
If another more complex basis – such as a hybrid between gilts and swaps – is chosen, the trustees should also be clear on how this compares with a cleaner, pure swaps-based return.
Setting a swaps-based benchmark does not prevent investing in other instruments such as gilts or credit, as long as these are permitted in the mandate.
Tapping into ongoing expertise
As well as the key decisions around the shape of the mandate, LDI managers have an important role to play in other areas, including:
ability to assess counterparty creditworthiness;
ability to negotiate the best terms for clients on counterparty credit events;
transaction costs;
yields achieved at execution versus a suitable window around the trade date;
ability to show a clear attribution of returns.
These skills are harder to assess explicitly, but should come across in the investment adviser’s monitoring process, assuming they are asking the right questions of the LDI manager.
Opening the conversation
The LDI industry has grown exponentially over the past 10 years, and trustees have access to a huge knowledge base of skills and experience.
If trustees are keen to ensure they are getting everything they can from their LDI mandate, they should speak to their investment adviser and LDI manager to talk about what is working, why it is working and how it could work better.
At the same time, providers must rise to the challenge.
Paras Shah is a senior member of Cardano’s LDI team
