Several UK asset managers that specialise in liability-driven investment (LDI) strategies have underperformed their benchmarks this year. This has put a strain on their pension scheme clients’ funding deficits at the worst possible time, with Gilt yields and defined benefit liabilities soaring to record highs due to Brexit-related uncertainty. The strategies have recouped some losses in recent months, but their poor performance is a sign that clients’ LDI portfolios were highly exposed to unnecessary risks.
Managers missed their targets because they bet on a particular trading strategy. These ‘active’ strategies consisted of taking positions in Gilts and swaps to take advantage of price differentials. Managers can do this by betting on Gilts rather than swaps when building an LDI hedging strategy from the ground up. They can also buy Gilts and sell similar swaps, picking up the spread of Gilts over swaps.
But this technique only works until the spread trades within a certain range. As the spread widens, and the value of the Gilts falls relative to the value of swaps, investors can see the value of their LDI portfolios fall. This can be reflected in increased funding level volatility.
That is precisely what happened up until the Brexit referendum and the subsequent Bank of England monetary stimulus.
A look at the history of the Gilt/swap relationship post-financial crisis shows the natural relationship between the two was reversed. High demand, partly driven by regulation, pushed swap rates higher. Many LDI managers saw this as an opportunity and bet heavily on Gilts, but Gilts once again started underperforming swaps throughout 2014 and 2015.
The widening spread wiped out returns for LDI portfolios, at least until the Bank of England pushed rates lower.
The schemes involved must have been disappointed to find that their choice of LDI strategy was not bullet-proof. Of course, investors hiring a manager to apply an active LDI strategy should be aware that any active strategy can suffer. But these events introduce some important questions.
First, why would an LDI strategy that is meant to protect investors from interest rate and inflation risk expose them to other risks? Second, was the active nature of these strategies communicated properly?
Pension schemes should conduct a thorough review of their LDI strategies to make sure that they are not chasing outperformance while putting funding levels at risk. Ultimately, LDI is about reducing risk, not increasing it.