Round the Island race is one of the largest yacht races in the world hosting 16,000 sailors on 1,700 boats, who are fiercely competing with each other to race around the Isle of Wight. This year’s race, albeit on a beautifully sunny summer solstice day, was plagued by light airs. Under these conditions sailing races are only won with intense concentration, strategic thinking and skill. The first leg of the race is from the sailing capital of the world, Cowes, to the western most point of the Solent marked by the Needles. This leg took an almighty 4 hours of concentration, strategy and sail trim.
When we rounded the Needles and what wind we had faded to a mere 5 knots I was reminded of a quote from William Arthur Ward ‘the pessimist complains about the wind, the optimist expects the wind to change, the realist adjusts the sails’. At the risk of sounding like a pessimist, it made me think that in reality winning races isn’t simply about adjusting the sails, to win you need more than that. You need to understand why and how the sails should be trimmed and this requires clarity over:
With this information you can start to make strategic decisions around the course and consistently trim the sails to maximise your boat speed in the current, and ever changing, conditions.
Similarly, with an LDI portfolio it's all good and well putting an interest rate hedge on (trimming the sails) but if you don't know what your target hedge ratio is (the race course) or how your assets are performing relative to your liabilities (boat speed) and rates rise (wind changes direction) you could end up with a fall in funding level (losing the race).
An LDI benchmark is a tool that allows you to clearly define the goals of your LDI portfolio (e.g. hedge 65% of liabilities) and measure the performance of the LDI manager relative to this goal to help improve your chances of winning the race to full funding. Using an LDI benchmark allows a pension scheme to take a more dynamic approach to managing and monitoring their LDI portfolio within a clear and risk managed structure.
Theoretically, an LDI benchmark is to an LDI manager what the FTSE 100 Index is to a UK Equity Fund manager. However, instead of being a collection of stocks, it is a series of annual zero coupon (single payment) cash flows that replicate the interest rate and inflation sensitivity of the liability cash flows. An LDI manager can then use this benchmark to manage the hedging portfolio to ensure the liability risks are protected against as efficiently as possible, on an ongoing basis.
The key objectives of an LDI benchmark are to:
2. To assess the performance of the hedging strategy and the LDI manager by establishing a measurable point of reference – you know how fast you are going
3. Align the LDI portfolio with the Scheme’s overall objectives by setting a customised benchmark for the LDI portfolio which is based on the Scheme’s funding and risk objectives – once you know the course and the speed it’s time to navigate your boat
4. Implement a dynamic approach to managing the LDI portfolio by providing a robust framework to measure and monitor the impact of market changes on the LDI portfolio and the liabilities – whilst navigating around the race course you can adjust the sails as the wind and tide change
Once they have visibility over the variable parameters the LDI manager can minimise the risks associated with the LDI portfolio and hedging by adjusting the metaphorical sails to remain in line with the benchmark, and therefore the liabilities, on an ongoing basis.
Can you generate incremental outperformance?
Once a benchmark has been created for a Scheme it opens up the possibility of implementing a more active LDI mandate. Under these more active mandates, the manager’s objective is to closely match the hedging assets to the benchmark whilst having discretion to make relative value decisions on investment instrument (i.e. swaps or gilts or gilts TRS or gilt repo) and tenor point (long-end or short-end). This discretion provides the manager with the opportunity to generate marginal outperformance relative to the benchmark.
What are the risks?
Although outperformance, however marginal, is always nice to have it is often associated with higher risk. As the benchmark is created primarily to lower liability risks by aligning the hedging assets with the liabilities, it would be counterintuitive to allow the manager unlimited discretion as this could introduce significant risks. It is therefore necessary to impose on the manager stringent risk limitations relative to the benchmark to prevent the manager deviating significantly from the benchmark. The main risks to be considered are:
- Outright Risk: If the overall interest rate and inflation sensitivity of the asset does not match the overall sensitivity of the liabilities
- Curve Risk: If the interest rate and inflation sensitivity profile of the assets does not match the sensitivity profile of the liabilities
- Basis Risk: If the instrument used to discount the liabilities (e.g. gilts) differs from the instrument used to hedge the liabilities (e.g. swaps)
For pension schemes navigating their way to full funding, successful implementation of an LDI benchmark could well make the difference between winning and losing the race.