STRENGTH IN NUMBERS
Alex Soulsby, head of LDI at F&C confirms 2014 was a very strong year, picking up 50 pooled fund and a handful of bespoke clients.
The dynamic LDI funds were launched at the end of 2011 and Soulsby says they have been a massive success and are influencing how people think about LDI funds.
“Schemes invest by choosing something that broadly looks like their liabilities and all the clever engineering is done under the bonnet.”
These are more straightforward and many people find other LDI strategies overcomplicated and it has scared them off in the past. And it’s been an opportunity to outperform liabilities when yields are challenged and all the assets need to work harder.
“We look at different asset classes – government bonds/index-linked gilts, swaps – and choose whichever is the cheaper. This makes a more efficient hedge and is not overly clever or active, but it is efficient, which has delivered out-performance,” says Soulsby. “Those in from the start are several percentage points ahead of index-linked gilts.”
TO HEDGE OR NOT TO HEDGE
The fundamental change in the last year has been that real rates and nominal rates have collapsed again and people are considering what they should do next.
This has resulted in some new perspectives on the hedging decision says David Bennett, head of investment consulting, Redington.
“Those who haven’t hedged have found it very painful and of these pension funds, some remain resolutely passionate they won’t hedge because they believe interest rates are historically low and that their asset strategy will enable them to meet all the future liability cash flows,” says Bennett.
That said, the recent move into negative government bond yields in Europe and long-dated nominal gilt yields to nearly 2% has resulted in a resurgence in the belief that long yields will stay lower for longer than previously thought, resulting in the need to do some hedging. But this is not a consensus – there are a lot of confused investors out there.
The lack of certainty has meant that schemes have reviewed how they implement hedging, with many abandoning market level derisking triggers.
“It’s historically been popular to come up with some notion of fair value such as a specific target for the index-linked gilts yield and set a trigger level to do some hedging at that point,” says Bennett, “but these triggers have generally failed and so we are seeing a clear move to time-based triggers instead, set within some schemespecific criteria.”
DIVERSIFICATION CONUNDRUM
There are also widespread concerns about the traditional de-risking route of selling equities to buy index-linked gilts. The deterioration of funding levels means that pension schemes can’t afford to sell their return-seeking assets as they need to keep the returns up to repair deficits. One solution is a move to greater derivative exposure which enables hedging while preserving expected returns.
A specific derivative solution that is quite attractive is the use of interest rate options, known as swaptions, says Bennett. This allows pension funds to put hedging in place that protects against long-term rates falling while allowing participation in future long-term rate rises.
“This is a much more complex strategy with a lot of moving parts,” he says, “and requires a significant governance budget,” Bennett adds. “However, if you can make the time and effort, the payback can be enormous.”
One lesson from the last couple of years, he continues, is to not allow inflation and interest hedge ratios to get too far away from each other. It was tempting when inflation dipped a couple of years ago to increase inflation hedging. Many schemes ramped up their inflation hedge as inflation looked priced fairly cheap, but did nothing with nominal rate hedges as nominal interest rates looked too low.
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