By Mark Davies
For those of you that follow the KPMG LDI survey, you will have seen the increase in the number of pooled LDI mandates in the previous 12 months. Anecdotally our sales team are certainly seeing an increased appetite for pooled funds and are constantly asking us to build a pooled fund as it “makes LDI easier”.
Rightly or wrongly we haven’t built a pooled fund because we don’t believe that they offer the right result for our clients – both in today’s conditions but also, more importantly, in the future as well. So, in this article we will attempt to debunk some of myths that surround pooled vs. segregated LDI.
Is pooled documentation easier?
Firstly we will address the point that is least irrefutable – the documentation for a pooled fund is more straightforward. Correct. Or is it? Whilst the documentation removes the need to worry about ISDAs or custody it adds in a lot of wording that you don’t get in segregated mandates – for example, contingent requirements to put more money into the fund. Segregated documentation has also moved to an agency model (whereby custody and ISDAs are effectively delegated to the manager, much like in a pooled fund) which has made them more straightforward.
Is pooled easier to implement?
The follow on point from easier documentation is that it is quicker to implement. All things being equal I agree save for the fact, in our experience the education process is also a significant time commitment for most Trustees.
Education is about understanding why you are doing LDI, how it will fit within the portfolio and a broad idea of how it works so that you can better understand how it will behave. Just because derivatives are wrapped in a pooled fund does not mean that this education process is any less important. On top of that you should also aim to understand the mechanics of a pooled fund which you clearly don’t need for a segregated mandate.
Therefore in terms of access although pooled may be quicker for some, running education in parallel with a streamlined agency set of segregated documentation means that that gap is not as large as people think.
Segregated mandates give you flexibility and future proofing
Our core argument for using a segregated approach is one of flexibility and future proofing. The following sections elaborate on this in more detail.
Use your competitive advantage
A pension fund is considerably more prudent than a hedge fund or any other leveraged entity. Yet with pooled LDI you are not utilising this advantage – a pooled LDI fund effectively creates a leveraged entity in order to trade derivatives. This has consequences for investment strategy today but also in the future. Pension schemes are losing out on the potential of LDI because of this.
Strategy flexibility today
The nature of a leveraged institution is that it is more constrained than one that isn’t – for users of pooled funds this constraint is in the form of the amount of hedging you can achieve for a given level of return seeking assets. This means that schemes who have more than 60% on risk will never be able to get to full hedging without potentially sacrificing return.
In addition to this many more pension schemes are starting to think about other risks they have that they would like to manage – such as equity and currency. A segregated platform allows schemes to address these risk in a cost effective manner which is significantly more difficult with a pooled fund.
Strategy flexibility in the future
Many Trustees will be thinking that they don’t want to hedge a lot of liability risk today and they are not currently thinking about using other tools. Clearly, however, many schemes would like to have the ability to reduce risks in the future if they choose to – a segregated mandate provides this.
In addition, in our opinion regulation and credit assessments are only going to become more onerous for leveraged institutions going forwards. As a result we would not be surprised if we started to see leverage levels in pooled funds falling in the coming years, which means the return strategy of more schemes will be limited by the leverage reduction.
Endgame future proofing
Finally, looking into the future, most pension schemes today will have talked about targeting an endgame – whether that is buyout or self-sufficiency. Segregated mandates are automatically buyout friendly, being easy to in-specie gilts and (if required) derivatives across to a buyout provider.
Look before you leap
Pooled funds have historically been an easy way to access an asset class. For LDI this access route can have some significant consequences on the effectiveness of the strategy you are trying to implement. Arguably our viewpoint is biased. However, we have the ability to build pooled funds for clients but, having looked long and hard at the implications of pooled funds we have chosen not to as we believe that they don’t offer the right outcome. All we ask of trustees and clients is that they simply look twice before leaping into what seems like the easiest option.
Mark Davies is managing director, derivatives at River and Mercantile