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When smart asset owners get together (a clubby group, you are), liability-based returns have replaced absolute returns as the topic du jour—or they should have, at least. So when peer- and market-based benchmarking is waning and performing relative to your liabilities is waxing, how do funds go about assessing performance?
Look no further than the even-clubbier corporate pension space for the answer. Liability-driven investing (LDI) has been written to death (by us, mostly), but what has largely been ignored (perhaps also by us) is this question: If absolute return isn’t the goal with LDI, how do we measure (and we mean measure quantitatively, not “feel-good” measure) the value of an LDI manager?
“The question is spot on,” according to Russell Investments’ resident LDI-guru Marty Jaugietis (who is also lucky #13 on our Knowledge Brokers listing of the world’s top consultants). “We have spent an increasing amount of time over the past 18 months discussing this concept. Clients want a better way to judge success.”
Benchmarks, by and large, don’t do the trick—largely because every corporate plan has a different liability stream. Traditional measures also fail in many senses. “Alpha production above a benchmark for pure return-seeking objectives are not the top-line objectives for corporate plans within an LDI structure,” Jaugietis argues. “What we try to look at instead is risk–reduction of the fixed-income exposure versus a calculation of a liability return.” Tracking error of the hedging portfolio as a representation of whether the LDI portfolio is actually “hedging” and to what degree has replaced absolute returns.
Other firms generally agree. “LDI should be measured relative to its objective of matching the liability’s performance,” says NISA Investment Advisors’ David Eichhorn. “In many implementations, there are two levels of measurement. First, it’s strategy versus liability. Second, it’s manager versus the stated strategy benchmark. In more complete, end-game implementations, the manager can be compared directly to the performance of the liability, with appropriate adjustments being made for ‘non-market’ risks contained in the liability.”
Do corporate CIOs managing LDI portfolios agree with the likes of Russell and NISA? Largely, yes. “Tracking error matters,” Xerox CIO Carol McFate believes. “That said, if you’re at a relatively low hedge ratio, you don’t have to be as precise, but the closer you get to fully funded, you have to be more accurate. Hedging should be done with a scalpel, as opposed to a meat cleaver.” She adds another wrinkle into the equation, “However, it also really depends on how you pay out, whether it’s a lump sum or annuity stream. The uncertainty of lump sums makes the process a wee bit more difficult. Hedging starts out as art, then it becomes more like science, although lump sums require you retain a bit more art in the process.”
But what about an actual LDI-performance equation? Is there an LDI-equivalent to eF/eAUM * R = X?
Not quite. “We haven’t yet gone down the path of incorporating tracking error of the hedging portfolio into fees,” Russell’s Jaugietis says. “That said, there may be a point in the future where the goal is to keep the tracking error of an LDI portfolio below, say, 3% on a rolling basis versus liabilities—which could be the basis for compensation. To the extent that one believes in their process, that may be a road people go down.”
Perhaps that should be the topic of the next asset owner get-together.
Read the related cover story here.