Barker Tatham's Steve Barker, PTL's Richard Butcher, Spence's Marian Elliott, Legal & General Investment Management's Laura Brown, Axa Investment Managers' Jonathan Crowther and Redington's Dan Mikulskis discuss LDI asset allocation.
Marian Elliott: This is where you see a lot of interest in infrastructure projects coming in – anything expected to generate a relatively predictable stream of revenue, which ideally would be inflation-linked. The thing trustees need to guard against when they are investing in proxies to hedge their liabilities is that it is not a direct hedge; they need to be aware of the risks that still remain.
Also, some of these asset classes are very different to anything they would have invested in before. It is therefore important that trustees make sure they really understand the nature of the asset they are buying and the potential impact on the funding position under a range of possible economic scenarios.
Richard Butcher: The other one is social housing. Any proxy is a compromise. There are going to be additional risks that go with it.
Steve Barker: I have seen some proxy investments where, if gilt yields were to fall, the pick-up in capital value would not approach anything like what you would need to match the extent the liabilities would have gone up by. So you have got to be very careful of that.
In a way, pooled liability-driven investment funds allow you to get around this issue, because you are not talking about parking all your assets into bonds that are going to be earning very little. You might be putting a third of your assets into structures that hedge all of your liabilities, which leaves you two-thirds of your assets to play with. These can be put into growth assets that you can invest in alternatives, diversified growth funds or whatever. And this is where the engine for growth comes from.
Jonathan Crowther: Another strategy that is now starting to gather more momentum is the use of midfield assets – infrastructure, long-lease commercial real estate debt, and social housing. These asset classes tend to be less liquid but possess inflation sensitivity characteristics and have relatively predictable future cash flows, so can be used as a broad match for future pension scheme liabilities.
Therefore, as midfield assets exhibit useful liability-matching characteristics, I expect the demand for these assets will continue to grow, particularly if you consider the flight path and the extended timescales available to pension schemes, which mitigate the need for greater liquidity. Consequently, I think we will see these assets continue to come to the fore.
Dan Mikulskis: Illiquid credit investments (such as infrastructure debt or commercial real estate debt) have been one of the biggest things we have been talking about with our clients for the past year or so, and we have placed more than £2bn of assets in these types of mandates. We believe the long-dated and contractual nature of the cash flows generated by such assets make them attractive for a pension fund’s portfolio. The key question is how much you need to be paid for giving up that liquidity and how much liquidity can you afford to give up.
Those are not necessarily easy questions but you need to make some attempt to answer them. The answer is always that it is going to be a complement to a traditional LDI strategy built around swaps and gilts. It is never going to be a complete substitute for something like that.
Laura Brown: The advent of central clearing, and indeed the fact that pension schemes are just more mature and so liquidity management is more important, means the question of how to keep an eye on liquidity and make sure you are comfortable with what is going on as part of your LDI pooled funds becomes ever more important.
Crowther: Yes, unbeknown to many schemes, liquidity has been a relatively important issue over the past five or six years and it is likely to become even more important in the future. The challenge will come in the world where schemes are making use of both centrally cleared and bilateral over-the-counter derivatives, as well as gilt repo transactions. Given that schemes will have a single pot to provide the margin and collateral to support these instruments, it will be vital to ensure this is managed efficiently to reduce the exposure to cash and the corresponding drag on investment returns.
Brown: Which does actually create new opportunities to use that collateral pot to invest in different things. So where we have done LDI by investing in gilts and swaps using a smaller amount of collateral to back a larger amount of exposure, the same could be done for credit by using derivatives. I suppose, as with all of the things that we are talking about, the interesting question is always how to make that available to a broader set of clients, not just the very large ones.
