31/03/2008
How retail investors may benefit from LDI strategies in the future
Mention LDI (Liability Driven Investment) to many retail investors and they will either look at you like you’ve just landed from Mars or point out that LDI is really only for pension schemes. But if we look into what has been happening in pension schemes in recent years, there are lessons and investment strategies that can benefit the retail investor.
Since the turn of the century there has been a slow but gradual move by pension schemes to a more diverse set of investment strategies within their scheme. Why? Well, both the combination of a major equity bear market plus the introduction of new pension accounting standards for companies revealed that traditional investment strategies of equities and bonds were not a stable solution for beating liabilities on an ongoing year-to-year basis.
It was this ongoing volatility in the surplus/deficit of schemes that initially led them down the investment path of hedging their interest and inflation risks – this meant investing in a combination of bonds and interest/inflation swap derivatives so that this mirrored the respective sensitivities of their liabilities.
However, just investing in bonds would lower the overall long term return of pension schemes, and this would make the ongoing funding cost by the corporate sponsor unsustainable. So investment managers and investment consultants needed to come up with a way of generating higher returns for pension schemes but not with the high level of volatility that just investing in equities would do.
The answer in itself proved simple in concept – diversity. The more diversity you can introduce into a range of investment strategies then the more likely that any one time some of your strategies will be working when others are foundering.
For larger pension schemes, this entailed looking at a broader range of investment classes than historically had been the case; property, private equity commodities, high yield bonds, fund of hedge funds to name just some. Whilst this had the desired result of delivering more consistent returns, it came at a price of increased governance requirements by pension schemes, and hence more cost.
For smaller schemes, such an approach was not going to work – and this is where the fund management industry responded with the development of Diversified Growth Funds (DGF). In effect, these funds look to deliver the diversity of what larger schemes were doing but within just one pooled fund. Typically the performance target is designed around beating cash by some level, say cash+4% - hence these funds are also known as absolute return funds. The attraction of these funds to pension schemes was that they were still investing to deliver sufficient returns to meet members’ benefits but with a lot less risk than just investing in equities alone.
The growth in the number of providers of DGFs has increased markedly in recent years and there has been rapid take up by pension schemes.
The read-across to retail investors should be apparent. Whilst retail investors may be invested across a range of investment strategies, hence giving the benefits of diversification, many will not have the time to decide what the best blend of different fund strategies should be at any one time. This is where investing in funds that look to deliver positive returns over cash in a wide range of investment classes becomes so appealing; especially when you consider they are doing it with a lot less risk than just being long equities. These funds can therefore provide a good degree of comfort of mind that investment returns will be consistent if not spectacular.
In looking to deliver absolute returns on a consistent basis, different fund managers take different approaches and it is important for the retail investor to choose a style that gives them most confidence. By investing in this strategy, retail investors may say goodbye to the +20% year returns some equity markets can give in good times, but will be more confident that we will avoid the -10% or worse years in more difficult investment conditions.
By reading across from the lessons learnt by investment managers and pension schemes, retail investors have the opportunity to benefit from the new generation of absolute return funds.
Malcolm Jones, Investment Director at Standard Life Investments
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
Standard Life Investments may record and monitor telephone calls to help improve customer service.
All companies are authorised and regulated in the UK by the Financial Services Authority.
©2008 Standard Life Investments.
RSS Press Articles