Unique considerations in evaluating liability-driven investment managers

By: Ryan Dembinsky, Senior Research Analyst JANUARY 2013 Unique considerations in evaluating liability-driven investment managers Relative to traditional fixed income investing, liability-driven investing ( LDI ) takes a unique approach. The very specific exposure an LDI portfolio seeks to achieve differentiates it from a more traditional excess return oriented mandate, and its benchmark is far more than simply a starting-off point from which investors make value-adding decisions. Rather, the goal of achieving a pattern of returns that mirrors that of a pension plan s targeted liabilities takes on equal or greater importance than the goal of earning extra return. And because LDI is unique, so too are the considerations involved in identifying LDI managers. Selecting and evaluating fixed income managers in the context of a benchmark-aware mandate is a relatively straightforward affair. Generally speaking, the objective is simple: identify managers who demonstrate a repeatable ability to generate excess returns consistently relative to a benchmark within a risk-controlled framework. Alternatively, in the case of selecting best-in-class LDI managers, investors should consider a number of unique elements beyond simply identifying a manager with demonstrated ability to earn excess returns. For mandates constructed in a liability-driven framework (i.e., Barclays Long Government/Credit Index, Barclays Long Credit Index, Barclays Long Corporate Index, and Barclays-Russell LDI Index mandates), the primary objective is not necessarily simply earning excess returns or superior risk-adjusted returns relative to an index. To be sure, outperforming the given benchmark is one of the objectives, but rarely does it represent the only objective. The focus in a LDI mandate is to identify a manager or group of managers who have the capabilities to improve the hedge to the pension plan s liabilities; avoid potential credit defaults and downgrades; assist in the evolution of the hedge as it moves from a more diversified long government/credit mandate early in the glide path to a more targeted long credit or long corporate mandate; and, ultimately, work toward the goal of a truly customized liability mandate managed to the plan s unique liabilities. Therefore, the skill sets and resources called for go beyond those needed in a traditional fixed income mandate. The traditional skills are still needed, and fundamental credit research capabilities take on greater importance in the context of LDI portfolios, since they Russell Investments // Unique considerations in evaluating liability-driven investment managers

are so focused on that segment. But there are other nuances specific to selecting longduration managers in a liability context, and those nuances are the subject of this paper. Implementation and actuarial capabilities: The quarterback manager Commonly, managers with broad core fixed income capabilities and credit research skills will be well equipped to manage assets in their existing investment styles relative to long government/credit, long credit or long corporate mandates. These managers may do a suitable job of managing their segment of an overall portfolio, but it s important to recognize a more sophisticated cohort among long bond managers: those who can commit distinct dedicated resources to the implementation side of the LDI conversation. Liability-driven mandates typically evolve over time. 1 In many cases, the implementation of an LDI program begins with an initial move of simply extending the duration of the fixed income segment to more closely match the interest rate risk inherent in the liabilities. Then, the next step often involves increasing the fixed income allocation and focusing more closely on the credit hedge. Up to this point, the most important skills remain those used in managing against a corporate credit focused long duration benchmark, but other skills start to come into the equation: specifically, the ability to understand the complexities of an LDI process, the customization demands of clients and the evolving nature of the mandates. In addition to their deep fixed income investment teams, these managers typically have supplementary implementation teams (often with actuarial expertise) dedicated to collaborating with clients, modeling liability benchmarks, assisting in the education of clients, providing derivatives capabilities, devising customized solutions and managing key rate durations. In other words, it is important to be able to identify LDI managers who are equipped to work with clients from the various stages of the initial benchmark-relative phase all the way through to the fully hedged custom liability benchmark phase. Given that the transition to LDI ultimately involves a large and ongoing shifting of assets from equities to long duration fixed income, the allocation will ideally be divided among multiple managers with complementary skills and capabilities. In this case, the investor s task is to identify at least one manager with exceptional implementation capabilities. For example, it s not essential that every manager used has outstanding skills in guiding an LDI program along a liability responsive asset allocation glide path, but it is important to ensure that at least one does. Non-corporate and out-of-index exposures: How does the manager seek to add alpha (and how much)? Pension liabilities are calculated from the yields on a fairly narrow range of securities, so LDI mandates need to consider how to adequately diversify exposures and take advantage of the full opportunity set in fixed income while staying true to that liability calculation. Given the relatively limited opportunity sets within long duration, long credit, customizable benchmark, and long corporate investment universes from a sector standpoint, it is important for an investor to recognize how a manager seeks to outperform, to assure that the manager s style aligns with the investor s objectives. In Barclays Long Government/Credit mandates, the index includes allocations to treasuries, agencies, corporate bonds, Build America Bonds, global sovereign debt and supranationals. In Barclays Long Credit mandates, the index includes corporate bonds, Build America Bonds, global sovereign debt and supranationals. The Barclays-Russell LDI Indices include the same sectors as the Barclays Long Credit Index with the addition of STRIPS in the longest maturity bucket. And finally, the Barclays Long Corporate Index includes corporate bonds. 1 For more details, please refer to the September 2011 research paper by Martin Jaugietis, Michael Thomas, and James Gannon entitled, LDI Benchmarking: When Does the Basis Risk of an LDI Hedge Begin to Matter?, at Russell.com. Russell Investments // Unique considerations in evaluating liability-driven investment managers / p 2

Bear in mind that the Pension Protection Act ( PPA ) curve used for discounting liabilities to their present value is a corporate bond curve constructed from a corporate bond universe of A- to AAA-rated credit quality. Hence, the tracking error between a high-quality portfolio that includes only corporate debt and a more diversified long duration portfolio that includes noncorporate exposure and out-of-index positions calls for assessing the trade-off between the quality of the hedge and diversification. Generally speaking, a reasonable degree of diversification can be beneficial in long bond portfolios, for improving risk-adjusted returns; however, when selecting managers, it is also important to recognize that investments such as the State of California (Build America Bonds), Mexico (Sovereign Debt) and Brazil (Sovereign Debt) all of which are among the top ten holdings in the Barclays Long Credit Index are less related to the corporate curve by which liabilities are discounted. These broader mandates make sense early on in the program, when simply hedging the interest rate risk is the primary objective, but as the funding gap narrows, the credit hedge should generally tighten as well, thereby moving the investment universe closer to that of the discount curve. Some managers will see heavy allocation to non-corporate segments of the markets as their primary source of added value, while others may aggressively allocate tactically between corporates, treasuries and other segments to take advantage of risk-on/risk-off environments. Finally, many managers will seek to bolster performance with out-of-index holdings, plus investment in sectors like high-yield or emerging markets debt. Again, these are valid approaches to outperforming a benchmark, but it s important to assess whether the strategies are appropriate when the investment is first and foremost a hedge to corporates. Strategies like these make sense when deployed in a limited, complementary capacity for modest returns generation, but they also represent a deviation from the hedge. In some cases, clients simply prefer to keep return-enhancing sectors such as high-yield and emerging markets debt separate in the return-generating portfolio, and to isolate the long bond exposures in the hedging portfolio. Systems infrastructure, custom liability management and key rate duration matching Consistent with the themes highlighted in the above section regarding the identification of managers implementation capabilities, a final attractive characteristic of managers in the LDI space is the ability to manage custom liability portfolios and match key rate durations. Again, many managers have the expertise to simply manage a credit portfolio versus a predetermined benchmark target, but closely managing liability-based portfolios is more complicated. A liability-driven investment manager should have a sophisticated risk system that can systematically introduce customized liability streams; model liabilities to a wide variety of customized discount curves; and provide updated discounted liability values on a daily basis. The LDI phenomenon, while not entirely new, has not yet attracted a material number of third-party providers for off-the-shelf systems. Hence, a fully equipped LDI manager recognizes the importance of developing software to manage not only the asset side of the equation, but also the operational challenges on the liability side. Russell Investments // Unique considerations in evaluating liability-driven investment managers / p 3

Derivatives comfort, sophistication and risks LDI mandates can benefit from an assessment of implementation efficiencies for duration hedges and rate strategies, e.g., derivative solutions such as interest rate swaps, treasury futures, STRIPS, swaptions 2 and credit default swaps ( CDS ). Furthermore, in the long corporate bond space, there is not likely enough cash bond supply to meet the expected demand as defined benefit plans continue to move assets into the long corporate bond space. As a proxy for long corporate bond supply, the Barclays Long Corporate Index boasts a market cap of $1,033 billion as of November 30, 2012. The latest estimates for the total corporate pension obligations have been pegged at $2.3 trillion dollars, or more than two times the supply. 3 Clearly, the mismatch is significant. Given this supply/demand mismatch and the growing importance of liability-hedging mandates following the Pension Protection Act of 2006, derivatives usage is becoming more prevalent in LDI mandates, and will likely continue to do so as more defined benefit (DB) plans move toward LDI. Many investors assume that the derivatives exposure in LDI mandates is significant only in overlay strategies, but this is not necessarily the case. Investors should be aware that derivatives exposure may be materially present within traditional mandates as well. In the case of heavy CDS usage, investors should be mindful of a number of risks. First, the basis risk between CDS and cash bonds can be quite inconsistent and volatile. Currently, many corporate bond issuers exhibit negative basis risk, meaning the LIBOR levels on cash bonds are cheap relative to where credit default swaps trade. Second, most liquid CDS contracts are in the five-year range, so constructing the appropriate portfolio with respect to overall duration, key rate duration and spread duration would likely require investors use of interest rate derivatives and/or significant notional exposure to achieve the desired overall positioning. The usefulness of manager size diversification In light of the limited opportunity set from a sector standpoint, one potential way to introduce diversification is via manager size diversification. The strongest credit and technical skills often reside at the largest firms; however, these firms are managing large pools of money, and that can restrict their ability to be nimble in securities selection in the long end. For example, in the Barclays Long Credit Index, there are 979 securities with issue sizes under $500 million, and 674 securities with issues sizes over $500 million. Interestingly, the smaller segment of the market consists of 621 issues rated A or better, whereas the larger segment of the market includes 397 issues rated A or better. Thus, the bottom half of the index contains the most securities that best represent the closest hedge to the PPA discount curve. Exhibit 1: Small manager benefit with respect to the A-AAA discount curve hedge Total number of issues in Barclays Long Credit Index 1,653 Total number of issues - issue sizes over $500 million 674 Total number of issues - issue sizes of $500 million or less 979 Total number of issues - rated A or better 1,018 Number of issues - issue size over $500 million and rated A or better 397 Number of issues - issue size $500 million or less and rated A or better 621 Percentage of issues rated A or better and $500 million or less (based on number of issues) 61% Source: Barclays Live as of November 30, 2012 2 For a complete discussion of the usage of swaptions applications in LDI portfolios, refer to Mike Thomas s June 2011 research paper, Interest Rate Swaptions Downside Protection You Can Live With, at Russell.com. 3 Federal Reserve Flow of Funds Report, 2nd Quarter 2012. Russell Investments // Unique considerations in evaluating liability-driven investment managers / p 4

Furthermore, managers who have smaller asset pools can take more meaningful positions in the smaller issuers of the long corporate market, which tend to have performance that is less highly correlated with that of other managers. For a hypothetical example, assume that three managers of varying size would like to take a 1% position in a $350 million long corporate bond issue. Let s assume one manager runs $20 billion in long corporate bonds, another manager runs $10 billion and the third runs $5 billion. Exhibit 2: Long Corporate Assets $20 billion $10 billion $5 Billion 1% portfolio position size $200 million $100 million $50 million Percent of issuance 66% 29% 14% Clearly, larger managers are at a disadvantage in buying and selling securities with smaller issue sizes. In the case of the $20 billion manager, a 1% position in a $350 million cash bond would result in owning 66% of the total issuance. Not only would sourcing such large positions be both extremely difficult (in practice, impossible), but owning that proportion of an issue would seriously jeopardize the manager s liquidity and trading volume in the market. In reality, the larger manager will likely end up with an allocation of much less than 1% and ultimately hold a greater number of bonds. Without the ability to take meaningful positions in the individual cash bonds of the long-dated bond market, the alternative for a larger manager is to utilize derivatives contracts to gain exposure. Conclusion LDI mandates have a unique profile in that they are objectives-driven. The desire to hedge a pension plan s assets to that of its liabilities in many cases outweighs the need to outperform a benchmark. Thus, the identification of the proper manager lineup requires additional considerations beyond the ability to identify attractive securities from a bottom-up perspective or employ a top-down framework whereby the manager can outperform relative to the benchmark. Ideally, pension plans might consider structuring LDI portfolios in a multi-manager framework within which an implementation specialist in possession of dedicated, sophisticated LDI capabilities is coupled with return seeking and/or smaller, more nimble managers, thereby reducing the risk of manager concentration and allocating management across complementary skill sets. Russell Investments // Unique considerations in evaluating liability-driven investment managers / p 5

For more information: Call Russell at 800-426-8506 or visit www.russell.com/institutional Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Liability Driven Investment (LDI) strategies contain certain risks that prospective investors should evaluate and understand prior to making a decision to invest. These risks may include, but are not limited to; interest rate risk, counter party risk, liquidity risk and leverage risk. Interest rate risk is the possibility of a reduction in the value of a security, especially a bond or swap, resulting from a rise in interest rates. Counter party risk is the risk that either the principal or an unrecognized gain is not paid by the counter party of a security or swap. Liquidity risk is the risk that a security or swap cannot be purchased or sold at the time and amount desired. Leverage is deliberately used by the fund to create a highly interest rate sensitive portfolio. Leverage risk means that the portfolio will lose more in the event of rising interest rates than it would otherwise with a portfolio of physical bonds with similar characteristics. Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide and is part of London Stock Exchange Group.. The Russell logo is a trademark and service mark of Russell Investments. Copyright Russell Investments 2013. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: January 2013 (Disclosure revision: December 2014) USI-15355-01-16 Russell Investments // Unique considerations in evaluating liability-driven investment managers / p 6