Liability-Driven Investing Active or Passive? Vlad Putyatin Portfolio Manager

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1 Liability-Driven Investing Active or Passive? Vlad Putyatin Portfolio Manager Jeroen van Bezooijen Senior Vice President Vlad has joined PIMCO recently as a Portfolio Manager, working closely with Vineer Bhansali and the Portfolio Analytics team. He joined PIMCO from Deutsche Bank, where he was a Director in Asset and Liability Management focusing on customised LDI approach for life and pension schemes in Europe. Prior to that, Vlad had been a fixed-income analyst with Lehman Brothers. Vlad has nearly 10 years industry experience and holds a PhD in Financial Mathematics from the University of Southampton. In the past he taught Mathematical Finance at Oxford University. Mr. Van Bezooijen is a Senior Vice President and Product Manager responsible for PIMCO s European LDI business. He joined PIMCO in 2008 and has twelve years of investment experience. Prior to joining PIMCO, Mr. Van Bezooijen was an Executive Director in the Goldman Sachs Pensions & Insurance Strategy Group. Before that, he worked at Morgan Stanley and at Mercer Investment Consulting and holds Masters Degrees in Economics and Econometrics from Erasmus University Rotterdam. Liability-driven investing (LDI) is high on the agenda for most pension funds and insurance companies as these institutions are increasingly looking to benchmark their assets more closely to their liabilities. 1 The trend has strengthened since the early 2000s, as more traditionally benchmarked, asset-driven strategies have led to significant deficits relative to liabilities and pension accounting standards have tightened. For most investors, LDI is a risk management and risk reduction exercise. Thus, some investors believe it is best to structure LDI as passive mandates. At PIMCO, we challenge this belief: we assert that actively managed LDI mandates offer distinct advantages to investors. First of all, in our opinion, risk-free passive LDI implementation is not possible (or at least very expensive). Second, the inherent uncertainty about future liabilities (remember that actuarial estimates are just that estimates) means that passive strategies are not riskless as actual liability cash flows may differ from these estimates. And third, the complex nature of most LDI mandates means that an experienced and specialised active investment manager can exploit sources of structural alpha in the bond and derivatives markets to add value for the investor

2 LDI and Active Management: An Overview PIMCO cites many reasons in favour of active fixed-income management (see text box). The decision active or passive? is in every case a difficult one. But especially in the context of LDI, it requires more attention to detail due to the relatively complex solutions that both passive and active managers employ to implement the strategies. The main purpose of LDI is to help investors fund their future liabilities, not to outperform a market benchmark or a peer portfolio that has no real relevance to the investor. LDI replicates the investors liability risk characteristics either through unlevered mandates or through overlays. Managers lack a generally agreed benchmark index because the liabilities themselves are the benchmark; each investor s liability risks are unique and call for customised solutions. Passive asset managers typically go about LDI mandates through constructing static swap overlays. These swaps are standardised instruments that can be used to match key rate duration exposures and are ultimately easy to understand. Active asset managers like PIMCO are not limited to (spot starting) swaps and have therefore a far wider toolkit of investment instruments available to implement LDI structures and overlays. This allows active managers to extract added value. In the LDI space specifically, active management makes sense for these reasons: Most passive LDI approaches rely on a swap overlay to create the required liability risk characteristics, combined with a portfolio generating the London Interbank Offered Rate, or LIBOR (see Chart 1) to finance the floating leg of the swap. However, investors cannot generate LIBOR in a risk-free way. Therefore, passive structures will not generate risk-free LDI. Liability risk characteristics can be reproduced in many different ways, for example through bonds, futures and swaps. There are often structural opportunities to add value by exploiting the relative attractiveness of these different securities at any point in time. Investment managers rely on actuarial estimates of projected actual future cash flows to analyse the risk characteristics of the liabilities and plan the LDI strategy. This inherent uncertainty in liability projections calls into question the effectiveness of passively hedging the estimates with great precision. 2

3 Passive LDI Approach via LIBOR Asset Plus Swap Overlay Pension Fund Fixed Payment Floating Rate 6-month LIBOR Counter party Floating Rate 6-month LIBOR Cash pool Source: PIMCO Chart 1 Let s address the complexities investors face in assessing active versus passive management for LDI by explaining and analysing the various factors. We will start by looking at passive LDI mandates before taking a closer look at the approach active managers take. Passive Management and the Risks in LIBOR Generation As mentioned, passive managers often structure LDI portfolios by creating a static swapbased overlay that replicates the liability risk characteristics. In order to fund this swap overlay, passive portfolio managers consistently need to earn a 3- or 6-month LIBOR. Despite the common perception, LIBOR is not a risk-free rate. First, LIBOR only reflects the offered rate of the market and not the bid. When putting money on deposit, the 3

4 interest that investors receive is linked to the London Interbank Bid rate or LIBID, which is 0.125% lower than LIBOR. This means that if the client were to implement a swap-based LDI solution and put its cash on 6-month deposit, it would underperform its liabilities by 0.125% per year. With most liabilities being long-dated this could result in a total shortfall versus liabilities over time of 2 3%. Second, LIBOR contains credit and liquidity risk, which can become significant in times of financial stress. Therefore, a passively managed portfolio that invests in assets that pay a LIBOR coupon (in order to avoid the LIBOR-LIBID funding spread) is typically taking credit (and/or liquidity) risk. However, such static passive exposure to credit bears greater risk (in particular at times of financial stress) than taking an active exposure. Examples include investments in highly rated structured finance paper (e.g. AAA tranches of Asset- Backed Securities (ABS), Collateralised Debt Obligations (CDOs), Collateralised Loan Obligations (CLOs)). Before June 2007, these types of securities typically paid a small spread over LIBOR and were valued at par. Since then, as a result of the credit crunch, the majority of these securities trade at a discount to par, illustrating that these positions have credit risk, although this may not have been obvious months ago. By contrast, an active asset manager with the resources and expertise for thorough analysis can dynamically rebalance the portfolio to maintain specific characteristics with respect to ratings and industry sectors. Therefore, the actively managed portfolio is less prone to jump (default) risk than a passively managed portfolio. While the proprietary title selection and the rebalancing of active managers may lead to higher monthly volatility in the short-term, it results in equal or lower average volatility compared to passive mandates over time. In a nutshell, clients trade off jump risk for a potential increase in monthly volatility and consistent alpha generation longer-term by going active instead of passive. Passive LDI managers often invested in enhanced LIBOR vehicles to fund the swap overlay. Chart 2 shows the average performance of euro enhanced cash funds. On average, these funds performed in line with LIBOR in early Since then a significant performance gap has opened as a result of the credit crisis, with many funds being heavily invested in the structured finance securities described above that have been hit by the crisis. The same observation can be made for sterling enhanced cash funds. 4

5 Average Performance of Euro Enhanced Cash Funds Percentage of Par Value Average of Euro Enhanced Cash Funds 3-Month LIBOR % 96 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Source: Morningstar/Micropal, Bloomberg Chart 2 While investors with a longer-term investment horizon can expect to recover at least some of these losses as a result of the pull-to-par as these investments mature, the example shows that these structures are not riskless. Mark-to-market losses can turn into realised losses when these funds are forced to sell if clients withdraw assets. An alternative approach would be to invest in money market funds. However, these funds typically target 7-day LIBID rather than the 3- or 6-month LIBOR on which the floating leg of LDI swaps is based. Therefore, investing in a money market fund would result in an expected negative performance versus liabilities, as Chart 3 shows. The time series depicts the spread between 6-month LIBOR and 7-day LIBID for pound sterling and euro. In over 80% of the time, this spread is negative, and on average by about 20 basis points (bps) in pounds and 23 bps in euro. 5

6 Spread Between 7-Day LIBID and 6-Month LIBOR 150 Spread (bps) GBP EUR Jan-2001 Apr-2001 Jul-2001 Oct-2001 Jan-2002 Mar-2002 Jun-2002 Sep-2002 Dec-2002 Feb-2003 May-2003 Aug-2003 Nov-2003 Jan-2004 Apr-2004 Jul-2004 Oct-2004 Dec-2004 Mar-2005 Jun-2005 Sep-2005 Nov-2005 Feb-2006 May-2006 Aug-2006 Oct-2006 Jan-2007 Apr-2007 Jul-2007 Sep-2007 Dec-2007 Mar-2008 Jun-2008 Source: Bloomberg. Chart 3 A more recent alternative approach is to structure swaps based on a shorter-dated financing rate that is more easily replicated in money markets than LIBOR, such as SONIA or EONIA (Sterling/Euro Overnight Index Average). Investors have to be aware, though, that the market expectation of SONIA/EONIA being below LIBOR will be priced into these contracts (i.e. the fixed leg on a SONIA swap will be lower than the fixed leg on a LIBOR swap). In addition, these contracts are by no means the current market standard so are likely to be less liquid and therefore involve higher transaction costs. In effect, the only risk-free passive way to implement an LDI portfolio is to hold 100% government bonds. This approach is not practical for all LDI portfolios because the government bonds need to have the appropriate characteristics for the liability match and have to be in sufficient supply. For example, inflation-linked LDI mandates in the UK and the euro zone have only a few outstanding bonds to choose from. Nominal LDI mandates in the euro zone have plenty of government bonds of different maturities available. However, the downside is that the yield on (the highest quality) government bonds is relatively low, which means that more money needs to be allocated to LDI to achieve a specific liability target. 6

7 Active Management and the Replication of Liability Risk Characteristics Active managers aren t limited to static swap overlays like passive managers but have a full toolkit of investment instruments available to replicate the client s liability risk characteristics. Among the LDI management tools available are forward starting swaps, bond futures and repo transactions. 3 PIMCO has a wealth of experience in the use of these instruments, having deployed, for example, futures in portfolios since the 1970s and over-the-counter (OTC) derivatives like swaps since the 1980s. PIMCO regularly generates additional yield for clients by actively repo-ing out (government) bonds in portfolios. The full fixed-income toolkit opens up a multitude of ways to implement LDI structures while at the same time extracting additional value for investors. A solution PIMCO recently implemented illustrates how an active manager can extract additional value. At PIMCO, we have identified various ways to take advantage of the impact the recent market turmoil has had on the shape of the swap spread curve. In a first example in Chart 4, let us look at the path of forward starting sterling LIBOR (i.e. the 3-month spot rate, the 3-month 3-month forward rate, the 6-month 3-month forward rate etc.) relative to the forward path of 3-month SONIA at the end of March The 3-month LIBOR is relevant as it is close to the reference rate for the floating leg of swaps (i.e. 6-month LIBOR). The 3-month SONIA swap rate represents an overnight rate and is therefore closer to the risk-free rate that can be earned on short-dated liquid investments. The chart shows that this spread is close to 2% in the spot market and about bps three to nine months forward. We believed this situation to be a function of the liquidity crunch, resulting in LIBOR spot rates being much higher than implied in the derivatives market on a forward basis. As a result, we concluded it was more expensive to enter spot starting swaps (where you would pay the LIBOR reference rate which was high relative to the risk-free rate (SONIA)) when compared to forward starting swaps (e.g. 6-month forward starting), which are priced off the much lower forward LIBOR-SONIA spread. This situation has normalised to some extent in the second quarter of 2008, but it is a good example of how an active manager can add value in LDI portfolios during certain market environments. 7

8 The Forward Path of 3-Month Sterling LIBOR and SONIA OIS 31-Mar Month LIBOR 3-Month OIS 5.0 Rate % Month spot 3M 6M 9M Term Source: Bloomberg Chart 4 For our second example of how an actively managed LDI portfolio can find opportunities to add alpha, let us move further along the curve where the swap spread curve has become inverted. Charts 5 and 6 compare the pound sterling and euro 30-year swap spreads curves over recent history. The charts show that long-dated swap spreads now stand at very tight levels. Looking at swap spreads is only half of the story, though. Swaps are derivative instruments and in order to make a like-for-like comparison with government bonds, we need to take the financing cost into account. This is done by also plotting the LIBOR-GC (General Collateral) spread, i.e. the difference between the financing cost of swaps and the financing cost of gilts (i.e. the GC/repo level). The chart shows that this spread is currently higher than the swap spread, suggesting gilts are currently attractive versus swaps. 8

9 UK 30-Year Swap Spread versus LIBOR-OIS Spread 120 Sterling 30-year Swap Spreads Sterling Spread 3-Month LIBOR vs 3-Month OIS Spread (bps) Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Source: Bloomberg Chart 5 30-Year Swap Spread versus LIBOR-EONIA Spread Euro 30-Year Swap Spreads EURO Spread 3-Month LIBOR vs 3-Month OIS 70 Spread (bps) Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Source: Bloomberg Chart 6 9

10 Effectively, the question for investors is: What is the best way to take a position at the long end of the curve? The answer to this question basically comes down to a choice between swaps and government bonds. Again, an active manager can make this assessment and trade the portfolio accordingly, while a passive investor will most likely hold on to swaps irrespective of the spread levels. In addition, it requires the manager to have access to the repo market and make active use of repo in their portfolio management process. These are just two examples of the methods an active portfolio manager can apply to create an LDI structure uniquely tailored to an investor s liability risk characteristics and possibly generate additional value as well. LDI and the Liability Estimation Error The inherent uncertainty in liability projections supports the case for active management of LDI portfolios. The uncertainty stems from the many actuarial assumptions that drive liability profiles, such as mortality tables and lapse rates. This raises the question whether it makes sense to passively hedge these estimates to a high degree of precision, given the potential for actual cash flow needs that are markedly different from the estimates used to structure the passive portfolio. The question then is, how much risk do active strategies add to the overall asset-liability risk? We investigate this below, using data from JPMorgan Life Metrics we used the males set to analyse liability estimation risk. This data suggests that the uncertainty for mortality assumptions is about 21 bps, loosely meaning that the standard deviation of mortality rates is 0.21%. If we assume that the uncertainty inherent in other demographic assumptions results in potential 10 bps deviation from liabilities and a liability duration of 15 years, this suggests an overall liability tracking error of about 3.5% p.a. Chart 7 shows the impact on total asset-liability risk (i.e. tracking error versus liabilities) of adding different levels of active management risk to the LDI portfolio (assuming liability estimation error and active management risk are uncorrelated). The important takeaway from this chart is that an active strategy with a tracking error of 1.5% increases the total risk only marginally from 3.5% to 3.8%. Assuming an information ratio 4 target of 0.5, this suggests an additional return of 0.75% for just 0.3% in additional risk. 10

11 Risk from Liability Estimation Error and Active Management 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00% Active Risk Liability Estimation Error Source: PIMCO/JPMorgan Life Metrics. Incremental Risk due to Active Management Chart 7 Summary and Conclusions LDI is a technical subject and running LDI portfolios requires expertise of and experience in the full toolkit of fixed-income instruments. This toolkit comprises both bonds (including the ability to repo bonds) and derivatives. Recent history has shown that it is virtually impossible to run LDI portfolios on a riskless, passive basis. Passive managers often choose a cash-type asset plus swap overlay approach to LDI. The challenge of that approach is that the financing rate on swaps is typically 6-month LIBOR, which cannot be replicated in a risk-free way because It is the offered (and not the bid) side of the market, and It represents 6-month unsecured financing of financial institutions. This means investors either need to take credit or active risk to meet the LIBOR target, or accept a structural underperformance versus swaps by investing the cash in lower returning money market funds. We believe LDI portfolios should be managed actively by managers using the full fixedincome toolkit because there are plenty of opportunities to outperform. In addition, a passive approach will at best be based on estimated liability cash flows. Given the substantial uncertainty about actuarial assumptions such as future mortality, active management offers the potential for additional return without substantially increasing overall risk. 11

12 PIMCO s Philosophy on Active Management Since PIMCO was founded in 1971, we have held a strong belief that in the longerterm, active management is superior to passive management. This is especially the case in times of market turmoil. The cumulative, long-term amount of alpha generated (after fees) in crisis periods as well as non-crisis is substantial, as measured by PIMCO s longest-running strategy, the US Total Return. There are four main reasons why active fixed-income managers have an advantage over their passive counterparts: 1. Active managers can generate excess returns through tactical opportunities 2. Structural opportunities in fixed-income markets create sources for added value (including the existence of liquidity, term, volatility and credit premiums) 3. Diversification allows active managers to reduce risk 4. Passive fixed-income strategies have limitations and come with significant opportunity costs The recent turmoil in global financial markets led to volatility in fixed-income markets as well. Overall, this has created more favourable conditions for active fixed-income managers than we have seen in the years leading up to the crisis that erupted in the summer of 2007; these conditions include steeper yield curves, higher volatility and wider credit spreads. 1 We assume that both assets and liabilities are measured on a mark-to-market or fair value basis for the purpose of this paper. 2 In addition, many passive LDI providers have developed their current market position as passive equity managers before moving into LDI more recently. Fixed-income (derivative) markets are technically complex, and we would argue that you need a manager with a long experience in fixed-income markets to be able to run LDI portfolios efficiently as equity derivative market experience can t sufficiently be leveraged. 3 In a repo transaction, an investor enters into a sale-and-repurchase agreement, selling typically government bond collateral to a counterparty and receiving the purchase price for a fixed period of time. At the end of this period, the seller will buy back the securities sold, thus effectively borrowing cash against a collateral. 4 Information ratio is a risk-adjusted measure of return relative to the benchmark, defined here as the ratio of alpha to tracking error. London PIMCO Europe Ltd (Registered in England and Wales, Company No ) Registered Office Nations House 103 Wigmore Street London W1U 1QS England Munich PIMCO Europe Ltd 12

13 Munich Branch (Registered in Germany, Company No ) Registered Office Nymphenburger Strasse Munich Germany Amsterdam PIMCO Europe Ltd Amsterdam Branch (Registered in The Netherlands, Company No ) Registered Office Schiphol Boulevard 315 Tower A BJ Luchthaven Schiphol The Netherlands PIMCO Europe Ltd, PIMCO Europe Ltd Munich Branch and PIMCO Europe Ltd Amsterdam Branch are authorised and regulated by the Financial Services Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. PIMCO Europe Ltd Munich Branch is additionally regulated by the BaFin in Germany in accordance with Section 53b of the German Banking Act and PIMCO Europe Ltd Amsterdam Branch is additionally regulated by the AFM in the Netherlands. The services and products provided by PIMCO Europe Ltd are available only to professional clients as defined in the Financial Services Authority's Handbook. They are not available to individual investors, who should not rely on this communication. Past performance is not a guarantee or a reliable indicator of future results. Portfolios may use derivative instruments for hedging purposes or as part of the investment strategy. Use of these instruments may involve certain costs and risks such as liquidity risk, interest rate risk, market risk, credit risk, management risk and the risk that a portfolio could not close out a position when it would be most advantageous to do so. Portfolios investing in derivatives could lose more than the principal amount invested. Swaps are a type of derivative in which a privately negotiated agreement between two parties takes place to exchange or swap investment cash flows or assets at specified intervals in the future. There is no central exchange or market for swap transactions and therefore they are less liquid than exchange-traded instruments. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investments in Collateralized Debt Obligations ("CDOs") and Collateralized Loan Obligations ( CLOs ) may involve a high degree of risk and are intended for sale only to qualified investors capable of understanding the risks entailed in purchasing such securities. Such securities can principally cause a decrease in income, which result in a decrease in residual profits. Diversification does not ensure against losses. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Charts are not indicative of the past or future performance of any PIMCO product. This article contains the current opinions of the manager and such opinions are subject to change without notice. This article has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this [presentation/report] may be reproduced in any form, or referred to in any other publication, without express written permission of PIMCO Europe Ltd (Registered in England and Wales, Company No ), Registered Office Nations House 103 Wigmore Street London W1U 1QS. 2008, PIMCO. 13