LDI ‘land grab’ could push schemes out of the frying pan and into the fire
The fallout from the gilt crisis following September’s ill-fated mini-budget – particularly the impact on liability driven investment (LDI) – has adopted almost soap-opera status in the last few months, with new revelations still coming to light.
But behind the headline stories, a more concerning plot twist is taking place.
LDI managers are using the crisis as an excuse to further ‘grab assets’ from defined benefit (DB) pension schemes
Within his evidence at a Work & Pensions Committee hearing1 , Independent Economic and Financial Markets Commentator, Toby Nangle, described how LDI managers were demanding higher buffers from their clients, and that this “had been understood as an asset grab by the asset managers to say, ‘we just want to have more of your assets, and we will charge fees on more of your assets and this is the prudential thing to do.’”
Billed as a solution to mitigate potential future crises, this could in fact be exposing schemes to new and persistent systemic risks, even under normal operating conditions.
The ‘prudential thing to do’
The proposed rationale is that by controlling more of schemes’ assets – particularly credit assets that sit within cashflow driven investment (CDI) strategies – LDI managers would be in a better position to raise cash should a similar liquidity event arise again.
In practice, the combination of CDI and LDI portfolios could see a single manager running circa 80% of a DB pension scheme portfolio. And the majority of LDI assets currently sit within a small group of just three managers.
Make no mistake – better governance and increasing efficiencies are pragmatic and noble aspirations. However, there are other ways to try and achieve these, and what is not being communicated are the dangerous ramifications of handing over such huge amounts of assets to a very small number of managers.
For a start, handing such control to only a few market participants in an already relatively shallow market such as the UK credit market (typically the core asset class in many CDI portfolios) would create significant concentration risks.
The LDI market turmoil was in itself a cautionary tale of concentration risk – too many similar assets (in that case UK government bonds) were managed by too few managers, with the resultant scale and speed at which they rushed to sell leading to complete market destabilisation and necessitating intervention from the Bank of England.
To allocate more assets to those same participants would create an acuter risk in an even shallower market than that of UK government bonds, leaving the system vulnerable to eventualities far beyond anything quite as isolated as we witnessed last year.
In such a scenario, the resultant sell-off from portfolios would cause enormous skews in the credit market, creating similar ‘doom loop’ spirals to those in September, but with more assets – and more asset classes – pulled into the fray.
This represents a systemic risk that cannot be allowed to go unnoticed or unchecked.
We would be jumping out of the frying pan and straight into the fire.
Horses for courses
Second, the LDI ‘land grab’ would threaten the principle of selecting best in class managers for each individual strategy.
As pension schemes mature, the focus shifts to ensuring they have the necessary cashflow to pay their member benefits in full. This would typically see a scheme allocating between 20-50% of its portfolio to a CDI (Cashflow Driven Investment) strategy – normally invested in corporate bonds and other income-generating assets.
In the same way you wouldn’t hand an emerging market equity mandate to a developed market specialist, we mustn’t forget that, while LDI and CDI are two complementary strategies, each requires a very different skill set.
Driven largely through credit assets, cashflow driven investing requires deep fundamental research so as to limit downgrade and default risk, minimise trading costs to avoid capital erosion, and find the best relative value across a vast universe of investible credit assets.
In an environment which could see default rates rise towards historical averages, navigating a landscape marked by a greater dispersion of credit returns between issuers will be crucial to helping schemes reach their endgame goals.
Achieving the best possible performance (capital growth, predictability of cashflows) throughout this period requires specialist credit management expertise.
The term ‘horses for courses’ rings true in investment as in other areas.
As such, we do not believe that schemes should compromise on selecting their credit managers by skillset, especially when governance efficiencies are often overblown. That would be penny wise but pound foolish.
Purported as a solution to ease efficiencies should a liquidity event of such magnitude occur again, the reality of LDI managers being successful in this asset grab would undoubtedly de-value other areas of the system and create systemic risks and vulnerabilities to make recent events almost pale in comparison.
Ultimately, we don’t believe that as an industry we should foster a scenario where schemes are pressured into a supposed solution for one eventuality which in fact presents a more immediate and pervasive set of risks.
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