It’s just plain efficiency
We believe that segregated mandates offer some very significant benefits for pension schemes, which is why at River and Mercantile we only offer our clients segregated LDI.
Last week, we published an article discussing the reality that many of the perceived benefits of pooled funds in LDI do not really exist. Now we move onto the tangible economic benefits of segregated mandates.
A segregated approach is the most efficient way to implement derivatives, and this efficiency can translate into material benefits for the pension scheme. Very crudely, a segregated mandate can mean more assets invested in growth, which is a material benefit.
How this works is that it all boils down to the approach taken to determining the size of the collateral pool to support daily collateral movements. In a segregated mandate, for a given allocation more hedging can be achieved or, conversely, for a given level of hedging a smaller allocation is required and more assets can be invested in the growth portfolio. It’s easiest to think of this from the counterparty bank’s perspective.
When a counterparty bank trades with an entity, it needs to make a credit assessment of that entity, based on the level of assets that that entity has, and the trades it plans to put on.
In an LDI context, let’s imagine a hypothetical scenario of a £100m pension scheme trying to trade £100m of derivatives in a pooled fund, versus in a segregated mandate of its own.
Pooled fund scenario
The pooled fund will have less than £100m in it because the more assets in the pooled fund the more return is sacrificed to support LDI. In that respect, arguably, the ideal amount in the pooled fund is zero. However, the bank would not trade with a fund with zero assets. As a result, the pooled fund has to come up with some rules to ensure:
a) It has enough assets to meet collateral calls
b) It has enough assets to satisfy the bank’s credit assessment
The main driving force behind pooled fund design is going to be (b) as it has to be able to trade every single day as flows come in and out. And because of this (b), which is the trigger levels put in place to ensure that the fund meets the bank’s credit assessments, will always be as prudent as the pooled fund can get away with, whilst balancing these competing forces.
So how prudent are these triggers?
Clearly different funds take different approaches but in Table 1 below, we use a typical example of leverage-based triggers and consider the prudence in terms of what needs to happen to interest rates to exhaust the allocation:
Table 1: Target leverage for £100m of hedging
“A segregated approach is the most efficient way to implement derivatives, and this efficiency can translate into material benefits for the pension scheme. Very crudely, a segregated mandate can mean more assets invested in growth, which is a material benefit.”
On the face of it, this approach seems sensible but in reality, as shown in Chart 1 below, for the 8x leverage stop out (i.e. where the pension scheme’s interest rate protection is removed), since 1996, 30 year gilt yields have almost never moved by that amount in 2 weeks.
The top up trigger (i.e. where additional assets are requested from the pension fund), implies there is a need for more assets and additional capital and that it will be required within 2-4 weeks, gilt yields over the same time horizon have risen by more than 1% in fewer than 1% of observations.
Chart 1: Percentage of observations where the 30 year gilt rate has changed by more than a given amount for different periods
Source: Bloomberg, River and Mercantile, December 2020
So these triggers are overly prudent (i.e. the market scenarios they are aiming to protect from are far less likely than the urgency of “request” and “stop out” imply), and the key takeaway is that they are not really protecting the pension scheme from market scenarios, but the pooled fund. This pooled fund protection has no immediate economic benefit to the pension scheme. And the actions mean that there is going to be more of the scheme’s assets tied up in a collateral pool, and less in a growth-based part of the portfolio.
Segregated mandate scenario
In a segregated mandate, the counterparty bank sees the pension scheme and so sees an entity of £100m trying to trade £100m of derivatives – we’ve illustrated this below in Figure 1. The bank sees this as a far more secure entity to trade with so few, if any restrictions are put in place.
Figure 1: consider this from a bank's perpective
This means that in a segregated mandate, both the initial allocation and the top up triggers can be set at levels that work for the pension scheme. Which means freeing up assets to invest in growth and/or allowing them to hedge more risk. A 20% higher growth asset allocation could mean (assuming growth assets earn gilts + 4% p.a.) almost 1% p.a. of additional return for the pension scheme so this efficiency has material benefits.
It is really just a question of plain efficiency.
Should you wish to find out more, please contact us and we'll be happy to discuss further.
Glossary of key terms
Segregated mandate – an LDI mandate where the client has their own set of derivatives direct (through an LDI manager) with the bank
LDI Pooled fund – here we mean leveraged pooled funds with multiple investors where £100 of hedging is achieved by investing less than £100 in a pooled fund
Equity-linked LDI pooled fund – As above but the amount invested in the pooled fund is also exposed to equity movements (through futures)
Collateral – collateralisation is the movement of assets between the parties of a trade to manage counterparty risk. The aim of the process is to ensure that the entity with the positive value of derivatives has the same value of collateral (typically gilts or cash) posted from the other side
Collateral pool – as the collateral process is two way the pension scheme/pooled fund must hold a pool of assets to be comfortable that it can meet the collateral requests from the counterparty if the derivatives are negative
Leverage – we mean that the amount of hedging is greater than the size of the collateral pool.
LDI Trigger points – a defined point, usually based on either market conditions (such as levels of interest rates) or the schemes funding position, where pre-agreed increase in LDI will take place.
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