Article 9 February, 2021

Segregated LDI mandates: comparing to the best pooled LDI funds can do

Over my last few articles, I have discussed the benefits of a segregated approach to LDI. Here we show what this means in practice. To do this we have considered a comparison of segregated versus pooled funds by way of two examples. The two comparisons are: Conventional LDI & Equity-Linked LDI

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Conventional LDI

A conventional LDI portfolio consists of a pooled LDI holding and some growth assets. If we imagine a £100m pension scheme wanting to hedge £100m of their liabilities, this will typically mean an allocation of £30-£40m to the LDI pooled fund. A segregated approach would typically require a £20m initial allocation. This means in a segregated approach the scheme will have 10-20% more in growth assets which could mean 0.5%-1% of additional return per year over the pooled fund approach. An obvious question we get here is “surely the segregated mandate will need more collateral top ups?”. There are two answers to that:  First, as we explained in our article on efficiency in Week 2, the pooled fund top ups are set so prudently that in practice the top ups in the above segregated mandate would be of a similar frequency (if not less frequent) than a pooled fund. Secondly, even if top ups were more frequent, the segregated approach would still have more assets in growth as it needs less collateral in the first place– so even if you halved the additional return above, this is still a meaningful benefit to pension schemes. In addition to this the segregated approach will be bespoke rather than profile based, meaning that all the return benefits are enhanced further, as explained last week.

The additional benefit of a segregated approach is that even more could be invested in growth assets by adding structured equity over the collateral pool (effectively rather than a £20m allocation to collateral pool you would have a £20m allocation to structured equity). In this scenario 100% of the assets are in growth and the scheme will still be hedging 100% of the LDI risk.

Equity-linked LDI

In order to compare like-with-like we can compare this to equity-linked LDI pooled funds as shown in Figure 1 below. In such funds, a £1 allocation to the fund provides £1 of equity exposure and £2 of LDI. Therefore in order to maintain 100% hedging the pooled fund would need a £50m allocation to the Equity-Linked LDI fund.

Figure 1 - segregated vs. pooled LDI mandate

Source: River and Mercantile

In a segregated mandate, not only would the LDI piece be bespoke and tailored to each client but so would the equity exposure. The challenge with equity-linked LDI is that it is exposed to equity downside which is both undesirable from a risk perspective, but also increases the collateral pool top up frequency. With a segregated mandate the £50m of structured equity could be tailored to provide protection from market falls. In addition, with £50m of structured equity it is extremely unlikely that any top ups will ever be required. An alternative in the segregated mandate would be a £25m allocation to structured equity, freeing up £25m for other uses in the growth portfolio yet probably still having fewer collateral pool top ups than in equity-linked pooled LDI.

So, to bring it together the efficiency and tools of a segregated approach allows clients to:

  • Target more return and or more LDI through the efficiency of a segregated approach
  • Manage more risks through the use of additional tools
  • Manage those risks more accurately by tailoring the approach to suit each client’s liabilities, risk and return tolerances.

All of this in combination could add material return or risk management benefits to all schemes.  There has not been a better time to review your pooled LDI approach and we would be delighted to discuss your requirements with you.

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.

 

This article has been issued and approved by River and Mercantile Derivatives, a division of River and Mercantile Investments Limited, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority. Please note that all material produced by River and Mercantile Derivatives is directed at, and intended for, the consideration of professional clients only. Retail clients must not place any reliance upon the contents.
The information expressed has been provided in good faith and has been prepared using sources considered to be reliable and appropriate. While the information from third parties is believed to be reliable, no representations, guarantees or warranties are made as to the accuracy of information presented, and no responsibility or liability can be accepted for any error, omission or inaccuracy in respect of this. This article may also include our views and expectations, which cannot be taken as fact.
The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.
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