The benefits of pooled LDI funds that do and don’t exist
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.
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. There are however, many areas where perceived benefits of pooled funds are still debated –these range from benefits which definitely did exist and now no longer do, to benefits which can be slightly misconstrued or ‘may exist’, to benefits which definitely do exist, but the benefit is to the LDI manager rather than the scheme. These are explained below.
Benefits that used to exist and no longer do
There used to be some significant barriers to accessing segregated mandates, as Table 1 below illustrates. However, over the last ten years, these have all but been eliminated.
Table 1 - the evolution of pooled scheme benefits
Benefits that may exist but don't in practice
One benefit that is often proposed that needs a little more explanation is that pooled LDI provides protection to pension schemes because they can only lose what they put in.
Whilst technically at a single point in time this is true, in practice the economic exposure is the same across a pooled and segregated mandate. This is because if interest rates rise and the pooled fund asks for more money from the pension scheme, then the pension scheme will add more money – this is a given, because you would obviously still want to keep your LDI strategy if interest rates were higher. So as rates continue to rise (the scenario where this alleged “protection” from the pooled fund is meant to occur) you will continue to put more into the pool. So, whilst it is true to say that the scheme can only lose what it puts in, it will still put in more money as rates go up. The net result is that the economic exposure is the same across pooled and segregated mandates and therefore pooled funds do not offer such protection.
The definite benefits of pooled LDI
There are, of course some definite and irrefutable benefits of pooled funds as shown in Table 2 below. But these benefits are to the LDI manager, and not to the scheme.
Table 2 - the benefits of pooled LDISo, if we take a step back:
- The documentation and governance challenges of segregated mandates have been removed
- The cost hurdle has been lowered
- The only benefits that remain for pooled funds are those that are for the benefit of the manager.
We can see that the benefits of pooled funds don't exist for schemes anymore. So, over the next few weeks, we are going to be discussing the tangible economic benefits of a segregated approach, starting next week with an overview of efficiency gains.
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.
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.
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