October 2016. For professional investors only. Please read the important disclosure at the end of this article.
spotlight
Supporting the liability-hedging and return-seeking demands of a modern LDI strategy
Julian Lyne Global head of distribution
A firm foundation:
absolute-return funds
in an
LDI strategy
T
he objective of an occupational DB pension scheme is simple – pay members their
benefits in full and on time. The reality of achieving this premise, however, can be
more complex. There are two moving parts within a pension scheme that determine
the ease with which benefits can be paid: first, assets – that is the amount the pension
scheme has available to pay pensioners, and, second, liabilities – the amount the scheme owes.
Any deficit between those assets and liabilities can only be closed by additional cash
contributions and/or investment returns.
Changes in regulation, volatile market conditions and increasing life expectancy have caused
the gap between assets and liabilities to grow (see exhibit 1 below). Consequently, more
schemes are turning to investment strategies that better match the movement in their assets
to the movement in their liabilities. Liability-driven investment (LDI) is one such approach.
EXHIBIT 1: HISTORICAL AGGREGATE BALANCE (ASSETS LESS SECTION 179 LIABILITIES) AND FUNDING RATIO
OF SCHEMES IN THE PENSION PROTECTION FUND UNIVERSE
240
120
160
Aggregate balance (LHS)
Funding ratio (RHS)
£ (billions)
80
110
100
0
90
-80
80
-160
%
70
-240
60
-320
-400
50
2008
2009
2010
2011
2012
2013
2014
2015
2016
A scheme’s section 179 liabilities represent, broadly speaking, the premium that would have to be paid to an insurance company to take on the payment of
Pension Protection Fund levels of compensation.
Source: Pension Protection Fund 7800 Index, 30 June 2016. Data represents estimated aggregate assets and liabilities of the 5,945 UK pension schemes in
the PPF 7800 Index. http://www.pensionprotectionfund.org.uk/DocumentLibrary/Documents/PPF_7800_july_16.pdf
1
SPOTLIGHT
The first is a liability-hedging pool which focuses on investing in assets that move in the
same way as factors that cause liabilities to grow. These factors include falling interest rates,
rising inflation, and increasing longevity. Investing in assets that match movements in liabilities
is known as liability hedging and typically uses physical bonds and derivatives in order to
add ‘leverage’ to the physical bonds held.
‘Swaps’ and gilt repurchase agreements are also becoming common instruments for pension
scheme trustees. A swap is simply an agreement between two parties to exchange a series of
cash flows. For example, a pension fund may pay an investment bank a floating rate of interest,
and receive an agreed fixed rate of interest in return. This is similar to a fixed-rate mortgage
arrangement which many home owners now choose.
The second LDI pool is
a return-seeking pool,
which seeks to find
additional return to fill
any funding gaps and
make it easier to pay
benefits. It may include
growth assets such as
equities.
return-seeking
liability-hedging
LDI strategies create two pools:
EXHIBIT 2: SWAPS IN ACTION
Inflation = expectations
Fixed (at expected inflation)
Inflation higher than expectations
Fixed (at expected inflation)
£3 £3 £3 £3 £3
Pension
fund
£3 £3 £3 £3 £3
Inflation lower than expectations
Fixed (at expected inflation)
£3 £3 £3 £3 £3
Counter
party
Pension
fund
£3
£4 £4 £4
£5
£3 £3 £3 £3 £3
Counter
party
Pension
fund
Counter
party
£3
£2 £2 £2 £2
Floating (actual inflation)
Floating (actual inflation)
• No net impact on either party
• Pension fund gains on swap
• Liabilities will have grown
Floating (actual inflation)
• Pension fund makes loss on swap
• Liabilities will have fallen
For illustrative purposes only.
What is involved in LDI?
The starting point with LDI is to
understand a scheme’s liabilities and how
these are likely to grow in the future.
present value of those future (benefit)
liabilities. The lower the yield on bonds, the
lower the ‘expected’ investment return over
the period and thus the higher the present
value of the liabilities today.
Prevailing running yields on ‘risk-free’ gilts
(plus some margin) or AA-rated corporate
bonds are often used to determine the
It makes sense, therefore, to choose
fixed-income assets for a liability-hedging
portfolio since they respond to changes in
EXHIBIT 3: HEDGING CONCEPTS
Deficit
Deficit
Assets
0% hedged
Liabilities
Yields fall
Assets
100% hedged
Deficit
Assets
Yields fall
Liabilities
Source: Mercer. For illustrative purposes only.
Liabilities
Deficit
Assets
Liabilities
interest rates in the same way as liabilities
(see exhibit 3).
However, the maturity of fixed-income
assets is often too short to provide the
long-term hedge needed by most pension
funds. Secondly, most bonds (index-linked
issues being the exception) fail to provide
risk protection against rising inflation.
Finally, investing in traditional bonds locks
investors’ capital in and prevents them
from seeking additional return elsewhere.
Including swaps in an LDI strategy helps
to mitigate some of the limitations of bonds
by providing better duration matches and,
through leverage, freeing up assets to be
better employed in seeking return.
As LDI has evolved, the approach to both
return-seeking and liability-hedging assets
has changed, with many schemes now
adopting an LDI approach.
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SPOTLIGHT
LDI in action
When pension funds enter into a swap
arrangement as part of a liability-hedging
strategy in LDI, both parties need to
provide collateral to secure the deal. In the
past, schemes have relied on cash or gilts
since these are low risk and liquid.
Should the worst happen and the cash
reserves not be sufficient to meet collateral
agreements, schemes may be forced to sell
assets, which can be costly and damaging.
In seeking to support an LDI programme
and potential cash calls, investing in liquid,
return-seeking, and (relatively) low-risk
assets alongside cash and gilts can help to
mitigate against the dangers of forced
selling at inopportune moments.
The right ingredients
Diversification has become increasingly
important in return-seeking strategies –
both to limit volatility and to allocate
tactically to the best market opportunities.
Multi-asset absolute-return funds,
unconstrained by traditional benchmarks,
can offer a route to stable returns, with
the additional benefit of seeking to
preserve capital.
The focus for LDI strategies today, across
both their pools (liability-hedging and
return-seeking), is the right mix of global
diversification, freedom from benchmark
constraints and the ability to protect
capital against volatility and downside loss.
EXHIBIT 4: LDI SUMS
Multi-asset absolute-return
funds, unconstrained by
traditional benchmarks, can
offer a route to stable returns,
with the additional benefit of
capital preservation
Schemes can put a ‘liquidity ladder’ in
place which has cash and gilts on the
lowest ‘rungs’ and gradually adds
higher-return options above those.
This approach may be particularly useful
following the prolonged period of
quantitative easing which has sent gilt
yields to their lowest levels on record
and meant government bonds can
arguably be said no longer to enjoy
their ‘risk-free’ status.
Those assets might include currency
forwards, equity futures, or absolute
return funds which invest in a range of
fixed-income assets.
LDI evolution has not been limited to the
liability-hedging pool; the return-seeking
side of the approach has also undergone
important development.
Liabilities
+ x%
=
Liability-hedging pool
• Swaps (interest rate, x etc.)
• Options
• Futures
• Fixed-income instruments
• Currency hedges
• Commodities
• Fixed-income absolute return strategies
+
Return-seeking pool
• Equities
• Renewables
• Infrastructure
• Corporate debt
• Convertibles
• Multi-asset absolute return strategies
For illustrative purposes only.
Fixed income is at the heart of the
liability-hedging pool in LDI strategies.
With bond yields at historic lows, the asset
class faces a challenging future, but where
a manager is free to invest based on their
conviction and knowledge of the markets,
opportunities can still be found.
An unconstrained manager investing
across a range of fixed income assets can
use their knowledge, experience and skill
to invest in regions, sectors and economies
that present the greatest chance of
meeting their investment objectives.
By employing a dynamic approach, the
manager can react to market conditions, as
well as divergences between regions, currencies
and economic policies, and change course
to try to deliver the best outcome.
At the same time, by taking risk-offsetting
positions and investing in ‘stabilising’ assets,
an investment manager can seek to preserve
capital and protect a portfolio from
downside loss. Having an absolute-return
(e.g. ‘Libor +’) aim for these approaches is
also consistent with the wider LDI objective.
Using this globally diversified, absolutereturn approach can be beneficial on the
return-seeking side.
By targeting a higher return and including
assets outside fixed income, absolute-return
multi-asset funds can provide the necessary
return-seeking element needed in an
LDI strategy.
An absolute-return multi-asset fund
invests in a range of assets – from traditional
bonds, equities, cash and property, to more
alternative classes such as renewable energy
and infrastructure.
These funds also include stabilising assets
such as index-linked bonds, commodities,
and risk-offsetting currency and equity
hedges.
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SPOTLIGHT
Where Newton fits in clients’ LDI approaches
At Newton we have two tried and tested strategies that support both the liability-hedging and return-seeking demands
of a modern LDI strategy. We have a number of clients using these as part of an LDI mandate.
Strategy 1
Newton Global Dynamic Bond strategy
Invests in a globally diversified range of fixed-income assets.
The strategy is dynamically managed, and
bond investments and currency positions
are driven by our interpretation of market
opportunities and risks. An unconstrained
approach gives us the freedom to move
dynamically between different regions,
asset classes and currencies to try to weather
market turbulence while continuing to
deliver returns.
The focus is in on simple, liquid fixed-income
assets which are divided into a returnseeking core and a stabilising outer layer,
both of which are dynamically managed.
The Global Dynamic Bond strategy aims
to deliver 2% a year above one-month
LIBOR before fees over rolling five-year
periods, and also aims to achieve a positive
return on a rolling three-year basis.1
The Newton Global Dynamic Bond Fund
has achieved an annualised gross return
of +7.0% since inception in 2006.2
An unconstrained approach
gives us the freedom to move
dynamically between different
regions, asset classes and
currencies
EXHIBIT 5: A FUND WE BELIEVE IS FIT FOR ALL CONDITIONS: NEWTON GLOBAL DYNAMIC BOND FUND
Low return world,
too much leverage
Credit crunch
Quantitative easing
Eurozone crisis
Mario saves
the day
Taper
Tantrum
Commodity
deflation
Commodity
deflation
fallout
190
180
170
Price (index)
160
150
140
130
120
110
100
90
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Source: Bloomberg, Newton (May 2006 to June 2016)
For illustrative purposes only. Performance shown is for the Newton Global Dynamic Bond Fund, in GBP, net of fees since its inception 28 April 2006.
1The strategy aims to deliver a minimum return of cash (one-month GBP LIBOR) +2% per annum over 5 years before fees. In doing so, the strategy aims to achieve
a positive return on a rolling 3-year basis. However, a positive return is not guaranteed and a capital loss may occur.
2S ource: Newton, 30 September 2016; inception was 1 May 2006. Past performance is not a guide to future performance. The value of investments and the income
from them can fall as well as rise and investors may not get back the original amount invested. Please see important information at the end of this document.
4
SPOTLIGHT
Strategy 2
Newton Real Return strategy
This strategy, launched in 2004, seeks to deliver an absolute return (of one-month LIBOR +4% per annum over
five-year periods and a positive return on a rolling three-year basis), while aiming to preserve capital. 3
It has the freedom to invest in multiple asset classes.
Stabilising assets / hedging positions
Again, the emphasis is on simplicity and liquidity, with the team
responsible for its management able to invest across multiple asset
classes based on their best ideas.
Physical
gold
The Real Return strategy invests in traditional asset classes
comprising a core of return-seeking assets, which is supported by
stabilising assets that aim to hedge risks and dampen volatility.
Gold
equity
Cash / short-dated bonds
Current returnseeking assets
We choose assets based on our views about long-term trends
across the investment landscape, and we adapt to changes in
market conditions and economic policies.
Equity market
hedges
The strategy aims to keep volatility between that typically
shown by bonds and equities.
Equity option
strategies
The Newton Real Return Fund has achieved an annualised
gross return of +8.8% since inception in 2004, and a gross
positive return in every year over that period. 4
Active
currency
positions
Corporate debt
Equities
Government
bond options
Renewables
Infrastructure
Conventional
government
bonds
Convertibles
Floating rate
notes
Currency
hedge
Index-linked
bonds
Commodities
EXHIBIT 6: NEWTON REAL RETURN FUND – PERFORMANCE SINCE INCEPTION TO 30 JUNE 2016
200
Newton Real Return Fund
180
LIBOR 1 Month +4% p.a.
160
MSCI AC World NDR
Total return %
140
FTSE Govt. All-Stocks
120
100
80
60
40
20
0
-20
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
1. Relaunched to new mandate 1 April 2004.
2. The Fund aims to deliver a minimum return of cash (1 month LIBOR) +4% p.a. over five years before fees. In doing so, the Fund aims to achieve a positive return on a rolling three year basis.
However, a positive return is not guaranteed and a capital loss may occur.
Source: Lipper, weekly data, total return, gross of management fees, gross income reinvested.
Figures are based on sterling returns. 31 July 2016. Comparisons are made to demonstrate correlation only and are for illustrative purposes only.
Performance calculated as total return, income reinvested, gross of charges in sterling.
3The strategy aims to deliver a minimum return of cash (one-month GBP LIBOR) +4% per annum over 5 years before fees. In doing so, the strategy aims to achieve a positive return on a rolling
3-year basis. However, a positive return is not guaranteed and a capital loss may occur.
4S ource: Newton, 30 September 2016; inception was 1 April 2004. Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise
and investors may not get back the original amount invested. Please see important information at the end of this document.
5
SPOTLIGHT
At a glance
Newton Global Dynamic Bond
strategy
Newton Real Return
strategy
Aim
Aim
One-month sterling LIBOR +2% per
annum over five years before fees,
with a positive return on a rolling
three-year basis.*
Performance
Annualised gross return of +7.0%
since inception.
One-month sterling LIBOR +4% per
annum over five-year periods,
with a positive return on a rolling
three-year basis.*
Performance
A gross positive return in every year
since inception, and an annualised
gross return of +8.8% since
inception.
Strategy size
Strategy size
Key characteristics
Key characteristics
£2.0 billion (as at 30 Sep 2016)
Unconstrained, dynamic and actively
managed; uses a mixture of returnseeking and hedging techniques;
global, thematic approach; focus on
traditional fixed-income assets.
Julian Lyne
Julian is responsible for
all aspects of Newton’s
global distribution and
marketing efforts.
He joined Newton in
2014 to lead the global
consultant relations and
UK institutional business
development team.
Prior to joining Newton, Julian was
Head of Institutional Business at F&C.
Throughout his career he has held various
roles covering client and consultant
relations across both DC and DB
arrangements.
£10.0 billion (as at 30 Sep 2016)
Emphasis on traditional asset classes;
a return-seeking core with
particular security characteristics;
risk-offsetting positions aiming to
dampen volatility and preserve
capital; portfolio combines the
characteristics of securities and
asset classes.
Further information
Please contact our consultant relations
and business development team:
*A positive return is not guaranteed
and a capital loss may occur.
*A positive return is not guaranteed
and a capital loss may occur.
Your capital may be at risk. The value of investments and the income from them can fall as well
arise and investors may not get back the original amount invested.
Telephone: 020 7163 3984
Email: [email protected]
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Important information
This is a financial promotion. This document is for professional investors only. Past performance is not a guide to future performance. Your
capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original
amount invested. You should read the Prospectus and the Key Investor Information Document (KIID) for each fund in which you want
to invest. The Prospectus and KIID can be found at www.bnymellonim.com. Portfolio holdings are subject to change at any time without
notice and should not be construed as investment recommendations. Compared to more established economies, the value of investments
in emerging markets may be subject to greater volatility due to differences in generally accepted accounting principles or from economic,
political instability or less developed market practices. The opinions expressed in this document are those of Newton and should not be
construed as investment advice or any other advice and are subject to change. This document is for information purposes only. Any reference
to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those countries or sectors.
Please note that portfolio holdings and positioning are subject to change without notice. The value of overseas securities will be influenced
by fluctuations in exchange rates. Where the portfolio is invested in sub-investment-grade bonds, which typically have a low credit rating and
carry a high degree of default risk, please be aware that this may affect the capital value of your investment.
In the UK, this document is issued by:
Newton Investment Management Limited
The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA
Tel: 020 7163 9000
Registered in England No. 01371973 Registered office: As above.
Newton Investment Management is authorised and regulated by the Financial Conduct Authority.
BNY Mellon Asset Management is one of the world’s leading asset management organisations, encompassing BNY Mellon’s affiliated investment
management firms and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation.
newton.co.uk
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