leadership series
JANUARY 2016
The case for diversifying
LDI managers
François Pellerin, CFA, FSA, EA, CERA l LDI Strategist
Dan Tremblay, CFA l Director of Institutional Fixed Income Solutions & LDI Strategist
KEY TAKEAWAYS
• Diversification of fixed-income managers
may be an easy first step for plan sponsors
seeking to mitigate risk.
• By diversifying, plan sponsors also gain
greater flexibility, as well as access to the
investment perspectives of a wider set
of managers.
• For a plan sponsor implementing or
expanding an LDI strategy, diversification
may hold additional benefits without adding
much complexity or cost.
In Canada, many defined benefit (DB) plan sponsors
have been actively de-risking their pension plans, either
generally, by increasing exposure to long-duration bonds,
or more specifically, by implementing a formal liability‑driven
investment (LDI) strategy. However, diversification of
fixed‑income managers is one simple element of de-risking
that often gets insufficient attention – even from plan
sponsors with a well-diversified roster of equity managers.
For Institutional Use Only
For the smallest range of plans (under $200 million in
assets) or for plans with very small bond allocations, it may
be effective to have just one or two fixed-income managers
in place. However, as a plan grows larger or increases
the proportion of its assets in bonds, diversification of
managers becomes a more compelling option. Although
there are no established best practices for the industry, our
global experience allows us to recommend general levels
of manager diversification for risk-conscious plan sponsors
to consider (Exhibit 1).
This paper discusses some of the important advantages of
manager diversification. For many plans, these advantages
may greatly outweigh any potential challenges.
The benefits of diversification
As a general practice of prudent asset management,
diversification is at the top of the list. Because they hold
fiduciary responsibility for obligations to plan participants,
DB plan sponsors with a substantial assets invested in fixed
income should strongly consider diversifying managers,
if only to mitigate the uncompensated “idiosyncratic risk”
of a negative event occurring for one particular manager.
This risk can be reduced by spreading assets among multiple
managers. For example, diversification may help to reduce
losses in the event of substantial portfolio underperformance
for a single manager, or from manager operational problems.
In this way, diversification functions like a form of insurance.
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Even if nothing major goes wrong, having a diversified roster
of managers could help facilitate a change of strategy. Simply
put: it is easier for a plan sponsor to reduce the allocation to
a manager when other managers are already in place, should
performance, reputational or other reasons arise. Although
the plan sponsor will need to perform a formal review of each
additional manager, due diligence as part of an intentional
program of diversification can be pursued more deliberately
than when it must be completed quickly to respond to a crisis.
Investing with a diversified set of managers may hold other
advantages as well. By diversifying, a plan sponsor gains
deeper access to the research, resources and overall market
perspectives of additional managers. This broader input may
help the plan sponsor and plan investment committee in
considering future strategic and tactical actions. Considering
a wider range of informed insights is an advantage in most
cases, but for DB plan sponsors this may be especially true,
given that many Canadian asset managers have developed
expertise in managing long bonds and have built experienced
teams of LDI strategists who are focused on de-risking.
Diversification in an LDI context
Some plan sponsors may be concerned by the potential for
added complexity in monitoring new managers. However,
many plan sponsors might be surprised to learn that adding
Exhibit 1 Based on Fidelity’s global experience working
with DB plan sponsors, we suggest a range of manager
diversification targets in proportion to the overall size of
the portfolio, depending on the size of the fixed-income
allocation and other plan specific factors.
Overall plan assets
Potential number of fixed‑income
managers in late LDI stage
< $250 million
1 to 2
$250 million to $1 billion
2 to 5
> $1 billion
3+
Note: A $1 billion plan near its LDI end-state could be almost entirely
invested in long-duration fixed income, such that using five different
managers would result in having almost 20% of total plan assets with
each manager. For illustrative purposes only. Source: Fidelity.
2 | For Institutional Use Only
fixed‑income managers, particularly for LDI strategies,
tends to add only a small amount of complexity. For example,
plan sponsors who are newly beginning or enlarging an
LDI implementation may find it an ideal time to add new
fixed‑income managers, because the efforts that will be
invested in crafting a tailored LDI strategy can also be used
to investigate how to best integrate diversified managers.
Plan sponsors that are in the process of reallocating assets
from an equity portfolio to a fixed-income or LDI portfolio
(as part of following their ongoing strategy) can use this
opportunity to introduce a new manager without reducing
the assets held by an existing manager.
For plan sponsors closer to their end-game – the point at
which an enhanced match between hedging assets and
liabilities is warranted – lower risk via manager diversification
can also be achieved without much complexity. For example,
at the later stages of their de-risking journey, many sponsors
adopt a “completion management” strategy. With this
approach, one completion manager is tasked with analyzing
the portfolio of one or more other managers investing
against traditional indexes, and then invests to “complete”
the residual gaps between assets and liabilities. Adding
a completion manager can convert an existing roster of one
or more managers with traditional index mandates into a more
customized liability-matching strategy. Once this strategy
is in place, adding additional managers may be even simpler,
requiring only the addition of a new mandate managed against
a traditional index, and routine coordination with the existing
completion manager.
What’s the catch?
Even with all of these potential advantages, a frequent concern
for plan sponsors is a possible reduction of economies of scale,
leading to higher fees. If diversifying means allocating fewer
assets to several managers, breakpoints to achieve lower‑tier
fees may not be met, and overall management fees may
increase as a result. In those circumstances, concern may
be justified.
At the most basic level, any additional cost should be thought
of as similar to an insurance premium. Diversification may cost
a little bit more, but the risk mitigation it bestows, particularly
in protecting against low-probability but high‑impact
events, may be well worth the cost. One might argue that
THE CASE FOR DIVERSIF YING LDI MANAGERS
a cost‑motivated undiversified roster of managers fits the
metaphor of “picking up pennies in front of a steamroller.”
In an LDI context, however, the cost-benefit considerations
may be even more in favour of diversification. LDI strategies
are inherently an actively managed approach to balancing
risk and return, because they require managing assets against
a plan’s specific liability. Accordingly, most LDI managers
have the capacity to pursue alpha, in order to reduce future
contributions. Diversifying managers may help diversify
potential sources of excess returns, because different
managers may have different areas of expertise, which can
translate into different alpha levers (such as security selection,
sector rotation, yield curve and duration positioning, currency
exposures, etc.).
Why would this be an advantage? In the early stages of an
LDI implementation, when the fit of the assets to the liability
is looser, different managers may look to different sectors
to help augment returns while managing risk. One manager
may favour global bonds, while another may favour the
high-yield sector as an overweight. Diversification may
therefore help mitigate the overall impact of individual
sector underperformance, since those sectors are not
perfectly correlated.
In the later stages of LDI, when a tighter fit to the liability
is desired, allocating among different managers may help
to mitigate idiosyncratic security risk, increasing the variety
of long-duration securities held. For example, there are only
approximately 100 corporate long bond issuers in the index
most often used in connection with managing a pension
plan liability (the FTSE TMX Canada Long Term Bond Index).
Each fixed-income manager will typically be constrained as
to a certain percentage of out-of-index securities that can
be held, which in practice limits the number of different
out-of‑index issuers that will be in the plan’s portfolio. By
diversifying managers, a plan sponsor effectively diversifies
these out‑of‑index holdings, which may serve to mitigate
credit risk in particular holdings while widening the universe
of potential alpha-generating investments.
incrementally higher management fees due to meeting lower
breakpoints. In our experience, plans as small as $100 to
$200 million in total assets have generally reached the point
where economies of scale and the additional alpha potential
from diversification can overmatch potential additional costs.
But in all scenarios, as previously mentioned, manager
diversification functions as insurance that may well be worth
a small additional cost.
Implications for plan sponsors
Many plan sponsors take the need to diversify equity
managers as a given, yet stop short when it comes to fully
diversifying bond managers. Diversification of fixed-income
managers carries the same set of benefits as it does for equity
managers, including the potential mitigation of idiosyncratic
(manager-related) risk, access to wider resources and
approaches, and the potential to tap different sources of alpha.
In a de-risking and LDI context, manager diversification makes
even more sense, because it allows for greater diversification
of asset-matched liabilities without requiring a corresponding
increase in complexity from the plan sponsor’s perspective.
With all of the advantages of diversification (and the potential
hazards of remaining too concentrated), plan sponsors who are
concerned with mitigating risk may find that diversifying their
fixed-income managers may be the most effective next step
they can take.
In most LDI scenarios where the hedging assets are actively
managed, a plan sponsor can specify (and the manager can
achieve) an alpha target that compensates the portfolio for
For Institutional Use Only | 3
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AUTHORS
François Pellerin, CFA, FSA, EA, CERA l LDI Strategist
François Pellerin is an LDI strategist in the Fixed Income division at Fidelity Investments. As a member of the Liability-Driven Investing (LDI)
Solutions team, he is responsible for developing and implementing pension risk-management solutions. He is a CFA charterholder, a Fellow
of the Society of Actuaries, an Enrolled Actuary, and a Chartered Enterprise Risk Analyst. François joined Fidelity in 2012.
Dan Tremblay, CFA l Director of Institutional Fixed Income Solutions & LDI Strategist
Daniel Tremblay is Senior Vice-President, Director of Institutional Fixed Income Solutions, in the Fixed Income division at Fidelity Investments.
In his current role, Dan oversees the Liability Driven Investment (LDI) Solutions team and is responsible for developing custom hedging strategies
for LDI clients, providing perspectives on de-risking solutions, and representing the investment process in the marketplace. He is a CFA
charterholder. Dan joined Fidelity in 1994.
Fidelity Thought Leadership Vice President Vic Tulli, CFA, provided editorial direction for this article.
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