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Overcoming Challenges in Liability-Driven Investing (LDI)
By Matthew Streeter CFA | January 24, 2017
Overcoming Challenges in Liability-Driven Investing (LDI)

LDI managers face a challenging market environment with low-returns and increased regulatory oversight. These factors make it difficult to generate solid returns and properly manage liability risk. 

FINCAD recently hosted a webinar around this topic, “Proven Tips for Maximizing Success with an LDI Strategy,” presented by Erik Vynckier, Board Member of Foresters Friendly Society and FINCAD Advisor, and Per Eriksson, Senior Account Executive at FINCAD.

LDI is an investment strategy that has been used by insurance and pension funds since the late 1990s. Its aim is to effectively manage assets with projected liabilities in mind.

In terms of regulation, many LDI managers face obligations to meet capital adequacy and solvency requirements imposed by MiFID II and Solvency II. Meeting the onerous demands of such regulations remains a significant challenge for firms throughout Europe.

From a technology standpoint, there is a good deal of complexity and specialization when it comes to the systems organizations use for LDI management. These range from home-grown, ad-hoc solutions to multiple disparate systems requiring significant integration and configuration. The problem is that asset managers typically have bespoke needs and it can be very difficult to adapt their technology and systems to fit these requirements.

To overcome the challenges of LDI today, many firms are turning to next generation valuation and risk analytics solutions that can help them generate improved investment returns, mitigate risk and better meet regulatory demands. Such systems can help LDI managers put multi-asset strategies into play that are yield-generating and utilize derivatives investments or hedging tools.

I know at FINCAD, our F3 solution has helped many LDI managers become more competitive with flexible curve building, accurate valuation, real-time risk, as well as useful scenario and pre-trade analysis.

In the webinar, presenter Per provided an overview of a typical insurance portfolio of assets and liabilities. The assets were in multiple currencies and distributed across multiple asset classes. In this example, the main risks consisted of inflation, interest rate risk and FX risk.

Starting with the base asset portfolio, Per constructed the discount curves in the different currencies. In the base portfolio he reviewed curve building. For this example, pre-built curves and regulatory curves were incorporated. F3 is helpful in this respect, as it allows for the creation and calibration of curves based on market data, while also providing utmost flexibility in curve construction.

In the second half of the case study, we saw an overview of how the insurance portfolio would be impacted under different market scenarios, at both an aggregate and a granular level. For this example, Per showed the hedging of trades through a combination of different swaps. He also explored how to capture different portfolio exposures at different tenors, showing how these exposures changed after incorporating hedging trades that capture interest rate, inflation and cross-currency risk. The outcome of the case study was that cross-currency swaps can be used to effectively reduce FX and inflation risk.

In summary, the right technology is critical to the efficacy of a given LDI strategy. For LDI managers to be successful in the current environment, they need a powerful valuation and risk solution offering:

  • precision and flexibility for constructing curves
  • automation for reducing operational risk
  • a flexible technology set-up
  • a robust view of aggregated analytics for fueling pre-trade analysis and understanding aggregated portfolio risk
  • the ability to define custom scenarios

It is possible to deliver an effective LDI strategy involving derivatives and fixed income instruments that allows you to optimally hedge risk and improve returns. Check out our case study on Ashburton Investments to learn how one firm used F3 to optimize LDI. Also, be sure to watch the LDI webinar in its entirety for more detail on the case studies touched on above.