Practical analysis for investment professionals
21 November 2017

Beyond Modern Portfolio Theory: Liability-Driven Investment Strategies

The portfolio construction techniques popularized by modern portfolio theory (MPT) are not always practical. This is especially true for investors who are more concerned about unavoidable costs than asset optimization — in other words, a majority of the world’s savers.

First proposed in 1952 by Harry Markowitz, MPT reflected a different world, one in which retirement and long-term health-care costs were much lower than they are now. Today, a 65-year-old UK citizen today can expect to live a decade longer than one who retired 60 years ago, according to the UK Office of National Statistics.

Indeed, similar demographic trends are prevalent in almost all other developed economies as increasing wealth and advances in medical technology have lengthened life expectancy.

Incredibly elegant and beloved by finance academics, MPT is probably the most influential financial theory in use today. It rests on the foundation that risk-averse investors can construct portfolios to maximize expected returns based on a certain level of market risk. But elegant solutions aren’t always ideal, and by neglecting one side of an individual or pension plan’s balance sheet, MPT is only looking at half the problem.

Hence the recent focus on liability-driven investment (LDI) strategies, otherwise known as asset-liability management (ALM). More complete and holistic than MPT, LDI explicitly includes an investor’s current and future liabilities.

LDI requires more expertise in fixed income than the traditional approach, as the liabilities could be considered fixed-income instruments. This may be intimidating for pension fund trustees and advisers. After all, fixed-income investment and analysis can often seem counterintuitive: Many government securities yield negative returns, and most investment-grade bonds are expected to lag inflation, implying an expected loss of value. The need for rising equity markets is far easier to understand than fluctuating bond yields.

Nevertheless, there is a growing consensus in the wholesale capital markets that LDI creates better portfolios, particularly when it comes to retirement needs. I believe LDI should filter down to the retail market, both through LDI-style passive investing and active multi-asset class funds and through adviser and user education.

LDI requires accurate cash flows. A defined-benefit (DB) pension scheme is the classic example. But similar LDI frameworks are also being used for defined-contribution (DC) plans, where cash-flow needs are implicit rather than explicit.

The idea is that rational investors would not look to maximize real assets, subject to risk constraints — usually defined as volatility with total portfolio value. Rather they’d seek to maximize the economic surplus — subject to constraints on the variability of the surplus. This makes a difference because the volatility of the present value of the liabilities is related to the volatility of the funding status. It also shifts the focus of investors from equity prices to long-term treasury or government yields.

For example, falling bond yields have created pension fund deficits in the last five years despite benign market conditions with rising stock prices and limited portfolio impact from credit loss. Rising asset prices have not been enough to counteract the increase in liabilities for the UK Pension Protection Fund, as funding deficits have increased despite an equity bull market. This is due to under-hedging of the liabilities. The implication is that a focus on asset-price optimization may not be enough in a world of long-dated liabilities.


UK Pension Protection Fund Assets and Liabilities
Hastings_Graph


For investors with similar objectives, an LDI framework is a useful risk management tool. A better understanding of ALM will lead to enhanced risk-adjusted outcomes for more investors.

The popular MPT framework of expected value optimization given a risk constraint is ripe for disruption. Digital asset management or robo-advice can help distribute LDI technology to the mass market, and we can expect the industry to move in this direction.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ fandijki

About the Author(s)
Dan Tammas-Hastings, CFA

Dan Tammas-Hastings, CFA, is managing director and founder of RiskSave, a digital asset management firm. Previously, he was a fixed income trader specializing in GBP derivatives at Merrill Lynch, and a hedge fund manager managing multi-billion £ portfolios across credit and rates. Tammas-Hastings is currently a thought-leader in risk management and is in charge of strategy and investment at RiskSave. He is a graduate of the London School of Economics and the University of Cambridge.

3 thoughts on “Beyond Modern Portfolio Theory: Liability-Driven Investment Strategies”

  1. Christina Wang says:

    From a portfolio manager’s perspective, a liability-driven investment is more like ALM. However, given the traditional ALM world is predominantly used for treasury liquidity and market risk hedging, i.e. portfolio return has never been the primary goal, the linkage of Asset-driven and liability-driven investment need some creative mind to reconcile the two approaches. As you rightfully pointed out, equity portfolio managers are shy of fixed income instruments, the reverse is probably true.

  2. james rich says:

    I certainly agree with the premise that we need to refocus individual retirees’ portfolio towards more of an LDI focus. That said, I think it also important to address the role of tradition and inflation-linked annuities in an optimal portfolio. In addition, the role of longevity annuities also needs to be considered.

    It may also be useful to consider the pros and cons of averaging into such annuities given today’s low real interest rates.

  3. In the U.S., LDI would fall under the domain of dedicated portfolio theory, and its use for individual investors is described in Wikipedia (https://en.wikipedia.org/wiki/Dedicated_portfolio_theory) and elsewhere. Simply do a Google search for “dedicated portfolio theory” and about 1.8 million hits pop up.

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