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Library of Congress Cataloging-in-Publication Data
Names: Tammas-Hastings, Daniel, author.
Title: Liability-driven investment : from analogue to digital, pensions to robo-advice / Daniel Tammas-Hastings.
Description: Hoboken, New Jersey : Wiley, [2021] | Series: Wiley finance | Includes index. | Summary: “The project aims to outline the usefulness and explain the growing popularity of Liability-Driven Investing (LDI). The ultimate aim of Liability Driven Investing is to ensure that investors have sufficient funds to pay liabilities.
This is a targeted approach that moves beyond the simple asset value maximization framework which is prevalent in the academic literature.”—Provided by publisher.
Identifiers: LCCN 2020055881 (print) | LCCN 2020055882 (ebook) | ISBN 9781119441953 (cloth) | ISBN 9781119441984 (adobe pdf) | ISBN 9781119441960 (epub) | ISBN 9781119441977 (obook)
Subjects: LCSH: Investments. | Liabilities (Accounting)
Classification: LCC HG4521 .T295 2021 (print) | LCC HG4521 (ebook) | DDC 332.6—dc23
LC record available at https://lccn.loc.gov/2020055881
LC ebook record available at https://lccn.loc.gov/2020055882
Cover Design: Wiley
Cover Image: © Tetra Images/Getty Images
Dedicated to my wife Dominica for her support throughout this process and to Angela Tammas for forty years of support and education.
Preface
Welcome to the first edition of ‘Liability Driven Investment’. This is my first experience of writing a book, and I'm grateful to John Wiley and the team for the commission. Plus of course the support and expertise received from the editors there; thank you Purvi for input, advice and changes. All mistakes are of course my own.
This book is an introduction to creating investment portfolios using a broad range of asset classes and shows how finance professionals increasingly use Liability Driven Investment frameworks to do this. Liability Driven investment for convenience is commonly known as LDI. LDI is sometimes also described as Asset-Liability Management (ALM) or in the States Dedicated Portfolios. We live in a world where the bulk of our pension money, in the UK at least, is invested with an LDI strategy at its core. In the rest of the developed world the techniques and frameworks are gaining increasing acceptance and market share. It is likely that this trend will continue. However despite its importance the strategy is unknown to even most financial professionals. With most of the advanced portfolio management textbooks focusing on the peculiarities of Fixed Income Wiley felt a broader guide was overdue. To describe how LDI works we look at the major asset classes, the basics of fund selection and management, and how to use these building blocks to create a diversified portfolio. We also look at the regulatory and ethical issues involved in creating multi-asset class portfolios and how these will impact the industry in the future.
The book can be used as a guide for pension fund trustees as they negotiate an increasingly complex regulatory landscape, but the text is very much aimed at the lay person with the aim of building up an investment strategy from first principles. It is first and foremost a book about investment theory, addressing the risk management frameworks currently used in capital markets across the globe to create modern investment portfolios. Later, we move on from purely investment matters to explain the some of regulatory systems in which financial professionals work in, and the regulatory obligations that are placed on professionals and amateurs alike when advising on investments. We also go on to look at the impact technology has had on how and when we invest, and how technology is likely to create further changes in the near future.
I will attempt to explain the numerous theories that underpin modern finance: in particular, Modern Portfolio Theory and the theoretical work of Harry Markowitz that underpins how the bulk of our pensions are invested. We then expand from MPT to look at risk frameworks that take into account both sides of an investor's balance sheet. Incredibly elegant and taught on every undergraduate finance course, MPT is the most influential financial theory in use today, and it will remain so tomorrow. It starts with the assumption that risk-averse investors will construct portfolios to maximise expected returns based on a certain level of market risk. However, Modern Portfolio Theory stems from original work in 1952 and some of the assumptions are not ideal for the needs of a pensioner in the twenty-first century. By neglecting one side of an individual or pension plan's balance sheet, MPT could be said to be looking at half the problem. (Although this is perhaps mean, as the assumptions are clearly laid out and there are frameworks explicitly developed from MPT that do include Liabilities.)
The field of Liability Driven Investment is particularly relevant to anyone with a pension, which in the UK at least is effectively all of us. We have seen talk in the press of ‘Peak LDI’ in the last few years as more and more pension schemes utilise cash flow driven frameworks. But growth has continued, indeed at the time of writing hedging of institutional portfolios against changes in UK interest rates and against inflation has increased to another record high. Growth will also continue in markets with limited take up, it is also likely that Digital or FinTech solutions will create a trickle down affect to the High Street.
The core idea behind LDI frameworks is that rational investors would not look to maximise real assets, subject to risk constraints as in traditional frameworks – usually defined as volatility with total portfolio value. Rather an investor would seek to maximise the profit – subject to constraints on the variability of the surplus, and subject to meeting cashflows that are defined as needs rather than wants. This approach can make a huge difference to portfolio construction and user outcomes. It also shifts the focus of investors from equity prices to long-term treasury or government yields because the volatility of the present value of the liabilities is related to the volatility of the funding status.
Across the world falling bond yields have created pension fund deficits since the global financial crisis. This is despite rising stock prices and limited portfolio impact from credit loss. Rising asset prices have not been enough to counteract the increase in liabilities for a large number of pension schemes, as funding deficits