The Hindu Business Line : Transporting LDI to private wealth management

Liability-driven investment (LDI) is now the norm in the pension-fund industry. This refers to matching the risk and horizon of the investment portfolio with that of the liabilities. LDI is commonly followed by defined-benefit plans. This concept can be transported to private wealth management.

Individual investors usually face two kinds of risks in wealth management- change in expected return after initiating the portfolio and price risk at the horizon.

However, it is possible to suggest a strategy that can meet the investment objectives even if the expected return changes during the investment period.

Horizon-matching portfolios

Suppose an investor proposes to buy a house for Rs 1 crore five years hence. The investor faces two kinds of risk. The liability risk is the risk that the house will cost more than Rs 1 crore at the time of purchase (the horizon). The price risk is the risk that his investment will not generate sufficient return to fund the purchase of the house at the horizon.

The investor can structure her portfolio in two ways to meet her objective. She can either invest a single lump-sum amount or initially invest some lump-sum amount and thereafter contribute capital periodically to the portfolio.

Assuming the investor prefers to take exposure in bonds. The optimal investment to match horizons will be a five-year zero-coupon bond.

This bond does not suffer from reinvestment risk (the risk that the interest re-invested will not deliver equivalent returns), as does a coupon-bond. Suffice it know here that reinvestment risk is the largest risk in the horizon-matching process. A zero-coupon bond, if available, mitigates this problem.

Enhancing returns

Suppose the investor takes exposure only in bonds. The initial portfolio size would have to be very large to meet the investment objective of Rs 1 crore, as bonds generate low returns. An investor facing capital constraints will be, hence, forced to take equity exposure to generate higher returns. This exposes the portfolio to price risk at the horizon. After all, stocks do not have fixed maturity.

Suppose the investor decides to allocate Rs 25 lakh in equity and Rs 30 lakh in bonds for a total investment of Rs 55 lakh.

Further suppose the bond portfolio generates 8 per cent return so that the investment expands to Rs 44 lakh in five years. This means that the equity portfolio has to generate 17 per cent per annum to achieve the investment objective of Rs 1 crore.

What if the equity portfolio suffers huge losses at the time of liquidation at horizon? The investment will simply not generate cash flows required to meet the proposed liability at the horizon.

Liability-driven investment

It is in context that LDI matches the assets with the liability structure so that liability risk and price risk is lowered. The institution adopting LDI will benchmark the portfolio to the liability structure.

Suppose a pension fund has a liability structure that translates into a required return of 8 per cent in the first year and 10 per cent in the second year. The pension fund will structure its portfolio such that the assets have similar risk profile as the liability structure and generate the required return or more in those years.

The LDI concept can be gainfully employed in private wealth management. In the above example, suppose real estate prices move up so that the house costs Rs 1.5 crore at the horizon. A normal investment portfolio that generates the required return set on initiation will still not meet the investment objective. The LDI process, however, offers a reasonable alternative by creating a natural hedge.

LDI and wealth management

An investor proposing to buy a house should have exposure to an asset that moves up with the real estate market. REIT is one such asset. These are funds that invest in residential and commercial properties. A portfolio with REITs, stocks and bonds will offer a better hedge against the liability risk.

Similarly, an investor wanting to meet her medical expenses post-retirement should have exposure to health-care sector. The rationale is that if health-care costs go up, profits of the health-care sector would also increase. And that would be reflected in the higher asset prices of health-care firms, after adjusting for asset mis-pricing. The idea is to take exposure in assets that move in line with the liability structure, thus, providing for a natural hedge.

The portfolio will be still exposed to price risk at the horizon because of the equity exposure. Hedging this risk requires complex structures such as total return swaps or OTC options. The hedging costs could be high. Exchange-traded puts can be used as a portfolio insurance strategy, though long-dated options are yet to be traded actively.

Individual investors should nevertheless adopt the LDI process so that their investment objectives can be met with reduced risk.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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