Using Hedge Funds to Improve LDI Strategy

Typically, plan sponsors want to address growth of the plan, reach a point where the plan is fully funded and minimize the downside of volatility, according to Kish, managing director of TeamCo and co-author of a white paper. In “Buckle Up, for (Your DB Plan) Safety—the Risk Paradox of Unrestrained Equity Volatility in Liability-Driven Investing Vehicles,” Kish makes a number of observations about LDI strategy and how to meet goals using hedge funds.

A plan sponsor’s mind is usually set on controlling volatility, Kish tells PLANSPONSOR, both volatility of contributions and volatility of the funded status. Most DB plans—about one-fifth of companies offer one, according to PLANSPONSOR’s 2014 Plan Benchmarking Report— turn to equities for growth, and they continue to do so. But there may be other ways to meet their goals.

“We challenge them to reconsider how they think about this and to think about using alternatives, like select hedge funds, to help them achieve their goals,” Kish says. Over a market cycle, a diversified portfolio of select hedge funds can offer returns similar to equities, he contends, but with a reduced amount of the downside deviation his firm thinks is more important.

“We’re talking about better risk-adjusted returns,” he says. “That’s what plan sponsors should be after. If you think about it, over longer-term time frames, we expect select hedge funds to provide returns that are very akin to equities, but with a third to half the risk.”

The decision to include hedge funds in the growth portfolio could depend on the investment committee. Kish says fees and transparency are among common concerns. “We make the case that with the proper amount of education, most investment committees can understand their use."

But more and more plans are using hedge funds, he says. Allocations might start small, perhaps 2% or 5%, which Kish calls a typically human response: “You start small, and move more in as your conviction grows."

Plan sponsors can find a myriad of resources to learn more about the investing impact of hedge funds in a portfolio, Kish suggests. He recommends asking consultants and investment managers to help model different scenarios. The point is to look at the portfolio with fresh eyes.

Other points the report makes include:

• LDI aims to stabilize a plan’s assets and reduce risk by utilizing a symbiotic combination of a growth portfolio (which grows assets) and a hedging portfolio (which hedges liability risk);
• Instead of relegating risk solely to the hedging portfolio, returns and risk should be considered in both the growth and hedging portfolios in order to help optimize the LDI framework;
• A growth portfolio typically largely comprises public equities, which typically have significant downside volatility and can therefore have an adverse effect on the plan’s assets, particularly in a down market environment; and
• Given hedge funds’ historically lower volatility and their outperformance of a blended equity index, TeamCo believes LDI growth portfolios should include diversified exposure to select hedge funds to help reduce long-term portfolio risk without foregoing return objectives.

“While there remain compelling reasons to include some equities in the growth portfolio, we believe it is essential that plan sponsors ‘buckle their seat belts’ and replace a portion of their equity investments with select hedge funds in order to reduce long-term portfolio risk,” Kish says.

Plan sponsors should think about their goals, and ask themselves what they want to accomplish. Once a plan sponsor outlines an LDI strategy that lowers volatility but continues to have returns, the next question to ask is what solutions the marketplace has to address these goals. “Look at it with fresh eyes,” he advises. The standard 60/40 mix of equities and fixed income may not be the only approach to consider.  

“We would challenge plan sponsors to ask themselves what the best strategy would be for their plan,” Kish says. They will find that coupling long-duration fixed income with a portfolio of select hedge funds should significantly increase their risk-adjusted returns over those from a portfolio of fixed income and equities, he contends.

TeamCo Advisers LLC, in San Francisco, is a privately owned investment advisory firm that manages portfolios of select hedge funds and other opportunistic alternative assets.

The white paper was co-authored by Kish and Savannah A. Thompson, director of TeamCo, and is available on TeamCo’s website.