Liability-driven investing (LDI) seeks to align risk exposures between investments and liabilities. Many pension plans that have adopted an LDI framework make use of interest rate derivatives to close any gaps in interest rate exposures between an asset portfolio lacking sufficient capital to hedge and the plan’s liabilities. There’s scarce difference, however, between a portfolio that extends its duration via derivatives and holds physical equities and one that holds long-duration physical bonds and achieves equity exposure via derivatives. In this paper we provide some insight as to why this is and how sponsors who internalize this logic can potentially gain advantages in their LDI endeavors.
- Two common LDI portfolio approaches—pairing cash with equity derivatives and pairing cash with bond derivatives—produce nearly identical results.
- When paired with a commensurate amount of cash, returns from the cash position may partially or wholly offset the cost of a fairly priced derivative, whether it’s equity or fixed income.
- Because both approaches get investors to the same end point, having the flexibility to transition between the two allows the investor to take full advantage of market dynamics.
- Choosing the best approach to gaining asset class exposure depends on context: There’s never one correct answer, and the answer may change though time.