In 2007 BNP Paribas Investment Partners began a partnership with the EDHEC Risk Institute, the “Asset and Liability Management and Institutional Investment Management” research chair. Five academic research papers have been produced during these years highlighting the importance of dynamic asset allocation strategies designed to control short-term risks while taking into account liabilities. The quality of this research was recognized by the Institute for Quantitative Investment Research Europe (Inquire) which awarded its first prize for the best research paper in 2009/2010 to the work produced in relation to the research chair.
This research, the state-of-the-art in academic terms, is nevertheless written in technical language aiming at specialists. For that reason, BNPP IP prepared a brochure highlighting the key messages for investment practitioners, which we summarise below:
1. The pension fund investment portfolio must be split into two: i) the Liability Hedging Portfolio (LHP) to hedge liabilities and ii) the Performance Seeking Portfolio (PSP) seeking upside potential.
a. The LHP should be highly correlated with the changes in the value of the liabilities of the pension fund.
b. The PSP should seek the highest possible Sharpe ratio and must be regularly adjusted to keep it in line with changing market environments.
2. Should short-term constraints be imposed on the funding ratio, an additional dynamic strategy to protect the floor of the funding ratio adds value to the investment strategy.
3. If the risk premium captured by the assets in the PSP mean reverts then the dynamic allocation between PSP and LHP is driven by two competing forces and their net impact depends which of them dominates at a particular moment:
a. A pro-cyclical force: when the value of the PSP falls, rising risk will push down the allocation to the PSP requiring the sale of part of the PSP, and conversely when the value of the PSP rises.
b. A counter-cyclical force: when the value of the PSP falls, its mean reverting expected return will rise triggering an increase in the PSP allocation requiring an additional investment in the PSP, and conversely when the value of the PSP rises.
4. Dynamic strategies play an important role on mitigating conflicts of interests between the pension funds different stakeholders: the beneficiaries (active and retired worker), the shareholders and bondholders of the sponsor company.
5. The latest research from the EDHEC was dedicated to a survey where 104 investors – the large majority being European pension funds – were asked about their investment strategies. The bottom line of this extensive survey is that too many pension funds remain asset-only rather than asset- and-liabilities driven and do not yet take sufficient account of the impact of their liabilities in their asset allocation policy or risk management.
The brochure also shows how our Multi Asset Solutions (MAS) team translates all these research findings into customized implementable investment strategies which the team is managing for pension fund clients.
Although the EDHEC research focused on issues which typically concern pension funds, the MAS team is also applying the key ideas behind this research to the development of customized solutions to other institutional clients such as insurers for which the landscape is undergoing huge changes as a consequence to new regulations (Solvency II).