Six reasons why Fiduciary Management is much more than “LDI+DGF” – part 6 of 6

December 16, 2013 Categories: Investment Strategy
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Yesterday, in the fifth instalment of Six reasons why Fiduciary Management is much more than “LDI+DGF”  we discussed the relationship between interest rates, inflation and currency risk. In this final instalment we discuss how the changing correlation between interest rates and equity can affect DGF (“Diversified Growth Funds”) and pension schemes investors in very different ways:

6. Impact of interest rates versus equity correlation

In a previous blog (“Changing correlation – changing strategy?”) We commented on the impact that changing correlations between interest rate and inflation risk and growth assets can have on pension scheme investment strategy. To dig a little deeper into this idea lets imagine two investors, one a total return DGF investor and another, a pension scheme Asset and Liability investor. Both investors are targeting a volatility objective, for the DGF investor it is the volatility of the total return, for the pension scheme investor it is the volatility of the funding ratio.

Imagine that the only thing that changes in the markets is the correlation between interest rates and equity returns. The correlation between the level of interest rates and equity returns shifts from being positive to negative. When the correlation was positive strong equity returns were accompanied, on average, by rising interest rates, falling bond prices and falling values on unhedged liabilities. So for the DGF investor equity and interest rate risk off-set each other, whereas for the pension scheme investor the risks add together.

So if the correlation shifts from positive to negative the volatility of the DGF strategy increases and the volatility of the funding ratio for the pension scheme investor decreases.  This means that in order to maintain a volatility target the DGF investor moves to a more conservative strategy (for example, decreasing equity exposure), while the pension scheme investor is able to move to a more aggressive strategy (increasing equity exposure).

So the same change in market behaviour results in a DGF investor and a pension scheme investor taking exactly the opposite actions in their portfolios

For those looking for a broader discussion of investment strategy for pension schemes, click here

 

Gwion Moore – Director, Client Strategy & Research, EMEA
 

 

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