As plan sponsors gain experience with liability driven investing and approach a higher funded status, many are focused on designing and implementing LDI mandates with greater risk control. The imposition of tracking error targets on these strategies has been an important step in this direction. Tracking error constraints allow plan sponsors to gain visibility and better control over the discrete sources of risk and excess return in actively-managed LDI mandates.
At Capital Group, our experience of more than a decade tells us that active managers can indeed add value in LDI mandates while respecting explicit tracking error targets. Deep credit research is an important component of added value in these mandates; close attention to transaction costs is another. Most importantly, managers must embed a level of risk management and investment discipline at each step of the process. These mandates require an approach that is more nuanced than bolting a layer of risk management to an existing investment process. In this paper, we also describe some of the ways in which active managers can add value in tracking error constrained LDI mandates.
Tracking error constrained mandates have only recently become popular in liability-driven investing. It is tempting for investment managers to believe that they can be implemented simply by taking an existing strategy and layering risk control on top of it to dial it back. This approach can be both risky and sub-optimal. A more effective approach involves weaving risk awareness into the investment process itself at every stage:
- Determining how to assign weights to different active strategies within the portfolio
- Formulating the investment guidelines to ensure optimal flexibility to add value
- Making specific issuer and industry selection decisions in a credit strategy
- Monitoring overall portfolio risk, decomposing it and taking action when necessary
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