With the big shift to working from home, a lot of us are thinking about how we, as individuals, can work more efficiently.

Is it efficient to have a 1 hour commute to the office, versus a 1 minute commute to the kitchen? Are we wasting time travelling to research meetings when we could just dial in? Are we wasting energy choosing what suit to wear when we could just sit comfortably with a shirt on top and our pyjamas on the bottom? (Let’s be honest, we’ve all done it!)

The questions around how we can make ourselves more efficient are tricky and the answers vary a lot from person to person.

So instead of just asking about how we as individuals can work more efficiently, let’s ask ourselves another question – can our pension scheme assets be working more efficiently? Now, even though it’s possible this question isn’t at the forefront of everyone’s minds as soon as they wake up in the morning, the answer to this one is pretty straight-forward. Based on how the majority of pension schemes are currently invested, it’s a resounding YES – and a great place to start working your assets more efficiently is with your LDI portfolio.

Many pension schemes currently have embraced liability hedging strategy (or “Liability Driven Investments”, “LDI”) but most schemes leave return on the table. The three most common inefficiencies are usually a result of:

1. Not enough shopping around for the cheapest price
2. Too much capital allocated to LDI, missing out on the higher returns that could be earned on this capital
3. Missing out the additional returns earned by taking investment grade credit risks

Not enough shopping around…

This is a bit like taking the same route to the office every day; it will get you there but actually, on some days, you’d be better off taking a different route depending on say traffic or the time of day. These different routes are like the different hedging instruments that can be used within an LDI portfolio such as swaps, gilt repurchase agreements, options and more. Taking a slightly different route will still get you to the same end destination, but you may be able to get there more quickly and efficiently!

You may even plan your route in a more dynamic fashion by checking google maps before you leave the house to see which route is the most efficient at that specific time. This is a bit like how dynamic LDI works. Dynamic LDI uses a mix of gilts and swaps and changes its allocation to each over time depending on which is cheaper.

The rationale for the dynamic approach is simple – both gilts and swaps provide natural, capital-efficient hedges to pension scheme liabilities with assets that are as close to risk-free as possible. Therefore, it’s reasonable to weight more towards the cheaper asset. The process of systematically rebalancing (a simple buy low, sell high strategy) crystallises profits.

Over long timeframes, a dynamic LDI approach has added excess investment returns relative to both gilt and swap measures of liabilities. For example, over a seven-year timeframe, outperformance of these funds vs their passive equivalents has been around 7% above passive gilt-based funds and 40% above passive swap funds.

Too much capital allocated to LDI…

Let’s think about what happens when you get to the office early and have a few minutes to spare. You could spend that time scrolling through social media on your phone, or you could log on a bit earlier and get a head start on checking your emails. We can think of that spare time as being like the collateral in your LDI portfolio. Scrolling through Instagram during that extra time is a bit like having all your collateral in cash – fairly harmless (depending on what kind of targeted adverts you get) but possibly not the best use of your time. Similarly, while there is nothing inherently wrong with investing all your collateral in cash, it may not be the best use of your assets. On the other hand, investing your collateral more efficiently is a bit like using that spare time more efficiently – either by checking your emails, having a chat with a colleague or finally writing down that to-do list.

We recommend that surplus collateral is invested in relatively low-risk, liquid asset classes that show limited sensitivity to movements in interest rates. Asset-backed securities and short-dated corporate bonds are a couple of examples of alternatives to just investing in cash.

Missing out on credit returns…

Whilst a lot of this time during lockdown has been spent dealing the challenges of working from home all day, there are also certain opportunities that have come up during this time – people have been able to spend more time at home with their loved ones, or pick up new hobbies, or finally get round to reading that book that’s been collecting dust on the bedside table for the last year.

The investment markets are no different. All the volatility we’ve seen in markets have made credit spreads more attractive, and an innovative way to access these attractive spreads without having to use up any extra money or pay large transaction costs is through credit-linked LDI. This allows you to keep your existing exposure to LDI while getting access to investment credit markets. Credit-linked LDI uses synthetic credit rather than physical credit (ie it does not involve physically holding corporate bonds, but instead invests in an index that replicates the performance of corporate bonds). In practice, this synthetic credit is generally more liquid than physical credit and is impacted less by downside scenarios.

So there are a lot of things that investors can do to get their assets to work more efficiently. While we start thinking about what new lifestyle approaches we want to hang on to that we’ve adopted during lockdown, lets do the same for our investment strategies by:

1. Getting the cheapest most efficient hedge through dynamic LDI funds
2. Using collateral efficiently to earn higher returns on excess capital by allocating monies to ABS and short duration corporate bonds
3. Get additional returns by getting investment grade credit exposure through credit-linked LDI

After all, what could be better than living in a world where our investment portfolios run as efficiently as possible AND we get to do all our meetings in our pyjamas?!