Cashflow and liability driven investing - why you need to separate the two

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Effectively managing cashflow and liquidity challenges is becoming increasingly vital for many institutional investors, something which has led to the rising popularity of cashflow driven investing (CDI).

Across pension schemes and wider institutional investors, CDI is experiencing a rise in demand not seen since liability driven investing (LDI) rose to prominence in the late-2000s.  A strategy that most of these investors will be familiar with.

Despite offering a number of similarities such as their rising popularity and fixed income foundation, these strategies require a different approach to investment, and as CDI becomes more mainstream, we are increasingly seeing the two conflated - either in investors' minds or in the mandates through which they are run.

One of the main reasons may be the perceived challenges of splitting the LDI and CDI part of portfolios - finding and appointment a new manager, for instance.

However, while it may seem simpler to have one manager running both parts of a portfolio, we believe that separate mandates do work, as long as the two managers work effectively together. This then should allow investors to pick the best manager for these two key elements of their investment strategy.

Moreover, to not do so can present a real issue as both strategies are working towards fundamentally different outcomes, and should be treated accordingly. A failure to separate the two could risk compromising both parts of the portfolio.

LDI, at its most simple level, is about hedging assets and liabilities, and controlling the volatility of the fund on a day to day basis. CDI, on the other hand, is far more forward-looking and centred on planning for the long-term, ensuring schemes have the payments to make all member promises efficiently.

It is not a hedging tool, whereby schemes are seeking to protect against market volatility or specific scenarios that may emerge. Rather, it is a strategy to ensure schemes have the required level of liquidity to make sure they have the right amount of cash to meet all of their liabilities as they fall due.

These outcomes require two distinctly different mind and skill sets and it is therefore vital that they should be treated as two separate mandates.

If CDI is used as an LDI building block then the fundamental objective of the mandate - or manager running it - will not change. Arguably, they are still focusing on the initial objective of hedging, with cashflow elements added on top.

Rather than killing two birds with one stone this just creates numerous inefficiencies, including introducing credit risk into the hedging element of a portfolio.

Another reason to separate out the two is to increase manager diversification. 

Diversifying manager risks is important for a number of reasons. Firstly, so as not to be too exposed should a manager face issues. Across Europe we have seen consolidation and exits, showing the importance of not putting all your eggs in the same basket.

Additionally, having different managers brings more perspectives and skillsets to the table - much in the same way that pension schemes have separate actuarial and investment consultants, rather than one adviser endeavouring to do both.

Separate skillsets is a particularly important point for investors to consider. Managing CDI is very different from managing LDI. The fact that both CDI and LDI share a fixed income foundation has, however, led some investors to erroneously draw similarities between the two.

When one introduces corporate bonds - a typical cornerstone of CDI - into a portfolio, the management of credit risk and default risk becomes crucial. This means devoting a substantial amount of energy to credit research, with analysts delving deeply into the fundamentals of each and every company the manager invests in. Extra financial considerations such as environmental, social and governance (ESG) criteria should be included in the analysis. The skills of long-term fundamental credit analysis - looking deeply into the company's future potential to see if it will deliver income for decades to come - are vital in CDI.

This notion of separation is important for another reason: CDI is not here to replace LDI. As CDI gains popularity as schemes mature and turn their attention to managing issues such as cashflow negativity, LDI will remain responsible for ensuring that schemes remain appropriately hedged.

Both have a vital role to play in the success of pension schemes meeting all of their member promises effectively. But it is important that pension schemes avoid muddying the water and separate the two.

Sebastien Proffit is head of portfolio solutions at AXA IM