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November 28, 2005 12:00 AM

A seller’s market in Europe

Liability-driven investing big area for manager growth

Thao Hua
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    LONDON — Barclays Global Investors Ltd. is leading the pack in liability-driven investing in Europe, with £17 billion ($29 billion) of assets under management, more than three-quarters in the United Kingdom alone.

    Other money managers are hot on BGI's trail, as liability-driven investing is considered one of the biggest growth areas for asset managers in Europe.

    Merrill Lynch Investment Managers, Plainsboro, N.J., manages about £11 billion in LDI assets for more than 40 clients in the U.K. and continental Europe. Earlier this year, the firm acquired the internal investment management unit of Royal Philips Electronics NV, Amsterdam. At the core of the transaction is a seven-year contract to manage a total of €13.5 billion ($16 billion) for the Philips Pension Fund, Eindhoven, Netherlands, and third-party clients. About two-thirds of its assets are invested in a cash-flow-matching LDI vehicle, while the rest is in alpha-generating strategies.

    Although liability-driven investing is less common in the United States, money managers say they're experiencing an upsurge in interest from U.S. clients. The recent announcement by the Financial Accounting Standards Board, Norwalk, Conn., that it will begin overhauling pension and other post-retirement benefit accounting statements is expected to further fuel the strategies' growth in the U.S. within the next couple of years.

    Beginning in U.S.

    "It is already beginning to happen in the U.S. among larger companies," said Mike Turner, head of global strategy and asset allocation at Aberdeen Asset Management PLC, Aberdeen, Scotland. "What's guiding the market (in LDI) is risk reduction, not a focus on return. This is an important distinction."

    At its core, LDI is the practice of making investment decisions based on a framework that reflects projected liabilities, rather than an index or peer-group benchmark. There are several ways of accomplishing that: structuring a fixed-income portfolio that matches expected cash flows; using swaps and hedges to synthetically reduce volatility between assets and liabilities, for example, by matching durations beyond the end of the actual bond duration; and focusing on a multiasset strategy to gain diversity for long-term growth while setting aside a tranche of assets to match liabilities.

    Because of the array of products under the LDI umbrella, it is difficult to measure just how much pension funds are investing in liability-driven strategies. But there's no doubt the market is booming.

    "There's such a significant, immediate demand that it's essentially a seller's, not a buyer's, market" in Europe said Kevin Carter, European head of investment consulting at Watson Wyatt Worldwide, Reigate, England.

    Inevitably, this culminates in a scramble to get on the bandwagon because "that's where (managers) see the opportunity at the moment," added Ralph Frank, senior consultant at London-based Mercer Human Resources Consulting Ltd.

    Led by the United Kingdom — where lower-than-expected equity returns and new accounting standards have left substantial deficits in many pension plans — liability-driven investing is a way of reducing volatility between assets and liabilities. The framework also fits snugly into the more general drift of continental Europe toward a mark-to-market system.

    While the concept is not new, the recent emergence of liability-driven investing as a preferred strategy has been driven not only by need, but also by design, Mr. Frank said. The increasing focus on pension liabilities on a company's balance sheets has upped the ante so that investment banks and corporate financial executives are more involved in investment decisions. Trustees and corporate executives also are now more comfortable with such sophisticated instruments as swaps and hedges to decrease volatility. In turn, this not only benefits the bankers who are counterparties to such transactions, but also asset managers, many of which are subsidiaries of the banks themselves.

    "That's where the hype comes from," Mr. Frank said. "Investment banks are marketing more aggressively to trustees and corporate sponsors, raising awareness of the financial risks and instruments that may be used in managing those risks."

    State Street Global Advisors Ltd., London, worked much more closely with corporate sponsors in its effort to wrest away the £873 million W.H. Smith PLC's pension fund from BGI and others in one of the most publicized coups this year.

    "The move toward LDI is driven, at least in part, by corporate sponsors' familiarity of risk management and their strong desire to control risk," said Richard Lacaille, SSgA's chief investment officer of Europe. "The growth in our business has mirrored that development. We've found ourselves speaking to corporate sponsors to a greater degree than we would otherwise."

    Alan Stewart, group finance director at London-based W.H. Smith, said the pension plan's decision to restructure was "absolutely driven" by a need to reduce volatility that outweighs the need for maximizing returns.

    "With LDI, there's a much narrower range of possible outcome of return. Investors tend to forget that there's a significant upside to equities, but there's equally a significant downside that ultimately ends up on your balance sheets."

    W.H. Smith's LDI strategy essentially deals with assets-liabilities management by extending duration using inflation swaps targeting the London interbank offered rate for 94% of its fund. The rest is placed in long-dated equity call options.

    Traditional balanced portfolio managers also are trying to gain a foothold in the LDI market by introducing a client-specific, liability-led benchmark into a multiasset strategy.

    Because balanced mandates have been on the wane in the U.K. and Europe for the past few years, the new multiasset platform is viewed as a way of capturing some of the lost market share. London-based Schroder Investment Management Ltd., for example, has gained about €300 million so far this year in this type of strategy, said Curt Custard, CIO of multiasset solutions at Schroder.

    8 mandates

    Insight Investments Ltd., London, has won eight mandates with about £1 billion in tailored multiasset strategies in the first half of 2005, said Stephen Millar, director of institutional business development.

    After the U.K., the Netherlands is the next most lucrative market for liability-driven investing, consultants said. Among those who have implemented liability-led strategies are the €187 billion Stichting Pensioenfonds ABP, Heerlen; the €69 billion Stichting Pensioenfonds PGGM, Zeist; and the €4.2 billion Hoogovens plan, Ijmuiden.

    Under regulations that will go into effect in the Netherlands in January 2007, pension plans will have to match the maturity of their liabilities using market rates of bonds with a rating of at least AA. The current practice is to use a fixed discount rate of 4% to value liabilities.

    But liability-driven investments are not attracting just the largest pension funds.

    Merrill Lynch is among about half a dozen managers to have launched — or are in the process of launching — LDI pooled funds so far this year. Others include BGI, SSgA, Aberdeen, Insight and Edinburgh-based Standard Life Investments Ltd.

    Initially aimed at small- to medium-sized pension funds, LDI pooled funds have attracted institutional investors with assets of more than $1 billion. Some of them have invested in both aggregate and pooled funds, which are used as "building blocks to create an overall more exotic finish," said Hugh Cutler, managing director and head of U.K. Strategic & Multinational Business for BGI.

    In the U.K., the swaps market could exceed £9 billion by year's end, according to estimates by Watson Wyatt based on swap transactions already completed this year. This compares to £3 billion in 2004. BGI has already recorded £5.5 billion in inflation swaps for its clients as of Sept. 30. The money manager's total for the previous two years was £2.5 billion.

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