Diversification is a widely accepted concept in investing. Whether it’s asset classes, geographies, styles, or factors, it is often regarded as the proverbial “free lunch.” Yet one type of diversification that deserves a bit more scrutiny is diversification of liability-driven investing (LDI) manager lineups. Developing a complete understanding of the potential benefits and trade-offs associated with expanding the LDI manager roster is critical because LDI alpha is a finite resource and paramount for plan sponsors seeking to reduce risk in their plans. The ultimate question is whether the potential advantages of amplified diversification outweigh the costs or vice versa. Our analysis provides some surprising insights.
Manager diversification trade-off
As they continued to increase LDI allocations over the last several years, many pensions have sought to significantly diversify their roster of active LDI managers in the name of blending investment styles and smoothing tracking error. Most understand and accept that they are likely to give up a certain amount of return or alpha. Some managers in the roster will inevitably perform better than others. So if the plan were to concentrate its allocations with the better-performing managers, returns and alpha would likely be better.
However, plan sponsors are often willing to increase manager diversification and incur this opportunity cost for the following reasons:
- They believe they will meaningfully reduce the risk of underperformance and smooth out alpha outcomes or volatility (or, in other words, reduce the tracking error of the actively managed LDI portfolio) over time.
- They are uncertain which managers will perform best in the upcoming cycle and therefore have the perception that a more concentrated approach may not lead to higher alpha.
To properly assess whether additional manager diversification is advisable, a plan sponsor needs to be able to quantify the risk-return (or cost-benefit) trade-off. Said differently, how does the magnitude of the potential alpha left on the table compare to the risk and volatility reduction offered by further manager diversification?
Quantifying the opportunity cost
Let’s start by quantifying the potential alpha given up from additional manager diversification. There are many different ways to do this, none of them perfect. So without trying to precisely pin down a number, we may get a sense of the magnitude of this cost by looking at a few scenarios.
Consider a hypothetical plan sponsor seeking to further diversify its LDI manager lineup by going from a single manager to three managers. The first line in Figure 1A contemplates the case of a fortunate investor who hires a trio of managers who will turn out to be the top three performers in their category over the time period. Even with this ideal selection of managers, the loss of alpha would correspond to an annual opportunity cost of 36 basis points (bps). In other (potentially more realistic) scenarios where the plan sponsor hires managers who will not all eventually rank at the top of the charts, the alpha given up can be quite substantial (ranging technically, 62 bps to 88 bps annually, as shown on the subsequent lines in Figure 1A).
Figure 1B shows a similar analysis for a plan sponsor that increases its manager roster from three to five managers. Assuming the unlikely selection of the managers who will ultimately be the top five performers over the horizon under consideration, the opportunity cost of further diversification would exceed 25 bps. In other scenarios where the plan sponsor is not fortunate enough to hire all the best performers, the opportunity cost would increase to 34 bps to 44 bps. It’s important to note that this is in addition to the opportunity cost incurred by going from one to three managers.
This historical analysis suggests that there could be a meaningful cost (manifested in terms of foregone alpha) associated with pursuing further diversification of an active LDI manager lineup. However, to judge whether it is reasonable or not to assume this cost we must also quantify the associated diversification benefits.
Risk reduction … or not
As discussed, a main objective of manager diversification is reducing the risk or magnitude of potential underperformance relative to a benchmark, as well as smoothing out alpha outcomes and volatility over time. To measure if further manager diversification could achieve that objective, we can compare the tracking error (relative to the LDI portfolio benchmark) of a portfolio with a larger number of managers to that of a portfolio with fewer managers.
Figure 2 shows (based on a universe of the 16 largest active long credit managers who reported at least 10 years of performance history in long credit mandates) that the tracking-error reduction associated with a larger number of managers in the LDI portfolio was limited. More specifically, there was no improvement associated with diversifying from one to three managers, and the improvement tied to going from three to five was just 25 bps. Beyond five managers, there was little to no reduction in tracking error as the number of providers increased. This suggests that for long credit mandates, further manager diversification may do little to achieve the objective of smoothing out alpha outcomes.
A portfolio for all seasons?
An often-cited argument for further manager diversification revolves around the idea that managers have dissimilar skillsets and approaches and, therefore, will perform well at different times. By emphasizing manager diversification, many believe that they can increase the likelihood of both smoothing out performance and having at least some of their managers among top performers at all times.
However, as Figure 3 shows, there has been limited migration in LDI manager performance rankings. The best ones remained at the top most of the time. Others have rarely cracked the top of the performance charts. While past performance is not a guarantee of future results, we believe this is yet another argument to limit the amount of diversification in LDI manager lineups.
Diversify, but in a measured way
So what’s the optimal answer to this cost-benefit analysis? Diversification is a noble endeavor and can be an institutional imperative for many pensions. However, the threat of alpha erosion combined with the lack of evidence that plan sponsors can achieve meaningful tracking error reduction can’t be ignored. As a result, and also because of the limited migration in performance rankings of LDI managers, we believe plan sponsors should consider limiting their LDI manager lineups to a small number of providers with established and long track records of outperformance.
Ultimately, we believe this could lead to better long-term performance in LDI portfolios and potentially translate into better funding ratio outcomes.