A common goal of insurance and pension organizations is to optimize their investment portfolios against the liabilities they are backing through risk-aware strategic asset allocation (SAA). Managers typically need to hedge market risks and achieve their return objectives, while respecting the limits imposed by the risk appetite framework of the company.
Government bonds are often not sufficient to hedge interest rates and inflation risk. For products such as Defined Benefit pension schemes, derivatives are necessary to minimize the occurrence of funding shortfalls and have become a crucial ingredient of Liability-Driven Investment (LDI) strategies.
The LDI Crisis
Everything works well in periods of falling rates, but what happens when bond yields hike, triggering margin calls on leveraged LDI funds? When the market movements become severe and abrupt, as happened in September 2022 in the UK, fire sales of assets become necessary to raise collateral, thus draining the liquidity of the scheme.
This phenomenon is by no means limited to the British market—the new market conditions challenge current investment strategies in different geographies. The quest for an optimal trade-off between growth, hedging ratios and liquidity risk calls for sophisticated and flexible platforms, allowing portfolio managers to quickly translate their analyses into actionable items.
Portfolio Optimization Workflow
Several steps are required to establish an effective SAA workflow:
Determine the investment portfolio objectives and risk appetite framework.
Model asset holdings (natively) and liabilities (through proxies) of the firm.
Generate balance-sheet projections under a stochastic scenario set.
Use scenario-based optimization to find a candidate portfolio.
The optimal portfolio should balance tail risk indicators, capital requirements and return objectives while respecting a set of limits (e.g., counterparty exposures, no short-selling) and constraints (e.g., exposures to asset types, sectors, currencies; duration mismatch). From a business perspective, the goal is achieved when shareholders’ expected return on capital matches policyholders’ willingness to pay a profit margin in exchange for solvency.