I know, I do not write that much lately AND my last post was on the same topic. I promise you, I am not obsessing over this matter (even if some days I have to provide almost hourly updates on where UK rates are…); in fact, I was mid-way writing a post on another topic when the light bulb went on. This also gives me the opportunity to epitomize, as usual in a worse way, Cullen Roche and his “Three Things I Think I Think”.
Ain’t that easy to be Burry in real-time
I was introduced to this Liability-Driven Investment (LDI) thing more than three years ago. I was obviously taken aback because I was expecting the strategy to manage a pension fund to be closer to the Glidepath & shit, definitely not a fixed income-only portfolio that was allocated to some dark corners like Private Debt (the fact that I was looking at this strategy inside a regulated company did not help; for example the 0% allocation to equity was more driven by regulatory choices than anything else).
But I did not question the strategy that much. Not because I had the chance to do a deep dive on it (I wish I have the time) but because I was sitting in a room where everyone else was seeing it as normal. It was like that part in Indiana Jones where they eat monkey brain for dessert…but instead of fainting I went along and filled my stomach:
All the strategy issues were already there. One thing is to realize “oh dear, this will lead to troubles in the future” and another crying over spilled milk. And that’s the key difference between Michael Burry and me (and you).
I just spent a weekend reading alarming tweets about Credit Suisse and guess what? If you are aware of an incoming gigantic crisis, then ain’t one. Maybe one of those crying did their homework but I bet not the majority. And it is definitely easier to spit out your ideas when no one is holding you accountable for them, another to stand in a room and call anyone else (your boss included) a fool.
Herd mentality, better to fail conventionally than to succeed unconventionally, call it as you want: this shit is hard. Another missed opportunity to be impersonated by Ryan Gosling on screen.
Destination vs Path
I read and listen to intelligent people as much as I can. The last time I wasn’t listening to a podcast at the gym was ages ago. No more music, very few fiction books. And yet: I. Do. Forget. Everything.
I even wrote about Corey, Jason and Kris talking about managing to path vs managing to destination. Did I make the connection with LDI? Fuck no.
Because that is it! Defined Benefit pension plans were managed to destination. Plan liabilities are set in the future and investments match those liabilities: you have a payment of XYZ in 30 years, you buy a 30-year GILT that pays XYZ at maturity. Whatever happens from here to there, is not your problem (unless the UK defaults…).
Then comes LDI, then comes leverage. Now you still think you are managing to destination while you are managing to path. Leverage and margins force the pension manager to care about path. The liquidity of your investments matter. How that liquidity flows between managers matters. How you build your stress-tests matter.
Corey recently tweeted about the Portable Alpha debacle during the GFC and the key difference between PA and Return Stacking. I am pretty sure he did not have LDIs in his mind but filling your pension fund with Illiquid Investments and then lever 4x the liquid part of the portfolio is exactly what brought down the Portable Alpha strategies in 2008. I was not aware of the PA story but I am not either a consultant to pension funds: they really not know?
Anyway, I guess why I am not able to do “1+1” is the reason why I am stuck where I am.
Options
Here I go back to Kris-Moontower again. In one of his Money Angle he wrote:
- If path is so important, how can you manage to it?
a) Avoid excessive leverage
b) Pre-determine when you will cut losses (beware this can be a big topic with lots of room for disaster)
c) If you insist on betting on terminal value, do it in fixed premium ways where your max loss is bounded. Now you don’t have to worry about mark-to-market risk.
LDIs are obsessed with terminal value and excessive leverage. Why did they not use swaptions (yeah, sorry for the funny name but that’s how they are called) instead of swaps to hedge? Just as a quick reminder: rates down -> bad for LDI, rates up -> good for LDI. So the LDI has to buy swaptions that protect from rates going down but leave the fund to enjoy profits when rates go up.
In which direction rates went in the last…century?
The whole point of using leverage and having the pension fund portfolio not 100% invested in GILTS was that GILTS yields were too low. The fund had to invest in Private Equity, Direct Loans and such because it needed higher returns. Imagine in that situation to suggest to ditch swaps, which are free, for options, which (premium) cost will lower the fund return. And then, if you manage to convince the Trustees, year after year the fund pays a premium and the upside never materializes. One day you are fired, also because you are the only ‘asshole’ in town who suggested this strategy (if you remember from the previous post, we are in this situation because ALL DB pension funds used the SAME strategy).
Finally you got vindicated, but unfortunately it was too late:
What I am reading now:
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