Asset Management: The pensions investment strategy fuelling the UK crisis

One thing to start: our friends over at FT Alphaville are resurrecting their pub quiz in London, after a pandemic-induced hiatus. Think you know your LDI from your LBO? Take part in the quiz, on October 13, to pit your wings against the question-setting sadism of the Alphaville team.

Is there anything duller than LDI?

In finance there is nothing quite so dangerous as a supposedly safe strategy, writes my colleague Robin Wigglesworth on Alphaville:

“After years of worrying over high-frequency trading, dodgy corporate debt, meme stock frenzies, China’s imploding real estate market and leveraged hedge funds, it turns out that one of the biggest risks lay hidden within an obscure risk-management strategy pursued mostly by UK defined benefit pension plans. Frankly, it is hard to think of something duller than liability-driven investing. Even many finance industry insiders would have glazed over if you tried to explain the numbing actuarial nuances. This is no flashy hedge fund strategy, or daring bond king bet gone horribly awry. It is the financial market equivalent of doing your family taxes. But it hammers home a truism from many previous market calamities, including the global financial crisis of 2008: the greatest damage is often caused by supposedly stolid investments that turned out to be anything but, rather than nakedly risky bets.”

LDI is now at the centre of the pensions industry turmoil which last week prompted a £65bn Bank of England emergency bond-buying programme.

“Here what we have is a relatively sleepy market that has had very few shocks, including during the financial crisis that’s suddenly going through turbulence induced by policy decisions,” Mark Wiedman, head of international and corporate strategy at BlackRock, told the FT’s Future of Asset Management North America conference in New York last Wednesday.

Since 2003, LDI has become widely used by the UK’s 5,200 defined benefit plans, which have more than 10mn members and £1.5tn under management. LDI strategies, which help pension fund clients match their liabilities with their assets, often using derivatives, are run by asset managers including BlackRock, LGIM and Insight Investment.

But their vulnerabilities were exposed last week as gilt yields rose at an unprecedented pace following the Chancellor’s “mini” Budget and thousands of pension plans struggled to meet emergency cash calls on their LDI contracts. Now UK pension schemes are dumping stocks and bonds to raise cash and seeking bailouts from their corporate backers as the crisis in the industry rages on.

But LDI was not designed to withstand such volatile moves, according to a leading City figure who helped introduce it.

Dawid Konotey-Ahulu was part of a team at US bank Merrill Lynch which in 2003 developed LDI in a bid to “immunise” defined benefit pension schemes against large movements in interest rates and inflation, he said.

It “has helped stabilise pension funding over the past two decades”, said Knowu-Ahulu, who went on to co-found Redington, a City firm advising large institutional pension funds and insurance companies.

“What happened this week was the gilt market got hit by the equivalent of a Category 4 hurricane and the LDI system wasn’t built to withstand a weather system of that ferocity.”

Meanwhile the UK watchdogs responsible for the £1.5tn corner of the pensions sector that came close to imploding this week are holding daily talks with asset managers to stave off a fresh crisis when the Bank of England’s emergency bond buying ends on October 14.

What is the next debacle lurking within some unlikely corner of the global financial system? Email me: harriet.agnew@ft.com

Short gilts: ‘the gifts that keep on giving’

The UK has been rocked by a week or so of financial turmoil, but traders betting against UK assets have been profiting handsomely.

One of the biggest beneficiaries has been Crispin Odey, founder of hedge fund Odey Asset Management and a longtime prophet of high inflation. His bets against gilts and sterling have helped his fund to a gain of around 145 per cent so far this year.

Odey told my colleague Laurence Fletcher that his bets against longer-dated gilts have been “the gifts that keep on giving”. Short selling sterling, meanwhile, had been “helpful”, he said, and the pound could go to parity with the US dollar.

Computer-driven hedge funds such as Rotterdam-based Transtrend, which use powerful algorithms to pick out market trends, have also benefited.

Rather than being direct bets on Chancellor Kwasi Kwarteng’s tax-slashing “mini” Budget, such positions have typically been long-held wagers that UK borrowing costs would eventually have to rise in the face of soaring inflation. Shorting sterling, meanwhile, has not just been a profitable trade for last week but a money-spinning position since summer last year against a strengthening dollar.

Odey’s fund is one of the most volatile in the $3.8tn hedge fund industry and has suffered several years of double-digit losses before more recent, heady gains as his bearish bets come good.

Odey also said that he wanted to be careful he didn’t “overrun” his positions, having been burnt in last autumn’s bond market upheaval. Sterling has now recovered almost all its losses since Kwarteng outlined his plans, while 30-year gilt yields have also fallen right back down, helped by a major intervention by the Bank of England.

Gains from shorting, particularly during times of financial crisis, attract plenty of public attention. However, with central banks actively involved in markets, short sellers themselves can find that their carefully researched positions can quickly move against them as well.

Chart of the week

Investors have withdrawn a record $70bn from emerging market bond funds this year, in a sign that soaring interest rates in advanced economies and the strong dollar are heaping pressure on developing countries.

Investors took $4.2bn out of EM bond funds in the past week alone, according to an analysis by JPMorgan of data from EPFR Global, a fund flow monitor — bringing the annual outflows to the highest level since the US bank began recording the data in 2005.

The investor flight underscores how emerging markets are facing mounting risks from surging interest rates in developed markets, which make the typically high yields on EM debt look less attractive. Powerful gains in the greenback also make it more expensive for EM countries to service dollar denominated debt and increase the cost of importing commodities, which are often priced in the US currency.

JPMorgan in September raised its forecast for EM bond outflows in 2022 to $80bn, having previously forecast $55bn.

10 unmissable stories this week

A profile of Vivek Ramaswamy, the self-styled scourge of “woke” boardrooms. The fund manager with a history of bold claims says energy stocks could triple if ESG aims are scrapped. Now he is putting other people’s money where his mouth is, with the launch of his new activist exchange-traded fund business, Strive.

New laws in Texas and other US states that punish financial firms for “boycotting” oil and gas endanger global financial stability by encouraging risky loans to energy firms, former deputy Treasury secretary Sarah Bloom Raskin has said.

Odey Asset Management and a number of top funds committed to reducing greenhouse gas emissions have invested in British fracking company IGas Energy, as they take advantage of the UK government’s decision to lift the ban on the controversial process.

Pension funds and insurers are “spooked” about committing cash to UK-focused private equity groups, in a sign that chancellor Kwasi Kwarteng’s crisis-provoking fiscal plan has also dented Britain’s appeal for some global investors.

Retail investors must be wary as a wave of alternative investment products comes to market because many carry high fees, lack diversification and offer poor quality investments, asset managers Russell Investments, Neuberger Berman and PGIM have warned.

Billionaire investor Ken Griffin has warned there will be a recession in the US and said the Federal Reserve needs to do more to bring down inflation. “It’s just a question of when, and frankly, how hard,” said the founder of hedge fund Citadel and market maker Citadel Securities at CNBC’s Delivering Alpha conference in New York.

M&G has appointed Andrea Rossi, the former boss of Axa Investment Management, as chief executive. Rossi said that he will not pursue a break-up of the investment and savings group, despite calls by some critics for radical action to revive an underperforming business three years after its demerger from insurer Prudential.

Orlando Bravo, the billionaire co-founder of Thoma Bravo and a bitcoin enthusiast, has said he was disappointed to find that ethical standards in parts of the crypto industry are not as high as in private equity.

The private equity is facing criticism from executives at the likes of ATP, Denmark’s largest pension fund, and asset manager Amundi that it is constructing a giant pyramid scheme that could be bad for business. A bigger problem is that it might be operating in an alternate reality.

AJ Bell’s chair Lady Helena Morrissey has resigned from the fund platform after a disagreement with the Financial Conduct Authority over the future role of the company’s founder Andy Bell.

And finally

To celebrate the centenary of his birth, a new exhibition at the National Gallery in London presents the paintings of Lucian Freud, one of Britain’s most well-known figurative painters. Meanwhile across Mayfair, the Lyndsey Ingram gallery presents a major retrospective of over 50 etchings by Freud, from the estate of his printers Marc and Dorothea Balakjian, with whom he worked for more than 25 years. The collection includes intimate portraits of sitters such as Lord Goodman, Sue Tilly and Lee Bowery.

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