LDI-Sensitive Equity Factor Portfolios: The ALM Perspective to Smart Beta Investing

Abstract

Pension plans often assume that the cost of producing high excess equity returns relative to their liability is a commensurate increase in liability tracking error. However, the authors show that a nuanced approach to equity risk factors may benefit plan sponsors by allowing them to generate upside gains while more effectively controlling their liability tracking error. Although equity risk factors may exhibit varying degrees of co-movement with a plan’s liability, a set of factors may be reconfigured to maximize liability sensitivity. By dynamically reweighting a portfolio of major equity risk factors, it is thus possible to create a liability-driven investing equity factor that can produce excess return versus plan liability while reducing tracking error.

TOPICS: Retirement, analysis of individual factors/risk premia