Liability-Driven Investments as well as Asset and Liability Management refer to those situations in which investors must monitor the difference between their assets and their liabilities. Conversely, Asset Management refers to managing assets with no reference to any liabilities whatsoever. Since it is unlikely that an investor has no liabilities at all, most real-world investment situations can be categorized as Liability-Driven Investment.

Unfortunately, unlike Asset Allocation, which offers quite a well-established framework, LDI and ALM cannot refer to any well-identified theoretical body. As such, most financial institutions are forced to make their own way through the interactions between asset allocation and liability hedging within an ever-changing accounting and prudential environment.

Despite this absence of a theoretical body, a soft consensus has emerged that LDI and ALM might not be of such practical importance. Long-term statistics, supported by decades of growth in stock markets, have shown that historically, equities would always perform in the long run, typically eight years. There was the Japanese case, of course, but that was very specific. Historically, a well-balanced equity portfolio would always outperform fixedincome liabilities. Liability hedging could therefore only appear as a costly, useless solution. 
Institutions should focus more on their long-run asset allocation and separate that matter from changes in their liabilities. Based on the literature on long-run investments, most strategies have converged towards a balanced, constant-mix portfolio approach. The equity exposure was essentially country-driven, depending on the local financial culture.

Some years ago, due to the constant decrease in interest rates, many institutions realized that investing had become a harder task, since more 'alpha' was needed to 'cover' unhedged liabilities. Another analysis would have been to acknowledge that because liabilities were not hedged, the necessary returns on the asset side were varied over time. By offering seemingly low risk and steady yields, hedge funds as well as structured credit products appeared to be the right solution to face this combination of decreasing interest rates and an unhedged institutional gap.

Unfortunately, the dislocation of part of the hedge fund industry, the major crisis suffered by securitization products as well as the equity markets' widespread drawdown has shed crude light on this consensus. First, the risk of long-term poor equity returns appears to be real. Second, hedging issues can no longer be hidden by the alpha quest and need to be addressed thoroughly. Eventually, market acceleration illustrates both the necessity of addressing volatility as a specific risk and considering governance structures capable of handling dynamic investment strategies.

In the years to come, financial institutions as well as accounting and prudential players will have to cope with this new reality. We at Lyxor see this as a major trend and want to help in addressing it. This is the aim of this second issue of the Lyxor White Paper Series.

Nicolas Gaussel
Publishing Director
PhD, Global Head of Quantitative Asset Management