What is the secret behind a good matching portfolio?
The simpler your matching portfolio, the greater your success.
Matching portfolios are supposed to match, that’s all. The simpler you make them, the higher your chance of success. Use any time you save to achieve excess returns in your return portfolio.
By Mark Petit, head of investment solutions at Cardano
Matching portfolios are supposed to match. That’s all. Nobel laureate Jan Tinbergen maintains that a policy instrument should only serve one purpose. If you target multiple objectives with one instrument, you’ll achieve none of them. Focusing on a single goal will increase your chance of success. This also applies to matching portfolios.
If you do it properly, it means executives won’t have to worry about that part of the balance sheet. All the energy you don’t spend on your matching portfolio can be used to manage returns and risk in the return portfolio.
Focus on a single risk
Good matching depends on turning a single risk dial: spread risk. This is the risk that interest on safe government bonds will develop differently from the swap rate, causing the value of a bond portfolio to develop differently than liabilities. Opting for more long-term bonds or more long-term swaps lets you increase or decrease the spread risk.
Make sure you have a tight risk framework and limit the amount of spread risk you give the LDI manager.
Avoid other risks such as credit, curve and currency risks, which will only make the portfolio less transparent. They are unstable and unpredictable and therefore difficult to control, even though neoclassical economists claim otherwise. These risks are not necessarily a bad thing, but it is better to bunch them in the return portfolio. This keeps the picture nice and clear and lets you properly weigh up all the risks.
“Everything should be made as simple as possible, but no simpler.”
– Albert Einstein –
You also want to invest in safe government bonds
Avoiding the spread risk altogether would be preferable, and in theory, such a ‘zero-risk portfolio’ would consist of cash and interest rate swaps. This approach, however, is too simple: it will leave you with a portfolio that’s always playing catch-up. Returns from cash or money market funds are low, which may temporarily be a good thing amidst certain market conditions, but in the long run, you want to invest in safe government bonds to minimise this loss. This, however, automatically introduces spread risk to the equation.
Opt for a passive approach: active management only results in unnecessary costs and less transparency. Only take action if there is sufficient compensation for risk involved
In a nutshell: simple, passive management is clear and unambiguous, affording executives with greater control because they can track what is happening and why. Switching to a passive approach will help save time and energy, which can then be channelled to the return portfolio.