The Ontario Teachers' Pension Plan "Advanced Investment Solutions for Liability Hedging for Inflation Risk" Research Chair
A recent surge in inflation uncertainty has increased the need for investors to hedge against unexpected changes in price levels. Inflation hedging is a concern of particularly critical importance for pension funds, in situations when pension payments are indexed with respect to consumer price or wage level indexes. The implementation of inflation-hedging portfolios has become relatively straightforward in specific contexts where either cash instruments (Treasury inflation protected securities, or TIPS) or dedicated OTC derivatives (such as inflation swaps) can be used to achieve perfect hedging. More generally, however, the lack of capacity for inflation-linked cash instruments and the increasing concern over counterparty risk for derivatives-based solutions leaves most investors with the presence of non-hedgeable inflation risk.
Another outstanding problem, even when perfect inflation hedging is possible, is that such solutions generate very modest performance given that real returns on inflation-protected securities, negatively impacted by the presence of a significant inflation risk premium, are typically very low.
In this context, we will be analysing the design of novel forms of inflation-hedging portfolios that do not solely rely on inflation-linked securities but instead involve substantial investment in traditional asset classes. Overall these novel forms of inflation hedging solutions should be engineered to generate higher expected performance for a given inflation hedging level, which in turn will allow for a decrease in the cost of inflation hedging.
The chair will be overseen by a steering committee which includes representatives of OTPP and EDHEC-Risk Institute.
Equity Portfolios with Improved Liability-Hedging Benefits
Guillaume Coqueret, Romain Deguest, Lionel Martellini, Vincent Milhau
This paper extends the LDI paradigm by assessing whether LDI solutions can be enhanced by the design of performance-seeking equity benchmarks with improved liability-hedging properties. We confirm this intuition and show that improving hedging characteristics of the performance portfolio generates welfare gains unless this improvement comes at an exceedingly large opportunity cost in terms of performance — a result that we call the fund interaction theorem. While two competing effects exist in principle (a better alignment of the equity portfolio with the liabilities leads to a higher allocation to equities for the same ALM risk budget due to enhanced liability-friendliness, but it may also lead to a lower reward per dollar invested compared to a pure focus on performance), our empirical analysis actually suggests that the selection of stocks with above-average liability-hedging properties leads to both a higher degree of liability-friendliness (as expected) and also to better performance due to increased exposure to rewarded factor tilts.
Hedging Inflation-Linked Liabilities without Inflation-Linked Instruments through Long/Short Investments in Nominal Bonds
Lionel Martellini, Vincent Milhau, Andrea Tarelli
In the absence of inflation-linked bonds or inflation swaps, no perfect hedging strategy exists for inflation-linked liabilities, and nominal bonds are often used as substitute hedging instruments. This paper, which was published in the Winter 2015 issue of the Journal of Fixed Income, provides a formal analysis of the problem of hedging inflation-linked liabilities with nominal bonds in the presence of real rate uncertainty as well as realized and expected inflation risks. While a long-only position in nominal bonds will always have a negative exposure to unexpected inflation, our analysis suggests that long-short nominal bond portfolio strategies can in principle be designed to achieve a zero exposure to changes in unexpected inflation (required to hedge inflation-linked liabilities), while having a target exposure to changes in real rate equal to that of liabilities. The practical implementation of such long-short replication strategies, however, is not a straightforward task in the presence of parameter uncertainty. We explore several non-exclusive solutions to the estimation risk problem, including the use of conditional parameter estimation methodologies as well as the introduction of robust restrictions on input parameters or portfolio weights. These approaches lead to substantial improvements in out-of-sample hedging performance.
Who Needs Inflation Hedging? A Quantitative Analysis of the Benefits of Inflation-Linked Bonds, Real Estate and Commodities for Long-Term Investors with Inflation-Linked Liabilities
Lionel Martellini, Vincent Milhau
This paper proposes an empirical analysis of the opportunity gains (costs) involved in introducing (removing) various assets with attractive inflation-hedging properties for long-term investors facing inflation-linked liabilities. Using formal intertemporal spanning tests, we find that interest rate risk dominates inflation risk so dramatically within instantaneous liability risk that introducing or removing inflation-linked bonds, or real estate and commodities, from their liability-hedging portfolio has relatively little impact on investors’ welfare from a short-term perspective. This holds true in spite of the attractive (in the case of real assets) and even perfect (in the case of inflation-linked bonds) inflation-hedging benefits of some of these asset classes. More substantial welfare gains/losses, comparable to the costs of ignoring equity return predictability, are obtained as the time-horizon converges towards the liability maturity date and as the relative importance of inflation risk within liability risk increases. Even more substantial utility gains are obtained if these asset classes are also used in the performance-seeking portfolio, where they provide diversification benefits with respect to equity returns.
About Ontario Teachers' Pension Plan
With $107.5 billion in net assets at December 31, 2010, the Ontario Teachers’ Pension Plan (Teachers’) is the largest single-profession pension plan in Canada. An independent organization, it invests the pension fund’s assets and administers the pensions of 295,000 active and retired teachers in Ontario.
A pension plan has existed for Ontario teachers since 1917. Today, the plan’s members include 178,000 teachers in elementary and secondary schools in Ontario, 117,000 pensioners and 68,000 inactive members. The plan has one of Canada’s largest payrolls with $4.5 billion in benefits paid to plan members, and $2.7 billion received in total contributions from teachers, the provincial government and designated employers in 2010.