Novel liability-hedging investment solutions can decrease the cost of inflation insurance and the probability of severe deficits for long-horizon investors versus a solution solely base
Novel liability-hedging investment solutions can decrease the cost of inflation insurance and the probability of severe deficits for long-horizon investors versus a solution solely based on Treasury Inflation Protected Securities or inflation swaps, according to research by Edhec.
Liability-hedging investment solutions include commodities and real estate in addition to inflation-linked securities.
The research, entitled Alternative Investments for Institutional Investors: Risk Budgeting Techniques in Asset Management and Asset-Liability Management, was drawn from the Edhec/Morgan Stanley Investment Management ‘Financial Engineering and Global Alternative Portfolios for Institutional Investors’ research chair.
In the case of a 20-year investment horizon, adding five per cent of alternatives (real estate and commodities) to a liability-hedging portfolio led to a 19 per cent reduction in shortfall probability, and a 42 per cent drop in severe shortfall probability, while adding ten per cent of alternatives led to a 39 per cent reduction in shortfall probability, and 78 per cent in severe shortfall probability.
While investing in real estate leads to higher shortfall probabilities in the short and medium term, the figures show that significantly lower probabilities are obtained in the very long run (greater than 30 years).
The increased expected return generated through the introduction of commodities and real estate in addition to TIPS in a liability-hedging portfolio allows a reduced global allocation to a performance-seeking portfolio while meeting overall performance expectations, which in turn allows better risk management.
Overall, Edhec’s results suggest that alternative asset classes are very useful ingredients for institutional investors facing inflation-related liability constraints.
