THE REAL GREAT ROTATION:

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Executive Summary

2 1: Introduction

4

1.1 Fixed income market growth 5

1.2 Higher yield opportunities 6

1.3 Challenges faced by fixed income managers 8

2. Seize the opportunity

9

2.1 How managers can respond to increased pressure from investors 9 2.2 The shift towards electronic trading of fixed income instruments 10 2.3 Consolidated systems offer a competitive advantage 11

3: Meeting the funding gap – the rise of LDI strategies

12

3.1 The benefit of a holistic view 13

3.2 Analytics of LDI strategies 14

3.3 Flexibility of running multiple models 15

4: Conclusion

16 About the White Paper’s authors

17

The ‘Real’ Great Rotation: Analyzing Shifts within Fixed Income and Towards Liability Matching

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It is clear that pressure among global institutional investors to meet their

long-term liabilities is driving forward the need for higher yielding assets.

But whilst certain market commentators have suggested that this will

result in a “Great Rotation” out of fixed income assets into higher return/

higher risk equities, the latest white paper by Misys considers a more

nuanced approach.

The central thesis of the white paper is that far from rotating completely out of fixed income securities, investors are relying on asset managers to find compelling alternative yield opportunities in other areas of global fixed income – high yield and investment grade corporate bonds are just one example of this. Indeed, global and Emerging Market government debt and global and Emerging Market corporate debt attracted 14% and 13% of year-on-year net growth in assets in 2012. As investors move towards retirement age their appetite for higher risk assets diminishes. They want the security of fixed income

investments that provide regular return streams. This is the ‘real’ Great Rotation under way and it is causing investment managers to re-assess their technology capabilities. Trading higher yield fixed income assets brings a new series of challenges to managers with respect to risk management and keeping on top of pre- and post-trade compliance limits.

This is especially important when considering the rise among institutional investors, both in the US and Europe, for Liability-Driven Investment (LDI) strategies to address the funding gap that arose following the global financial crisis.

This paper postulates that having a holistic view when running an LDI strategy is necessary for managers who wish to ‘seize the opportunity’ to trade further and deeper within global fixed income markets. Having a single view allows managers to understand their interest rate risk (e.g. key rate durations) and instrument coverage to effectively hedge liabilities on the one hand, and manage the performance of assets on the other, in order to generate the requisite yield in the strategy. Within fixed income and LDI strategies, those managers who have the IT architecture to support trading a wider range of instruments, all the while keeping a tight grip on risk management and analytics, will be best placed to respond to investor demands for new products.

The search for yield continues, but for many this remains within fixed income.

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Fixed income markets have been tough for asset managers to navigate in

recent times. Traditional instruments like US Treasuries have experienced

significant inflows. As a result, yields on 10-year Treasuries fell from 3.6%

in April 2011 to 1.45% in July 2012 as investors clambered to increase

their exposure to safe haven assets as geopolitical uncertainty pervaded

market consciousness. That figure has since risen to 2.88%. Nevertheless,

the dominant narrative of the last couple of years has been one of asset

managers seeking newer sources of yield in a perniciously low interest rate

environment to help investors meet their liabilities.

The natural behavior of an investor looking for better returns is to turn to equities, which would lead to the so called ‘great rotation’ out of fixed income into these higher risk assets.

However, this reasoning omits the demographical context in developed countries. With a long-term decreasing birth-rate coupled with increasing life expectancy, the population of developed countries is aging. With the exception of most pensioners, older people generally have a higher income. The closer an individual is to their expected retirement date, the more their investment profile will drift towards defensive strategies that typically use fixed income products. They have the huge advantage of providing predictable and relatively risk-free returns when compared to equity products. Figures from the US Federal Reserve show that between 1998 and 2007 the mean net worth of individuals between the ages of 55 and 64 years old rose from $677,000 to $936,000. By contrast, over the same time period the mean net worth of individuals between the ages of 35 and 44 years old rose slightly from $249,000 to $326,000.

This demographical phenomenon has therefore created another driver for the demand of fixed income products by institutional investors who make up the lion’s share of global AuM. However, traditional asset classes within fixed income such as developed market government bonds can no longer be relied upon to generate sufficient returns. Asset managers have had no choice but to diversify and become more adventurous with Emerging Market debt, both government and high-yield corporate, becoming a major source of interest. As a result, what we are seeing currently is not a shift of allocations from fixed income to equities but a shift within fixed income towards high yield Emerging Market debt.

This is the ‘real’ great rotation that the analysts did not predict but the markets were expecting.

CHAPTER 1: INTRODUCTION

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1.1 Fixed income market growth

The drivers mentioned previously helped global fixed income markets grow by 15% between June 2009 and March 2012 according to Celent. Moreover, whilst equity funds recorded net outflows of 1% in 2012, fixed income funds recorded net inflows of 4% according to a Boston Consulting Group report1_{entitled Capitalising on the Recovery,} released in July 2013.

For fixed income managers, now is as good a time as ever to reassess their strategies, see what they can do to take advantage of trading new asset classes like corporate and emerging market bonds, and ensure that they have the IT systems in place that will allow them to evolve. Those that do stand a better chance of success through their ability to respond effectively to investor demand for greater and stable returns.

1 Boston Consulting Group; Global Asset Management Capitalising on the Recovery, July 2013

“ Emerging Market fixed income

now represents 12% of the

estimated USD114 trillion global

fixed income market.”

In August 2013, Ashmore Group, a UK investment manager that specializes in emerging markets, wrote that the emerging market fixed income universe expanded to USD14trillion in 2012 from USD12.7trillion in 2011: a 10.6% year-on-year increase. Digging a little deeper, local currency corporate debt increased by 9.8% over the same period, while local currency sovereign debt increased 10.7%.

As PIMCO points out, non-US bonds comprise over 50% of the global bond market. Emerging Market fixed income now represents 12% of the estimated USD114 trillion global fixed income market.

2 –1 8 6 13 14 5 0 4 7 3 5 – –5 –1 1 –10 –5 0 5 10 15 Multiasset funds Money market Passive fixed income High-yield debt Global- and emerging-market corporate debt Global- and emerging-market government debt Developed-market corporate debt Developed-market government debt Fixed income Passive equities Global- and emerging-market equities Developed-market small- and mid-cap equities and

specialties Developed-market large-cap equities Equities All products

Source: BCG Global Asset Management Benchmarking Database, 2013.

EXHIBIT 1: Investors Continued Their Shift from Traditional Actively Managed Core Assets to

Specialties and Passives

2012 net inflows, by product strategy, relative to 2011 AuM (%)

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Moreover, Ashmore postulates that emerging market fixed income could reach USD52 trillion by 2020 if it continues to grow at the same rate as it has during the past 12 years; on a like-for-like basis, this would make it twice the size of the US treasury market. For today’s fixed income asset manager, the ability to diversify into and effectively trade a wider range of non-traditional instruments, either in developed or emerging markets has become a necessity. In its report, BCG note that emerging market asset classes continue to grow faster than active core assets and that the growth of solutions and specialty assets “will

continue to outpace and squeeze the market share of traditional products”.

1.2 Higher yield opportunities

This is evident in the way that investors are shifting their allocations away from traditional core assets to more specialized and passive assets. According to BCG, global and emerging market government debt and global and emerging market corporate debt attracted 14% and 13% of year-on-year net growth in assets in 2012, with inflows into high-yield debt and passive fixed income climbing by 6% and 8% respectively. Compare that to developed market government debt and corporate debt – 0% and 5% – and the trend is startlingly clear.

“ Growth is taking place across

the yield curve, as evidenced by

the demand for higher yield

assets such as corporate bonds.“

Even though equities have performed strongly over the last 12 months they still remain highly volatile. Much was made of the ‘Great Rotation’ that was expected to happen as investors put more risk on the table but in reality this is yet to happen, at least not from fixed income allocations into equities as was anticipated. Rather, investors have extended their appetite for risk within fixed income. Growth is taking place across the yield curve, as evidenced by the demand for higher yield assets such as corporate bonds. This is helping investors overcome the perniciously low yields in government bonds yet at the same time supports their desire – among older investors that is – for stable, reliable investment returns. Bond 44% Money Market Instrument 12% Equity 30% Other 14% 2009 Bond 46% Money Market Instrument 11% Equity 29% Other 14% 2011 Bond 40% Money Market Instrument 13% Equity 37% Other 10% 2007

EXHIBIT 2: Shifts in asset allocation

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Figures from EFAMA’s 2013 European Asset Management report2_{actually show an increase in} fixed income holdings from 40% in 2007 to 46% in 2011 in asset allocation by European asset managers compared to the previous year.

Ironically, this has come at the expense of equities where asset allocations have fallen from 37% to 29% during the same period.

The inference here is that fixed income markets remain highly favored. For investment managers, how successful they are at harvesting higher yield opportunities in these different markets will separate the winners from the losers going forward. Any asset manager who chooses to widen out his investment strategy, or indeed launch a new one, to tap in to the yield (and potentially lower volatility) opportunities in fixed income will want to have the confidence of the instruments they are trading. These might be Brazilian government bonds, Emerging Market corporate bonds; instruments that the manager has potentially never traded before. It is therefore essential that before any trade is executed they understand the risks, what the impact will be on the overall risk profile of the portfolio, perform scenario or stress test modeling, and have confidence in what the pricing methodology and risk exposure for each trade should be.

In terms of what the most favoured strategies are by investors in Europe, BCG’s report shows that in respect of net sales, high-yield bonds and emerging market bonds were the two most popular, attracting USD73bn and USD61bn respectively. Overall, credit conditions have improved in non-government bonds. At the peak of the crisis in 2009, Standard & Poor’s recorded an 11.35% default rate in US corporate junk bonds. This fell to 2.59% in 2012, with no defaults recorded on investment-grade debt. In emerging markets, debt issued by corporates in eastern Europe and the Middle East remains attractive according to an article written by Faisal Al, an investment manager at Baring Asset Management, in FTadviser at the end of July 2013.

2 EFAMA; Asset management in Europe facts and figures, 6th annual review, June 2013

What is surprising to investors is that approximately 70% of emerging market corporate debt is

investment-grade, as outlined in a recent paper by BNP Paribas3_{entitled Emerging Markets}

Corporate Debt: A Bright Spot in the Bond Market.

Attractive yields are of course the main reason for asset managers to diversify into new markets and reduce correlation across asset classes.

According to the BNP Paribas report, Emerging Market investment grade (IG) corporate debt can yield 3.8% (3.4% for Emerging Market sovereign debt), while Emerging Market B-grade debt can yield 8.5%. Relative to US Treasuries, this offers a spread of 243 basis points and 782 basis points respectively, based on JP Morgan’s corporate emerging markets broad index (CEMBI) and emerging markets broad index global (EMBIG), March 31, 2013.

EXHIBIT 3: Emerging Market

Corporate Debt Regional Composition

Good regional balance compared to Emerging Market Sovereign

Mid East / Africa 19% Latin America 27% Europe 14% Asia 40%

Yield (%) UST Spread (bps)

Corp Sov Corp Sov

IG 3.8% 3.4% 243 156

BB 5.7% 4.1% 444 230

B 8.5% 8.2% 782 654 Source: JP Morgan, based on CEMBI Broad Div and EMBIG Div

Mar 31, 2013

3 BNP Paribas: Emerging Markets Corporate Debt: A Bright Spot In The Bond Market, July 2013

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Moreover, Emerging Market corporates tend to use less leverage. Triple-B rated Emerging Market corporates potentially yield over 150 basis points of spread per unit of leverage compared to around 100 basis points of spread per unit of leverage for US corporates.

The fact that fixed income assets offer predictable return streams is especially important to institutional investors like pension funds and insurance firms who, more recently, have begun to seek out Liability-Driven Investment (LDI) strategies to address the funding gap that arose following the global financial crisis.

Reliance on traditional markets no longer cuts the mustard. But LDI strategies are far from straightforward and necessarily require analytical prowess. Risk management expertise at the pre-trade level is absolutely vital for any asset manager running such a strategy.

They need to know as precisely as possible how the portfolio’s assets are performing at the position level and the impact this is having on the funding ratio (more on this later). Discounting liabilities based on today’s interest rate environment, across multiple markets, and calculating future cash flows also has to be as accurate as possible so that the portfolio manager can adjust the return/risk profile of the portfolio, increase or decrease exposure to higher or lower yielding instruments.

It’s all about having the right tools to hand to have a clear aggregated view of the portfolio on which to make the best investment decisions.

1.3 Challenges faced by fixed

income managers

Analytics is a core function for any successful fixed income manager. Understanding how changing interest rates and inflation might impact the portfolio is an active part of fund management. The more information traders have to hand before executing a trade, the better placed they will be to make the right call. In years gone past, traditional asset managers concerned themselves solely with traditional fixed income instruments like developed market government bonds. From a risk analytics perspective, this was more manageable.

Fast forward to today, and portfolio managers have a wider choice of fixed income instruments to trade than perhaps ever before as Emerging Markets continue with their cycle of economic growth and regional bond markets mature and deepen. The yield opportunities on offer in these diversified markets are proving to be an important source of alpha for managers. But without a robust risk and portfolio management solution that allows portfolio managers to pre-determine how increasing

exposure to Latin American debt, for example, will impact the overall risk profile, trading these new instruments can be a potential minefield.

“ The fact that fixed income assets offer predictable return streams is

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As investors become more demanding of asset managers, they will

likely lose interest in those who aren’t able to respond quickly and seize

opportunities as and when they arise. This is the main challenge that

managers face today, particularly, within the context of this white paper,

in fixed income markets. Speed to market is paramount.

For managers that want to develop successful investment strategies by actively diversifying in the fixed income space they need comprehensive risk analytic tools for scenario modeling, understanding how trading across different parts of the yield curve in different markets might impact performance, analyzing ex ante tracking errors, stress testing etc. On the one hand managers need to be able to handle the instruments whilst on the other hand, from a risk perspective, they require an aggregated view of risk across the whole portfolio. That requires a consistent framework.

This ‘seize the opportunity’ point may seem obvious but when one considers the size of the world’s most successful asset managers, those who do not have a clear business strategy to build out their market share by investing in technology will fail to attract new assets. Allianz Group in Germany, for example, is one of the world’s largest asset managers with an estimated USD2.4tn in assets under management and have consistently invested heavily in technology.

” When time-to-market is vital,

and when asset managers

dedicate as much as 31%

of their spending to IT, it is

essential that the system is

not an obstacle to change.”

CHAPTER 2: SEIZE THE OPPORTUNITY

Not all firms have grand designs on becoming the world’s largest asset manager, but what is important is that they try to invest as much in their IT infrastructure, comparatively speaking, as the biggest fund houses. Technology is the backbone of success.

Even those with modest growth ambitions should be prepared to invest in their IT capabilities today to become a bigger firm tomorrow.

When time-to-market is vital, and when asset managers dedicate as much as 31% of their spending to IT, it is essential that the system is not an obstacle to change.

2.1 How managers can respond

to increased pressure from investors

The natural response to meeting investor demand for improved performance is to move into new asset classes and bring diversity into the portfolio to reduce volatility, and hopefully to harvest higher yields. Managers are not only looking for more effective ways to trade fixed income but to have the requisite flexibility within their systems to capitalize on each new market opportunity as it presents itself. But for every step taken in diversifying the strategy as managers become more adventurous, so they need to be mindful of the forensic level of detail investors now expect.

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In this respect, risk management is integral. Portfolio managers need to be able to clearly demonstrate to their investors what they are doing, where they are generating returns and how they are achieving them.

They need to monitor closely the risk (key-rate durations (KRDs), tracking-error, pre-trade compliance, etc.) while rebalancing the portfolio, thus minimizing deviations from guidelines and costly readjustments. Their clients expect them to justify their investment decisions a priori by providing a comprehensive set of analytics and a posteriori through performance attribution reports.

“ Portfolio managers need to

be able to clearly demonstrate

to their investors what they

are doing, where they are

generating returns and how

they are achieving them.”

Risk management has now become central in the investment decision process and moreover, highly relevant to ensure consistent portfolio performance. A good example to use here is insurance

companies. Under Solvency II which, admittedly, only targets Europe-based insurers, they will be required to calculate their solvency capital requirements (SCR). This is not too dissimilar to capital requirements faced by banks under Basel III and will determine the level of capital insurers will need to make available.

That means portfolio managers to whom they give investment mandates will have to provide them with precise risk analytics to help clients with the SCR calculation. They will expect greater transparency and ‘look-through’ capabilities on their investments, no matter how complex. And they will increasingly need to manage their clients’ portfolios under SCR target constraints. Greater adoption of derivatives and other instruments to enhance returns in the strategy will still need to be clearly documented and reported on, just as they would be for plain vanilla instruments like government bonds.

2.2 The shift towards electronic

trading of fixed income instruments

And then there is market regulation to deal with. Just as investor reporting demands are increasing, so too are they for global regulators. In the US, new CFTC rules under the Dodd-Frank Act now require all swap market participants to execute and clear their swap contracts using Swap Execution Facilities (SEFs) and Central Counterparties (CCPs); previously, everything could be achieved over the phone for lower cost.

Similar trade execution and reporting on cleared OTC contracts are introduced under EMIR regulation in Europe throughout 2014, with reporting obligations already commenced as of 12 February 2014.

Connectivity will therefore be a primary requirement for asset managers who trade derivatives, both to global trade repositories and CCPs, as well as stock exchanges. The more systems used for this purpose the higher costs will become. Ideally, managers will want to avail themselves of an ‘out-of-the-box’ connectivity solution to continue trading their strategies in the most cost-efficient way. With a good STP chain in place it will help reduce the costs of moving to this electronic trading environment and mitigate the cost of regulation as much as possible.

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2.3 Consolidated systems offer

a competitive advantage

As mentioned earlier in the paper, fixed income markets continue to grow. Managers who have successfully delivered on performance and have themselves grown will typically reach a tipping point where they need to decide, strategically, whether the IT systems they started with are still up to the task.

In its report, the Boston Consulting Group makes an interesting reference to the need for managers to become ‘ambidextrous’; that is, retain core assets in their portfolio but develop new solutions in parallel. Revenues for managers who develop specialty products rise 2.5 times according to the BCG report. Specialist managers generate net revenues of 46 basis points compared to 24 basis points for traditional managers.

Clearly, there would appear to be tangible gains to diversifying. Innovation, however, relies on having the right systems in place to navigate new waters. The systems used in the early days when managers were running one or two mandates might have sufficed, spreadsheet tools might have been manageable. As managers grow, and the number and complexity of products they bring to market increases, the more emphasis is placed on integrated systems.

In the last few years people have started to talk about IBOR – the Investment Book of Records – which, at its heart, is the ability for managers to work with and present a single intraday version of the truth. With this approach the front office team sees exactly the same data and trade information as the back office and compliance teams.

At the end of the day, managers need one place where they can look at all of their positions, all of their analytics and be able to run ‘What if…’ scenarios, do different types of stress testing and then go off and trade the necessary instruments in accordance with their analysis.

For many managers, this still means navigating between different screens, taking data from different sources and so on, which often becomes complicated.

“ A single consolidated view

makes the job of running

multiple mandates more precise

and reduces reputation and

regulatory risk not to mention

operational risk.”

Increasingly, there is a realization among asset managers that they need to have a real-time view of everything they own across all asset classes. In fixed income that could include all positions held in Treasuries, corporates, high-yield bonds, emerging market bonds (both sovereign and corporate), asset-backed securities (CMBS and RMBS), futures, not to mention their overlay OTC derivative positions.

A single consolidated view makes the job of running multiple mandates more precise and reduces reputation and regulatory risk not to mention operational risk.

Crucially, this allows CIOs and CEOs to get a clear idea of performance, make more informed investment decisions and quickly assess the feasibility of taking additional mandates from clients while remaining cost efficient and operationally secure.

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ASSETS LIABILITIES

ASSET-LIABILITY IMMUNIZATION

• Hedge Ratio monitoring

• Cash flows, sensitivity profiles, performance

• What-if analysis

• Completion management

Historically pension plans were not too concerned about the gap between

liabilities and assets. They were able to meet their liabilities based on the

yields that they were getting from traditional assets. Equities were yielding

higher returns than bonds and when that trend started to diminish the

funding gap between assets and liabilities started to increase.

Since the global financial crisis the tables have turned. Pension plans now face significant pressure to meet rising liabilities even though the returns from their assets have floundered; equities have just started to return to pre-crisis highs and the bond market rally has driven yields down to historic lows. Liability-driven investing (LDI) has, understandably, gained prominence among institutions in recent times as they look for managers to develop investment strategies that consider assets and liabilities jointly.

This brings a slew of additional challenges to asset managers because they need even more rigorous risk analytics to ensure that the way the strategy is being traded and hedged with respect to interest rates and inflation is sufficient to meet the current and projected liabilities of pension fund clients. In a recent LDI survey by KPMG4_{they note that} the notional value of liabilities hedged in the UK LDI market has increased 11% from GBP403bn to GBP446bn. Legal & General are the biggest player, representing 43% of the UK market.

4 2013 KPMG LDI Survey: Exploring the Evolution of the UK LDI Market

CHAPTER 3: MEETING THE FUNDING GAP – THE RISE

OF LIABILITY-DRIVEN INVESTMENT (LDI) STRATEGIES

EXHIBIT 4: Implementing an LDI strategy

ACTUARIAL SYSTEM

HEDGING PORTFOLIO

• Asset class coverage (IRS, Swaptions, Bonds) • OIS discounting

RETURN-GENERATING PORTFOLIO

• Asset class coverage (basket options, etc.)

• Internally-managed portfolios • Externally-managed portfolios

LIABILITY CONTAINER

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As for the US LDI market, adoption of LDI strategies rose by more than 35% between 2007 and 2010 according to a report by Booz & Co5_entitled

Strategic Opportunities for Asset Managers in US Liability-Driven Investing (LDI). The report found

that 77% of US large defined benefit plans (more than $1bn) plan to increase their allocation to LDI strategies.

The same report estimates that there is more than $610bn in AuM globally in LDI strategies, of which the US LDI market accounts for approximately 40% of assets.

“ 77% of US large defined

benefit plans over $1bn plan

to increase their allocation

to LDI strategies”

The ability to offer LDI solutions to investors is part of the wider narrative detailed in this paper in respect to diversification within fixed income. Those managers with the tools and systems in place to handle the complexities of discounted cash flows, daily hedging, and keeping the funded ratio (the ratio between the value of the assets over the value of the liabilities) as close to 100 or above as possible are the ones most likely to evolve ahead of their peers.

With respect to managing the hedging ratio in an LDI strategy, the smart managers are those who are able to employ a wide range of complex derivatives such as equity options, swaptions and interest rate swaps to give themselves maximum flexibility. They are the ones who can demonstrate a clear value-add to their investors. And they are the ones seeing the most growth in their AuM.

5 Booz & Co: Strategic Opportunities for Asset Managers in US Liability-Driven Investing

3.1 The benefit of a holistic view

The most important requirement is having a comprehensive, holistic view when running an LDI strategy. Portfolio Managers require a clear understanding of their interest rate risk, particularly key rate durations (KRD) and have full instrument coverage (according to the investment guidelines) in order to perform liability hedging on the one hand, and generate the requisite yield from assets on the other.

It may sound simple, but it is vital that the front office can see the portfolio and risk exposure profile in full. Portfolio Managers need to see all of their positions, both listed and OTC, and compare those positions to the current and future liabilities; what are the projected cash flows and what level of returns are required to support those cash flows? If there is too much divergence in terms of risk, perhaps on the 10-year point of the curve, having the right tools in place will allow managers to run different pre-trade simulations and determine the risk outcome of buying and selling other treasuries, or perhaps increasing/decreasing an IRS hedge. Managers therefore need to have that round trip of looking at the portfolio, understanding what types of trades they might need to do to manage risk, and then ultimately execute those trades. Without that, the complexities of risk management and managing the funded ratio could become too onerous a task. Too often, LDI managers are working in one system to manage the hedging of liabilities with the analysis tools and asset class coverage this entails and in another set of systems for the allocation to alpha-generating products.

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3.2 Analytics of LDI strategies

Just with any fixed income strategy, LDI strategies are highly dependent on accurate analysis of risks and exposure across a variety of durations and sensitivities in what will typically span listed instruments as well as OTC derivatives.

The funded ratio is the most important indicator as it directly impacts the accounting requirements on the balance sheets of corporations. Every day, the task is to improve the funded ratio as much as possible.

“ Managers who can trade with

a full range of instruments are

far more likely to handle the

numerous demands of running

effective LDI strategies.”

Coming up with that one number is not easy. It is dependent on a number of different inputs that include the liabilities themselves, the assets, volatility, corporate bond curves, interest rates, inflation and so on. It goes without saying, therefore, that robust analytics are crucial to dynamically calculate the funded ratio accurately on a daily basis.

Beside the funded ratio, running an LDI strategy involves mapping future outflows and inflows, and the interest rate sensitivities of the liabilities and the assets (hedging ratio). As a result, it is of utmost importance for the portfolio manager to have access to as much information as possible to manage the investment strategy and build the hedge overlay.

More precisely, this will include a concise view of all the future cash flows, the impact of any potential investment on KRD, risk budget and tracking error, and various other risk analytics. Collateral management requirements add another layer of complexity to trading OTC products as there is now a need to record the derivative agreement terms and conditions, provide the collateral status (including that which is posted and eligible), calculate initial and variation margin, match transactions and generate call notices. Pricing models are another important

consideration, especially as managers extend their trade capabilities into new asset classes. In addition, one should also remember that regulation is having a massive impact on how managers run their portfolios. The OTC markets are undergoing a paradigm shift as what were previously bilateral contracts move into a more transparent, centralized clearing environment.

Managers who can trade with a full range of instruments are far more likely to handle the numerous demands of running effective LDI strategies.

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3.3 Flexibility of running multiple models

Once computed, the proper handling of a client’s liability cash flows requires a consistent and flexible framework. Liabilities tend to be forward-looking for anything up to 100 years and are therefore an approximation. Different regulators use different accounting techniques to calculate liabilities, making them challenging to handle. A degree of flexibility is necessary to try and represent liabilities as accurately as possible; which in turn helps improve the investment decision making process. This means having the systems in place that are able to support multiple models to discount future cash flows. On top of this, the regulator might enforce methodologies which are not necessarily consistent with the market.

“ It is imperative that an LDI

portfolio manager is able to

analyse liability cash flows under

several frameworks.”

For example, the Ultimate Forward Rate method, which has been adopted by Danish institutions and Dutch insurance companies, could lead to liabilities being lower by up to 10%, according to PIMCO, compared to discounting under market-consistent conditions.

It is therefore imperative that an LDI portfolio manager is able to analyse liability cash flows under several frameworks. Moreover, those that can do this successfully are likely to develop long-lasting, trusted relationships with their investors.

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This is especially important for institutional investors such as corporate and public pension plans who are increasingly turning to LDI strategies to close their funding gap. The Great Rotation is yet to happen. Admittedly, investors are moving away from safe haven assets like Treasuries because yields have continued to fall in recent times. But rather than moving aggressively into equities, the rotation underway is more one of diversifying within fixed income into higher yielding instruments as evidenced by continued inflows into Emerging Market debt.

These new markets, and new instruments, are putting today’s asset managers under more pressure to diversify their product offerings and seize the opportunity to produce higher returns their investors increasingly demand. At the same time, more adventurous, complex trading strategies need to be closely aligned to enhanced risk

management controls and transparency, not only to satisfy investors but global regulators.

Managers are increasingly required to monitor portfolios relative to their benchmarks. This places more emphasis on pre-trade controls and the ability to run simulation workflows to compare results to a stated benchmark. Furthermore, it means that firms must maintain a library of benchmarks with full market data to effectively slice and dice; the US Barclays Agg Index, to illustrate, contains over 8,000 constituents.

In such a competitive environment, having a fully integrated platform that offers comprehensive pre- and post-trade controls and which provides the best time-to-market to trade new assets, while keeping the total cost of ownership (TCO) of technology as low as possible, could be a key factor for success. It also ensures that portfolio managers, middle-office staff, the CIO, the compliance officer all see the same picture of how the portfolio is trading.

Whereas previously, competitive advantages were derived from attracting the most talented managers and technology was seen as no more than a

necessary fixed cost, IT systems and tools now have the capacity to help managers stand out from the crowd. The ability to evolve a strategy to take advantage of higher yield opportunities in fixed income markets, and at the same time establish robust risk management and transparency controls, is becoming increasingly predicated on the need for sophisticated end-to-end solutions.

Fixed income strategies continue to hold favour with wealthy investors

thanks to the stable return flows they offer. These investors typically

exhibit less of a risky appetite as they approach retirement age.

However, whilst fixed income markets remain important there is no

escaping the fact that managers have to have dexterity at finding higher

yield opportunities.

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BEST CORE BANKING PRODUCT OR SERVICE

Misys Bank Fusion

READERS’ CHOICE AWARDS

Misys is at the forefront of the fi nancial software

industry, providing the broadest portfolio of banking,

treasury, trading and risk solutions available on

the market. With 1,900 customers in 120 countries

our team of domain experts and partners have an

unparalleled ability to address industry requirements

at both a global and local level.

Misys is able to address all customer requirements

across both the banking and trading book businesses.

Misys is the trusted partner that fi nancial services

organisations turn to for help solving their most

complex problems.

ABOUT MISYS

Misys and the Misys “globe” mark are trade marks of the Misys group

Find out more at www.misys.com

The authors would like to acknowledge contributions from:

Maan Bsat

Maan Bsat is Head of the Americas Business Solutions Group (BSG) for the buy-side. He has worked in professional services and in the BSG, primarily with asset managers, family offices and hedge funds.

Pierre-Alois Koch

Pierre-Alois Koch is Global Head of Buy-Side Specialists at Misys. He manages the strategic development of the Misys buy-side offering in coordination with product management.

About the White Paper’s authors

James Williams

Industry Writer and Journalist

James Williams is the News Editor at Hedgeweek, where he reports on key developments spanning fund performance and strategy, legal and

regulatory issues, technology and risk management. In addition, James has contributed articles on the buy-side industry and capital markets to the likes of the Financial Times, International Financial Review Asia, and Dow Jones Financial News. Prior to joining Hedgeweek, James worked at JP Morgan Treasury & Securities Services as an in-house editor.

Romain Mangeret

Buy-Side Product Manager, Misys

Romain Mangeret is a Product Manager for Misys. His role is dedicated to Misys’ flagship solution for investment management, Sophis VALUE. Romain is responsible for all strategic and client driven developments across the front-office, risk management and operations management areas of the system. Romain holds an MSc in general engineering from L’Ecole Polytechnique and L’Ecole des Mines de Paris.

Can be contacted at: [email protected]

Edited by Jay Mukhey, Global Product Marketing, Misys

Jay would value any feedback on this white paper. Please send comments to: [email protected]