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STRATEGY

Learn from the pros: Build your own liability-hedged portfolio Add to ...

Caroline Cakebread is editor of Canadian Investment Review and Chatelaine magazine's money expert. Follow her on @ccakebread.

If you go back 20 years, you’d see that institutional investing was all about the pursuit of outsized returns. Pension funds, big and small, carried unusually high levels of exposure to stock markets and, for a few years, they benefited handsomely.

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Until stocks let them down – twice. Once, as the tech bubble imploded in 2000, and again, as the global economy faltered during the 2008 financial crisis.

Some of Canada’s biggest defined-benefit pension funds saw headline-hitting losses: The Ontario Teachers’ Pension Plan, to name one, saw its assets drop over 18 per cent in 2008.

Never again, said pension managers. They began to rethink the way they invest. Their goal? To reduce risk and ensure they can meet their liabilities, no matter what happens. Rather than focusing on spectacular returns, they now concentrate on matching their holdings to their future obligations.

Many of us could benefit from a similar approach in our personal portfolios. We might not have billions of dollars to invest, but we can structure our investments to create a better match between our current holdings and our future needs, from helping to put our kids through school to achieving a comfortable retirement.

Pension fund managers call this liability-driven investment. It starts by drawing up a list of the money you will need down the road and then figuring out the best way to get there with the minimum amount of risk.

To achieve this goal, many pension funds are stepping off the stock market roller-coaster and choosing alternatives that generate less volatile returns – assets such as bonds, real estate and infrastructure. Several are also taking a two-part approach to investing. They will build a liability-hedged portfolio to meet future obligations and a return-seeking portfolio that focuses on finding opportunities in riskier areas.

Here’s what all of us can learn from what the pros are doing:

 

Understand your liabilities. How much money will you need, and when, to achieve your major life goals? Rather than simply hoping that things will work out, you should ponder the magnitude and timing of your future liabilities, from paying kids’ tuition to buying a bigger house to funding your retirement.

 

Separate wants from needs. At first, the size of your liabilities may seem daunting. So focus on what you will absolutely need to have in the future, and separate that from what you would like to have.

Enough cash flow to cover basic retirement expenses for food and shelter is a must-have. Travel, a vacation home and other luxuries are nice-to-haves.

In some areas, priorities will vary: For many of us, it’s a necessity to have enough cash to give our kids a good start on higher education. Not all of us, though, feel obliged to pay the entire bill for sending our kids away from home to an expensive university for four years.

 

Create your own liability-hedged portfolio. Now it’s time to create your own liability-hedged portfolio. Tot up how much cash flow you will need to achieve your must-haves.

If you’re on the verge of retirement, you may want to consider putting a portion of your portfolio into bonds or annuities that can pay out exactly what you need every month, when you need it, no matter where interest rates or stock prices go.

If you’re further away from your goal, the important thing is to assess how much it will cost to achieve your must-haves and put enough of your portfolio into low-risk investments to meet that goal.

Create your own return-seeking portfolio. Many of us will have some part of our portfolio left over after taking care of our major liabilities. Use this remainder to seek larger returns elsewhere. Risk taken here (and resulting volatility) won’t bite into your ability to meet your basic living costs. Any gains will help you live the dream in retirement.

 

Change it up as you age. As you approach your savings goal, your need to take risk will shrink. If you are 10 or so years away from retirement, or if your job security is on the shaky side, consider emphasizing low-risk assets such as bonds so that you have cash on hand in case you need it.

Liability-driven investing is really about identifying your future obligations and taking on only enough risk to meet them. Until bond yields revert to more customary levels, it will be necessary to take some risk – but by paying attention to your liabilities, you can make sure you’re not risking more than you need to.

 

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