Dynamic Liability Driven Investing Using Black-Litterman

In Liability Driven Investing (LDI) the profile of future liabilities is an explicit component of the asset allocation process. Similarly, Assets and Liabilities Management (ALM) deals with mismatches between assets and liabilities in banking books. Since extreme events have become the rule in financial markets, the usefulness of an LDI approach is now more appreciated. In fact, in the recent past, portfolios of institutional investors, such as pension funds and insurance companies, have been significantly invested in risky assets which were unable to absorb the impact of unexpected changes in the risk factors driving liabilities. These allocations where based on the naïve assumptions that most investment strategies had to converge towards a constant-mix portfolio and that equities would always perform well in the long run. As observed by many, unlike Asset Allocation, both LDI and ALM do not refer to a robust theoretical body and practitioners must often employ ad hoc solutions in order to adjust investment decisions for the complex interactions between asset allocation and liability hedging.The purpose of this paper is to propose and test the effectiveness of an LDI recipe which uses as main ingredients the probability of the funding ratio exceeding one at maturity and the expected returns vector derived within a Black-Litterman framework. The empirical performance of the LDI strategy is tested (in absolute terms and, preliminarily, against a passive investment alternative) in turbulent markets where the LDI approach is expected to generate superior risk-adjusted returns