Manager Diversification in LDI Portfolios: Consume in Moderation


  • Pension plan sponsors running liability-driven investing (LDI) programs often hire several managers who span a range of investment styles and approaches.
  • However, manager diversification in LDI isn’t necessarily the proverbial “free lunch.”
  • In fact, depending on the number of managers and a sponsor’s access to top alpha producers, the opportunity cost in terms of foregone alpha cost may outweigh the benefits of diversification.
  • Empirical evidence suggests that beyond a certain number of managers, tracking error and alpha generation benefits are limited – chiefly because LDI manager rankings tend to be stable over time.

Diversification is a widely accepted concept in investing. Whether it’s asset classes, geographies, styles, or factors, it is often regarded as the proverbial “free lunch.” Yet one type of diversification that deserves a bit more scrutiny is diversification of liability-driven investing (LDI) manager lineups. Developing a complete understanding of the potential benefits and trade-offs associated with expanding the LDI manager roster is critical because LDI alpha is a finite resource and paramount for plan sponsors seeking to reduce risk in their plans. The ultimate question is whether the potential advantages of amplified diversification outweigh the costs or vice versa. Our analysis provides some surprising insights.

Manager diversification trade-off

As they continued to increase LDI allocations over the last several years, many pensions have sought to significantly diversify their roster of active LDI managers in the name of blending investment styles and smoothing tracking error. Most understand and accept that they are likely to give up a certain amount of return or alpha. Some managers in the roster will inevitably perform better than others. So if the plan were to concentrate its allocations with the better-performing managers, returns and alpha would likely be better.

However, plan sponsors are often willing to increase manager diversification and incur this opportunity cost for the following reasons:

  1. They believe they will meaningfully reduce the risk of underperformance and smooth out alpha outcomes or volatility (or, in other words, reduce the tracking error of the actively managed LDI portfolio) over time.
  2. They are uncertain which managers will perform best in the upcoming cycle and therefore have the perception that a more concentrated approach may not lead to higher alpha.

To properly assess whether additional manager diversification is advisable, a plan sponsor needs to be able to quantify the risk-return (or cost-benefit) trade-off. Said differently, how does the magnitude of the potential alpha left on the table compare to the risk and volatility reduction offered by further manager diversification?