Indexing Strategies in Liability-Driven Investing

Hard Liability-driven Strategies Indexing

In the context of liability-driven investing (LDI), a fixed income portfolio manager is evaluating a new indexing strategy to better match the duration and cash flow requirements of their client’s liabilities. The liabilities pertain to a defined benefit pension plan where the expected payouts are fixed and occur at specific future dates.

The manager is considering the effectiveness of a broad-based bond index versus a more bespoke bond index tailored specifically to the characteristics of the pension plan’s liabilities. Understanding that the primary goal is aligning the cash flows of the investment portfolio with the timing and amounts of the liabilities, the question revolves around the benefits and drawbacks of these two indexing approaches.

Which of the following statements most accurately reflects the appropriate use of these indexing strategies within a liability-driven investment framework?

A broad-based bond index is preferable as it provides greater diversification and lower tracking error compared to a tailored index.

A bespoke bond index is more suitable for liability-driven investing since it can be structured to replicate the timing and cash flows of the pension liabilities.

Both indexing approaches are equally effective as they ultimately achieve similar risk-return profiles.

Hint

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