Article Detail

Liability Index Fund: The Liability Beta Portfolio

Journal 33: Technical Finance

Ronald J. Ryan, Frank J. Fabozzi

Historically, the practice of trustees of defined benefit programs has been to make the asset allocation decision based on prevailing risk-return relationship for asset classes without regard to the plan’s economic funded ratio, liability structure, and liability economic growth rate. Once the asset allocation decision is made, the market index that best represents that asset class is selected as the performance benchmark.

Ignoring the liability structure has been the major reason for the failure of both private and public pension funds to achieve their true objective of funding the liability benefit payment schedule at a stable and low cost to the plan sponsor. For trustees to properly manage pension assets in light of the true objective, they need a liability index customized to the fund’s unique benefit payment schedule. In this article, we explain how this should be accomplished and how Alpha and Beta portfolios should be redefined in order to work in harmony with the plan’s true objective.

In the 2004 Olympic Games in Athens, Matt Emmons of the U.S. was in the final round of a rifle shooting event. In this event, his score was so far ahead of his competitors that all he had to do was just hit the target and he would win the gold. Well, he hit a target, but he did not win the gold. In fact, he was placed eighth. What went wrong? He hit the wrong target on his last shot. That is what happens in life: hit the wrong target and your goals may not be achieved, a principle that corporate plan sponsors of defined benefit plans would be advised to remember when establishing investment policy.

In the late 1990s, most corporate pension funds had large surpluses with funded ratios above 130 percent. All corporate plan sponsors had to do was to match liabilities with a bond immunization-type strategy to secure this funding victory long term (i.e., no unfunded liability, no contribution costs, no pension expense, and little volatility for the funded ratio). Instead, plan sponsors in consultation with their financial advisors moved ever more aggressively away from bonds and into equities. In a span of three years, 2000 through 2002, most equity positions underperformed the plans’ liability growth by over 60 percent, sending funded ratios to an unfunded position and causing contribution costs to spike upward. This trend continued throughout the decade of 2000 and led to an unfunded liability position of over U.S. $3 trillion.1

Index funds
Index funds are quite popular in America but liability index funds are not common. Given that the objective of most institutions and individuals is to fund some type of liability schedule, liability index funds should be a core investment. A liability index fund has all the benefits of an index fund plus valuable features no other index fund can have. An index fund or Beta portfolio by definition is supposed to match or duplicate the risk/ reward of an index objective at a low tracking error.

Index funds became increasingly attractive due to four factors. First was the ability to purchase in one transaction (i.e., mutual fund or exchangetraded fund) a diversified portfolio that captured the efficiency of the market. Second, low to no tracking error versus the target index benchmark could be achieved. Third, the payment of lower fees for asset management services than imposed by active managers. Finally, realization of consistent performance versus an index objective compared to the variation in performance by active managers.

The well-documented difficulty of active managers to consistently outperform indexes (especially after fees) has led to index funds taking up an increasingly larger proportion of the overall assets or even becoming a core investment for many institutional and even retail investors in the last two decades. Some of the largest mutual funds consistently tend to be index funds (i.e., Vanguard’s VIMX, VTSMX, and VFIAX). According to the Lipper rankings, the S&P 500 (SPDR) exchange-traded fund (ETF) would be ranked as the largest equity mutual fund and the third largest mutual fund. In the last 20 years, ETFs have grown significantly to over U.S. $1 trillion in assets and over 1,000 index fund products. Not included in these statistics are “closet” index funds that do not want the label of indexing (in order to charge higher fees for supposedly active management) but tend not to stray far away from the key characteristics and statistics comprising the index objective (i.e., weightings, sector stratification, yields, modified duration, ratings, etc.).


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