Coming Up Short: Managing Underfunded Portfolios in a LDI-ES Framework
23 Pages Posted: 20 Feb 2014
Date Written: January 31, 2014
We employ a liability directed investment (LDI) rebalancing framework based on expected shortfall (ES), which we refer to as LDI-ES, to prescribe remedies for an underfunded portfolio. Investors in the LDI-ES framework face a risky asset, such as a stock index, and a risk-free bond. They begin with some level of current wealth and set their target wealth at the end of N periods, and their tolerance for shortfalls from that target wealth. Portfolio rebalancing in the LDI-ES framework is contrasted with common fixed-proportions rebalancing, where portfolio allocations are rebalanced to ratios, such as 60:40, at the beginning of each of N periods. We consider critical issues of underfunding, where there is no portfolio that can meet the shortfall constraint, and we explore the effectiveness of (a) portfolio infusions in resolving underfunded situations, relative to other measures such as (b) increasing risk, (c) cutting back on target liabilities/goals, and (d) extending portfolio horizon.
Keywords: Liability directed investing; behavioral portfolio theory; expected shortfall; re-balancing; infusions
JEL Classification: G02; G11; G23
Suggested Citation: Suggested Citation