Two-portfolio Approach
The two-portfolio approach, also known as the hedging and return seeking approach, is an approach to liability-relative asset allocation. It is one of three commonly used approaches. The other two approaches are surplus optimization and integrated asset-liability approach.
Liability-relative asset allocation approaches take into account the fact that the asset investment portfolio will be used to generate cash flows to repay a liability. This approach is mainly used by institutional investors such as pension funds, insurance companies, and banks.
On this page, we discuss how the approach works as well as the main limitations of the approach.
Two-portfolio approach definition
Conceptually, the two-portfolio approach is a straight-forward approach. We create an asset portfolio that hedges the liabilities and the remainder is managed independently using mean-variance optimisation. MVO is used to maximize utility and identify the optimal risk-return tradeoff.
The hedging portfolio can be created using cash-flow matching, duration matching and immunization. The hedging and return seeking approach is most commonly used for insurance companies and overfunded pension plans that want to minimize the risk of underfunding.
Two-portfolio approach modifications
This approach can be modified by:
- only partially hedging the liabilities and allocating more capital to the return-seeking portfolio
- increasing the allocation to the hedging portfolio as the funding ratio and the surplus increase.
Both of these approaches are more aggressive than completely hedging the liabilities, as they trade off higher expected return for higher risk.
Limitations
There are two limitations to the hedging and return seeking approach:
- If the funding ratio is less than one, it’s difficult to create a hedging portfolio that completely hedges the liabilities
- A hedging portfolio may not be available to hedge certain kinds of risk (like earthquakes)
Summary
We discussed the two-portfolio or hedging and return-seeking approach. This approach is one of three approaches that can be used to manage a liability-relative asset allocation.