Liability-Driven and Index-Based Strategies

Why it's important:
Liability-Driven and Index-Based Strategies are crucial for CFA Level 3 candidates to understand as they are commonly used by institutional investors to manage risk and achieve specific investment objectives. These strategies are frequently tested on the Fixed Income section of the exam.

What it is:
Liability-Driven Investing (LDI) is a strategy that focuses on managing assets to meet specific liabilities, typically used by pension funds and insurance companies. The goal is to minimize the risk of not having sufficient assets to cover future liabilities.

Index-Based Strategies involve constructing portfolios that track a specific bond market index, such as the Bloomberg Barclays U.S. Aggregate Bond Index. These strategies aim to match the performance of the index while minimizing tracking error.

How it works:
LDI strategies involve analyzing the liabilities and constructing a portfolio of fixed income securities with cash flows that match the timing and amount of the liabilities. This is done through a combination of duration matching, cash flow matching, and immunization techniques.

Index-Based Strategies are implemented by investing in a portfolio of bonds that closely resembles the composition of the target index. This can be done through full replication (holding all securities in the index) or stratified sampling (holding a representative subset of the index).

Exam Tips: Answering Questions on Liability-Driven and Index-Based Strategies
1. Understand the key concepts and terminology related to LDI and Index-Based Strategies, such as duration matching, cash flow matching, immunization, tracking error, and stratified sampling.
2. Be familiar with the main reasons for using these strategies and the types of investors who commonly employ them.
3. Practice calculating key metrics, such as duration, convexity, and tracking error.
4. When answering questions, carefully read the question stem and identify the specific strategy being discussed (LDI or Index-Based).
5. Focus on the main objectives and constraints of the investor mentioned in the question, as these will guide your answer.
6. Show your work when performing calculations, as partial credit may be awarded for correct steps even if the final answer is incorrect.