stock market performance and pension fund investment policy:
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Stock market performance and
pension fund investment policy:
Rebalancing, free float, or market timing?
NEW PERSPECTIVES ON INSTITUTIONAL INVESTING
ICPM Discussion Forum June 2008
Dirk BroedersDe Nederlandsche Bank
Joint work with Jacob Bikker and Jan de Dreu
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Overview presentation
I. IntroductionII. DataIII. ResultsIV. Conclusions
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I. Introduction
• Strategic Asset Allocation is based upon ALM studies using
• Long-term expected returns
• Return (co)variances of broad asset classes and liabilities
• Actual (or tactical) asset allocation is based upon
• Short term return expectations
• Maximum tracking error
• We observe large short-term variation in actual and strategic equity allocation due to relative stock market performance
• Paper studies interaction between stock market performance
and equity allocation
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Potential return from market timing
• Fundamental law of active management
• If investor makes quarterly decisions breadth = 4• To earn 50 basis points excess return per extra
unit of risk (i.c. an information ratio of 0.5) requires an information coefficient of 0.25
• To achieve an IC of 0.25 one needs to predict the stock market direction correctly about 63 out of 100 times!
breadthICIR *
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Stock market performance and equity allocation
Strategic asset allocation
Stock Market Performance
Equity Allocation
Market timing
Rebalancing
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Preview to findings
• Relative stock market performance influences the asset allocation of pension funds in two ways:1. In the short term as a result of imperfect rebalancing
• Free floating (passive management)
• Market timing (active management)
2. In the medium term as a result of adjustments to the
strategic asset allocation
• On average, changes in asset allocations over time have not generated additional returns
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II. Data
• Dataset contains information on • Strategic asset allocation
• Asset sales and purchases
• Market value of investments in different asset classes
• Time weighted returns
• Benchmarks indices• MSCI World index, AEX (stocks)
• JP Morgan EMU (bonds)
• FTSE EPRA Netherlands (real estate)
• 3-month Euribor (money market instruments)
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Data (cont.)
• Period 1999:QI – 2006:QIV (8 years or 32 quarters)
• 748 pension funds• Unbalanced panel• Source DNB• Source benchmarks Thomson Financial
Datastream
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Summary statistics
Number of pension funds
Average total investments
(mln euro)Average equity
investments (%)
Max - min equity investments
over time (%)
0-100 (Small) 524 29 29 18100-1000 (Medium) 177 320 37 18>1000 (Large) 47 8276 43 16Average / total 748 799 42 16
Type of pension fund**
Industry (all) 94 3819 41 14Company 528 306 43 20Professional group 10 2292 42 18
Total investments (mln euro)
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‘Eye ball test’ (1): Actual investments
30
32
34
36
38
40
42
44
46
48
50
1999
:Q1
1999
:Q3
2000
:Q1
2000
:Q3
2001
:Q1
2001
:Q3
2002
:Q1
2002
:Q3
2003
:Q1
2003
:Q3
2004
:Q1
2004
:Q3
2005
:Q1
2005
:Q3
2006
:Q1
2006
:Q3
Port
foli
o in
vest
men
ts in
equ
ity
(%)
60
80
100
120
140
MSC
I W
orld
inde
x
Equity investments (%) MSCI World index
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‘Eye ball test’ (2): Strategic investment policy
30
32
34
36
38
40
42
44
46
48
50
1999
:Q1
1999
:Q3
2000
:Q1
2000
:Q3
2001
:Q1
2001
:Q3
2002
:Q1
2002
:Q3
2003
:Q1
2003
:Q3
2004
:Q1
2004
:Q3
2005
:Q1
2005
:Q3
2006
:Q1
2006
:Q3
Por
tfol
io i
nves
tmen
ts i
n eq
uity
(%
)
60
80
100
120
140
MS
CI
Wor
ld i
ndex
Equity investment policy (%) MSCI World index
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III. Results
We run four different tests1. Short-term impact of stock market performance on equity
allocation
2. Short-term effect can be subdivided in rebalancing and
free floating
3. Medium term adjustments to strategic asset allocation
4. The contribution of market timing on overall return
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1. Short-term impact of stock market performance on equity allocation
• We run a model in which the equity weight (wi,t) for pension fund i at time t is regressed on• Excess return on equities previous quarter (up to 5 lags)
• Investment policy
• Pension fund size
titijtiT
jtiE
jtijjti SizePolicyReturnReturnw ,1,1,1,,5
01,
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(1) What would we expect?
• Suppose a pension fund invests 40% in equities
• After a 1% excess return on equities the weight will be
40.0100
40
%24.404.100
4.40
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(1) Stock market returns and equity investments
Full sample Small funds
Medium sized funds Large funds
(2) (3) (4) (5)
Excess equity returns 0.163 *** 0.144 *** 0.196 *** 0.260 ***Excess equity returns(t-1) 0.114 *** 0.103 *** 0.134 *** 0.139 ***Excess equity returns(t-2) 0.083 *** 0.071 *** 0.101 *** 0.138 ***Excess equity returns(t-3) 0.060 *** 0.051 *** 0.079 *** 0.079 ***Excess equity returns(t-4) 0.058 *** 0.053 *** 0.065 *** 0.111 ***Excess equity returns(t-5) 0.047 *** 0.044 *** 0.056 *** 0.060 ***Policy investment(t-1) 0.918 *** 0.933 *** 0.892 *** 0.869 ***Size(t-1) 0.002 *** 0.003 *** -0.002 0.005 ***Intercept 0.010 *** -0.002 0.068 *** -0.019Number of observations 14216 8601 4330 1285
R2 adjusted 0.88 0.87 0.85 0.86
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(1) Results
• 1 percent relative outperformance of equities to an increase in equity allocation of 0.16 percentage point in the subsequent quarter
• Excess equity returns have a significant impact on equity allocations up to 5 quarters later
• The impact for large pension funds is almost twice the impact for small funds (0.260/0.144)
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2. Short-term effect can be subdivided in rebalancing and free floating
• The previous result can be subdivided in• The percentage free floating (or market timing) and
equivalently
• The percentage rebalancing
• Also we distinguish between positive and negative excess returns
• Furthermore we analyze differences between small, medium sized and large pension funds
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(2) Stock market returns and rebalancing
Full sample
Full sample
(2) (3)
Excess equity returns 0.613 ***Positive excess equity returns 0.878 ***Negative excess equity returns 0.506 **Change in strategic equity allocation(t-1)0.074 *** 0.075 ***Intercept 0.012 *** 0.003Observations 11867 11867
R2
0.19 0.20
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(2) Results
• Pension funds rebalance 39 percent of excess equity returns; free float is around 61 percent• 61 percent of excess returns increases the equity
allocation in next quarter
• Rebalancing is asymmetric• Only 12 percent of positive equity returns are rebalanced
• While 49 percent of negative equity returns are rebalanced
• Large pension funds tend to ‘overshoot’• In a booming stock market they increase their equity
allocation even more then full free floating
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(2) Difference between positive and negative equity market shock
-30
-20
-10
0
10
20
30
-30 -25 -20 -15 -10 -5 0 5 10 15 20 25 30
Excess equity return (%)
Cha
nge
in e
quit
y al
loca
tion
(%
)
Free float
Free float
Rebalancing
Rebalancing
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3. Medium term adjustments to strategic asset allocation
• We run a model in which the strategic equity weight for pension fund i at time t is regressed on• Excess return on equities previous year
• Investment policy
• Pension fund size
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(3) Stock market returns and strategic equity allocation
Full sample(1)
Equity investment policy (t-1) 0.966 ***Yearly excess equity return MSCI 0.010 ***Yearly excess equity return pension fundSize(t-1) 0.001 ***Intercept 0.001Number of observations 16340
R2 adjusted 0.95
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(3) Results
• 1 percent relative outperformance of the MSCI in the past year leads to an increase in strategic equity allocation of 0.01 percentage point in the next quarter
• Strategic equity allocation is higher for large pension funds
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4. The contribution of market timing on overall return
• The contribution of market timing to overall return is subdivided in three components• Excess return from varying the strategic asset allocation
over time
• Excess return from varying the actual asset allocation over
time
• Excess return from deviating the actual from the strategic
asset allocation
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(4) Results
• The variation of actual and strategic equity allocation does not generate extra returns • The average loss is 24 basis points per annum for the
strategic asset allocation
• The average loss is 20 basis points per annum for the
actual asset allocation
• Pension funds have gained 5 basis points per annum from the difference between actual and strategic asset allocation
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IV. Conclusions
• Pension fund asset allocation is significantly driven by short term stock market performance
• Pension funds do not automatically sell equities in rising markets but are more willing to buy equities after stock market corrections
• Overall market timing does not add value