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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
Page 2
Overview presentation
I. IntroductionII. DataIII. ResultsIV. Conclusions
Page 3
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
Page 4
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 *
Page 5
Stock market performance and equity allocation
Strategic asset allocation
Stock Market Performance
Equity Allocation
Market timing
Rebalancing
Page 6
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
Page 7
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)
Page 8
Data (cont.)
• Period 1999:QI – 2006:QIV (8 years or 32 quarters)
• 748 pension funds• Unbalanced panel• Source DNB• Source benchmarks Thomson Financial
Datastream
Page 9
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)
Page 10
‘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
Page 11
‘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
Page 12
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
Page 13
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,
Page 14
(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
Page 15
(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
Page 16
(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)
Page 17
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
Page 18
(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
Page 19
(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
(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
Page 21
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
Page 22
(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
Page 23
(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
Page 24
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
Page 25
(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
Page 26
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