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

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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

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

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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

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)

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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

(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