Stock market performance and pension fund investment policy: Rebalancing, free float, or market timi

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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 Broeders
• De Nederlandsche Bank
• Joint work with Jacob Bikker and Jan de Dreu

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Overview presentation

• Introduction
• Data
• Results
• 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!

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Stock market performance and equity allocation
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Preview to findings

• Relative stock market performance influences the
  asset allocation of pension funds in two ways
• In the short term as a result of imperfect
  rebalancing
• Free floating (passive management)
• Market timing (active management)
• 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 1999QI 2006QIV (8 years or 32
  quarters)
• 748 pension funds
• Unbalanced panel
• Source DNB
• Source benchmarks Thomson Financial Datastream

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Summary statistics
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Eye ball test (1) Actual investments
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Eye ball test (2) Strategic investment policy
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III. Results

• We run four different tests
• Short-term impact of stock market performance on
  equity allocation
• Short-term effect can be subdivided in
  rebalancing and free floating
• Medium term adjustments to strategic asset
  allocation
• 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

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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

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(1) Stock market returns and equity investments
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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
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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
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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
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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