NEW PERSPECTIVES ON INSTITUTIONAL INVESTING ICPM Discussion Forum June 2008 Dirk Broeders

1. 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

2. Overview presentation • Introduction • Data • Results • Conclusions

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

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!

5. Stock Market Performance Strategic asset Market timing Rebalancing allocation Equity Allocation Stock market performance and equity allocation

6. 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

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)

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

9. Summary statistics

10. ‘Eye ball test’ (1): Actual investments

11. ‘Eye ball test’ (2): Strategic investment policy

12. 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

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 fundiat time t is regressed on • Excess return on equities previous quarter (up to 5 lags) • Investment policy • Pension fund size

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

15. (1) Stock market returns and equity investments

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)

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

18. (2) Stock market returns and rebalancing

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

20. (2) Difference between positive and negative equity market shock

21. 3. Medium term adjustments to strategic asset allocation • We run a model in which the strategic equity weight for pension fundiat time t is regressed on • Excess return on equities previous year • Investment policy • Pension fund size

22. (3) Stock market returns and strategic equity allocation

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

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

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

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