FIAP International portfolio diversification for pension funds

1. FIAP International portfolio diversification for pension funds Marlies van Boom AEGON Asset Management Head of Investment Solutions May 2009

3. Outline • International diversification • Literature • Example • Life Cycle Investing • Looking Forward

4. Literature International Diversification improves risk-return profile • Markowitz (1959) • Solnik (1974) • Sercu (1980) • Adler and Dumas (1983) But, most literature focusses on developed equity markets. Does this also hold for an emerging market investor?

5. Emerging Markets point of view Facts from research: • All investors tend to have a home bias • French and Poterba (1991), Kho, Stulz and Warnock (2006) • Emerging markets are less integrated with developed markets • Bekaert & Harvey (1995) • Higher expected returns in emerging markets • DeRoon, De Goeij and Pungulescu (2009) Does an EM-investor still benefit from diversification? ?

6. Example Let’s take the view of a investor of emerging Europe (e.g. Poland) with a defined contribution pension plan. He can choose to invest in: • Emerging Europe bonds and equities (2 assets) • Both Emerging, European and World bonds and equities (6 assets) The table below shows the characteristics: All investment are measured in Polish Zloty, based on the sample period of January 1995- December 2006EM bonds is US-dollar denominated debt.

7. Mean Variance • The efficient frontier significantly moves to the left • Diversification doesn’t increase returns, but lowers risk

8. A B Mean Variance • What is the effect of lower risk? • Let’s compare to equal return portfolio’s: • A: 55% Em. Equities and 45% Em. Bonds • B: globally diversified portfolio

9. Wealth Accumulation • World basket has same expected result • Smaller bandwidths => risk reduction of 35% Using optimal portfolio’s characteristics and an inflow of 1000 PLZ per annum, net of fees

10. Outline • International diversification • Literature • Practical Example • Life Cycle Investing • Looking Forward

11. Life Cycle Investing Defined Contribution Pension The investor would like to change his investment style • Maturity > 20 years: maximum return • Maturity 10-20 years: risk-return in balance • Maturity < 10 years: a low risk profile However, Within emerging markets an investor cannot lower his risk profile, so one should invest in other markets as well.

12. Life Cycle • Over time switch to less risky portfolio (1->2->3) 1 2 3

13. Life Cycle & Diversification • Smaller bandwidths at the end of the spectrum • Risk reduction of 15% at end date

14. Life Cycle- Final Years • Fixed end date nears: • Focus on risk reduction • Risk reduction of 50%

15. 2008 Credit Crisis “Diversification did not work at all during the crisis” This is not entirely true. • Every risk asset sold off during crisis • But… developed market bonds are a safe haven • Emerging market currencies dampen the blow Even crises don’t change our results! NB. Similar results hold for other Emerging Markets and other crises.

16. Outline • International diversification • Literature • Practical Example • Life Cycle Investing • Looking forward

17. Looking Forward • DataOur example is based on a relatively short sample period, as reliable EM-data is not available • Low bond yieldsEmerging market bonds had the best performance in our example. However, bond yields are much lower nowadays, leading to lower expectedreturns. • GlobalizationEmerging markets have been less integrated with developed markets, but this changes over time. All important, but don’t change our conclusions!

18. Conclusions • Emerging markets (equity and bonds) • Delivered high returns • But with a very high volatility (credit crisis) • International diversification is essential • Leads to a lower risk profile • Especially convenient for DC-pension plans • Looking forward • Data, globalization and low bond yield play a role • Even strengthen need to diversify!

19. Diversification rules! AEGON Asset Management – Investment Solutions - Marlies van Boom