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FIAP International portfolio diversification for pension funds
Marlies van Boom
AEGON Asset ManagementHead of Investment Solutions
May 2009
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3
Outline
International diversification Literature
Example
Life Cycle Investing
Looking Forward
4
Literature
International Diversification improves risk-return profileMarkowitz (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?
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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 marketsBekaert & Harvey (1995)
Higher expected returns in emerging markets DeRoon, De Goeij and Pungulescu (2009)
Does an EM-investor still benefit from diversification?
?
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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:
monthly EM EUR EUR World EM EUR EUR Worldmax 14.3% 10.1% 10.5% 14.0% 12.3% 11.8%min -20.3% -14.0% -11.2% -44.6% -5.5% -9.0%avg. ret 1.1% 1.3% 1.0% 1.7% 0.8% 0.7%volatility 5.9% 4.0% 4.4% 6.2% 3.1% 3.6%AnnualizedReturn 13.6% 15.4% 11.5% 20.8% 9.5% 8.6%Volatility 20.5% 14.0% 15.2% 21.4% 10.8% 12.4%
Equity Bonds
All investment are measured in Polish Zloty, based on the sample period of January 1995- December 2006EM bonds is US-dollar denominated debt.
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Mean Variance
The efficient frontier significantly moves to the leftDiversification doesn’t increase returns, but lowers risk
Efficient Frontier
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
0% 5% 10% 15% 20% 25%risk
Expecte
d R
etu
rn
Emerging Europe World Diversified
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Mean Variance
Efficient Frontier
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
0% 5% 10% 15% 20% 25%
risk
Expe
cted
Ret
urn
AB
What is the effect of lower risk?
Let’s compare to equal return portfolio’s:A: 55% Em. Equities and 45% Em. BondsB: globally diversified portfolio
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Wealth Accumulation
World basket has same expected resultSmaller bandwidths => risk reduction of 35%
Using optimal portfolio’s characteristics and an inflow of 1000 PLZ per annum, net of fees
Constant Portfolio - Accumulation of Wealth
1,000
10,000
100,000
1,000,000
10,000,000
100,000,000
1 3 5 7 9
11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 time
wea
lth
Emerging Markets (A) World (B)
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Outline
International diversification Literature
Practical Example
Life Cycle Investing
Looking Forward
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Efficient Frontier
0%
5%
10%
15%
20%
25%
0% 5% 10% 15% 20% 25%risk
Exp
ect
ed
Retu
rn
Life Cycle Investing
Defined Contribution Pension
The investor would like to change his investment styleMaturity > 20 years: maximum returnMaturity 10-20 years: risk-return in balanceMaturity < 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.
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Efficient Frontier
0%
5%
10%
15%
20%
25%
0% 5% 10% 15% 20% 25%risk
Exp
ect
ed
Re
turn
Life Cycle
Over time switch to less risky portfolio (1->2->3)
1
2
3
World EmergingPortfolio 1 2 3 1 2 3Return 20.1% 16.8% 13.0% 20.1% 16.8% 13.0%Risk 19.0% 10.2% 5.9% 20.6% 18.6% 12.5%
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Life Cycle & Diversification
Smaller bandwidths at the end of the spectrumRisk reduction of 15% at end date
Life Cycle - Accumulation of Wealth
1,000
10,000
100,000
1,000,000
10,000,000
1 3 5 7 9
11
13
15
17
19
21
23
25
27
29
31
33
35
37
39 time
wealt
h
Emerging Markets World
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Life Cycle- Final Years
Fixed end date nears: Focus on risk reduction
Risk reduction of 50%
Life Cylce- Final 10Y
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
3,500,000
4,000,000
4,500,000
5,000,000
25 30 35 40Time
Accu
mu
late
d W
ealt
h
World Low Risk EM Low Risk
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2008 Credit Crisis
“Diversification did not work at all during the crisis”This is not entirely true.
Every risk asset sold off during crisisBut… developed market bonds are a safe havenEmerging market currencies dampen the blow
Even crises don’t change our results!
NB. Similar results hold for other Emerging Markets and other crises.
in USD in PLZEquities EM Europe -56% -42%
Europe -36% -16%US/ Rest of World -32% -11%
Bonds EM Europe Bonds (US$ denominated) -15% 10%Europe 11% 37%US/ Rest of World 16% 51%
Returns during the credit crisis: September - December 2008
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Outline
International diversification Literature
Practical Example
Life Cycle Investing
Looking forward
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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!
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US interest rate EM Europe interest rate
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Conclusions
Emerging markets (equity and bonds)Delivered high returns
But with a very high volatility (credit crisis)
International diversification is essentialLeads to a lower risk profile
Especially convenient for DC-pension plans
Looking forwardData, globalization and low bond yield play a role
Even strengthen need to diversify!
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Diversification rules!
AEGON Asset Management – Investment Solutions - Marlies van Boom
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