Improved Risk Reporting with Factor-Based Diversification Measures

Improved Risk Reporting with Factor-Based Diversification Measures — February 2014

4. Empirical Analysis for Pension Funds

is also negative for the ENC. This means that, all weights remaining equal in 2007, the pension funds that performed over -5% (respectively over -20%) between 28/09/2007 and 26/09/2008 (respectively between 05/09/2008 and 27/02/2009) were more likely to perform better than other pension funds from the same sample if they were less diversified in terms of uncorrelated risk factors than these other pension funds. Indeed, we can clearly see in Figure 13 and in Figure 14 that there is a negative relationship between the performances that are over the thresholds and their ENB. We also see that, among the pension funds that performed above the threshold (-5% or -20%), the slopes of the linear relationship between the ENC measure and the funds’ performances are much steeper than the slopes obtained with ENB. One may wonder which asset classes these pension funds were invested in during the subprime crisis in order to be able to limit the losses even though the funds showed lower levels of diversification. In Figure 15, we display the charts representing the average asset allocation of the pension funds that perform under and over -5% during 28/09/2007-26/09/2008 and under and over -20% during 05/09/2008- 27/02/2009. We clearly see that the pension funds that perform over the thresholds are the ones that allocate 80% to 85% on average to US bonds and almost nothing in the other asset classes. This explains the negative relationship between ENC/ ENB and annualised performances. These pension funds performed best during the two periods considered because they were fully invested in safe asset classes that resisted well during the crisis. Indeed, we see in Table 12 that fixed income asset

classes are among the classes of assets that suffered the least during the two periods considered. They made positive returns during 28/09/2007-26/09/2008 and above -0.5% during 05/09/2008-27/02/2009. These pension funds were very poorly diversified in terms of asset classes since their aim is not to diversify their portfolio so as to maximise their risk reward but it is to invest into a safe, low risk-rewarding asset class. In other words, they seem to maintain a focus on liability hedging, as opposed to performance generation. As a result, their strategy is to have a highly concentrated portfolio in the asset class that represents the best hedge for the liabilities. The opportunity cost of this exceedingly cautious strategy is of course prohibitive in terms of renouncement to the access of the risk premia on risky asset classes that is allowed by a well-diversified portfolio. 4.3 Diversification Measures for the World's 10 Largest Pension Funds In this section we analyse the policy portfolios held by the world's 10 largest pension funds (except for the Central Provident Fund (Singapore) and the Employees Provident Fund (Malaysia), which are replaced by PFZW (Netherlands) and California State Teachers (U.S.A.), as mentioned previously). These funds are very different from each other in terms of geographic location, portfolio investments, management strategies, structure and purposes, and we provide below a brief description of their mode of operations. Government Pension Investment Fund (GPIF) is a Japanese pension fund that managed US$ 1,394,873 million at year-end

48

An EDHEC-Risk Institute Publication