Improved Risk Reporting with Factor-Based Diversification Measures

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

4. Empirical Analysis for Pension Funds

equities, real estate and other alternative investments. It follows two types of investment strategy: the CPP Reference Portfolio (CRP) and active investment management with value-added strategies. The CRP is a simple portfolio that invests in assets traded on public markets and is meant to insure the long-term 4.0% real rate of return while the value-added active investment portfolios use the CRP as a benchmark to access upward potential gains. Stichting Pensioenfonds Zorg en Welzjn (PFZW) which means “Pension Fund for Care and Wellbeing”, is a Dutch pension fund. It manages US$ 150,479 million at year-end 2011. PFZW is a non-profit company administered by PGGM, a cooperative of trade unions and employers working in healthcare and social sectors. PGGM’s portfolio is well balanced in terms of asset class diversification, investing around 20% of its portfolio in both domestic and international bonds, 20% in domestic and international equity and the rest in high-yield bonds, inflation-linked bonds, private equity, commodities, real estate, hedge funds and other alternative investments. California State Teachers (CalSTRS) is a pension plan that is part of the State of California’s Government Operations Agency and is meant to secure and manage the funds of educators. It is the largest educator-only pension fund in the world and managed US$ 139,534 million amount of assets at the end of 2011. It holds defined benefit and cash balance benefit programs. Like CalPERS, it is widely diversified in terms of asset classes. Even if it allocates more than 50% of its portfolio to international

and national equities, it also invests in fixed income securities (domestic only), high-yield, inflation-linked bonds, private equities, commodities and other alternative investments. We hand collect in Table 13 the allocations of these 10 funds using public information gathered from their official website, from their financial statements and from their comprehensive annual reports and compute, in Table 14, the ENC (top panel) measures and the ENB (bottom panel) measures at two different dates: 2007 and 2012. For the computation of the ENB, we use the MLT approach where the covariance matrix of the 10 risky benchmarks representing the asset classes is estimated using five years of historical daily returns before the date at which we perform the computation. We note that the two Dutch pension funds are by far the most diversified in terms of the ENC and ENB measures in 2007 and 2012 with ENC (ENB) values equal to 6.99 (5.05) for ABP and equal to 7.53 (4.95) for PFZW in 2012. Given that the maximum ENC is equal to the number of risky asset classes, that is 10 in this analysis, this shows that their asset allocation portfolio is closest, amongst all pension funds in the sample, to an equally-weighted scheme. On the other hand, the least diversified pension funds, both in terms of ENC and ENB, are KNPS (South Korea) and FRTIB (USA). They exhibit ENC (ENB) values below equal to 2.63 (3.05) for KNPS and 2.56 (3.56) for FRTIB in 2012, which shows that their allocation is very concentrated since they are exposed to only 2 to 3 asset classes (3 or 4 risk factors). It is worth noting that the ENC and ENB measures are consistent to determine the two most and least diversified pension funds among the

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An EDHEC-Risk Institute Publication