FIAP International portfolio diversification for pension funds

Marlies van Boom

AEGON Asset ManagementHead of Investment Solutions

May 2009

2

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?

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 marketsBekaert & 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:

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.

7

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

8

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

9

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)

10

Outline

International diversification Literature

Practical Example

Life Cycle Investing

Looking Forward

11

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.

12

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%

13

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

14

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

15

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

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!

0

10

20

30

dec-

90

dec-

91

dec-

92

dec-

93

dec-

94

dec-

95

dec-

96

dec-

97

dec-

98

dec-

99

dec-

00

dec-

01

dec-

02

dec-

03

dec-

04

dec-

05

dec-

06

dec-

07

dec-

08

US interest rate EM Europe interest rate

18

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!

19

Diversification rules!

AEGON Asset Management – Investment Solutions - Marlies van Boom