Improved Risk Reporting with Factor-Based Diversification Measures

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

4. Empirical Analysis for Pension Funds

8. Canada Pension Plan (Canada); 9. Stichting Pensioenfonds Zorg en Welzjn (Netherlands); 10.  California State Teachers (U.S.A.). The benchmarks we use are similar to the benchmarks used in the analysis of US pension funds, except for two main differences (see the list below for more details). First, they are specific to the country of origin of each pension plan in the case of domestic asset classes (fixed- income and equities). Secondly, we consider for each index the return series expressed in the six different currencies corresponding to the countries of origin for the pension funds in our sample, with a hedge against foreign exchange fluctuations. More specifically, we hedge each benchmark expressed in foreign currency by selling foreign currency exposure against the domestic currency at forward price. On the last business day of each month, the exposure in each foreign currency is sold forward with a one month maturity. When the forward contracts mature, the resulting net cash flow is reinvested in the unhedged benchmark. Domestic fixed income: We use the JP Morgan Government Bond Total Return Index for each of the following domestic markets: US, Canada, Europe, Japan, South Korea, and Norway; International/Global fixed income: We use the JP Morgan Global Aggregate Bond Index (JPM GABI); High-yield bond: We use the Bank of America Merrill Lynch Global High-yield Index (HW00); this index tracks the performance of USD, CAD, GBP and EUR denominated below investment-grade debt publicly issued in the major domestic or

eurobond markets; Inflation-linked bond: We use the Bank of America Merrill Lynch Global Government Inflationlinked Index; this index is a broad, market value weighted, capped total return index designed to measure the performance of inflation-linked sovereign debt that is publicly issued and denominated in the issuer’s own domestic market and currency; Domestic equity: We use the MSCI equity indices for each of the markets required in the analysis; International & Global equity: We use the MSCI All Country World where the aggregate return is the combination of each constituent’s return; Private equity: We use the S&P 600 small- cap benchmark; Real-estate: We use the MSCI All Country World Index Real Estate where the aggregate return is the combination of each constituent’s return; Commodity: We use the S&P GSCI Commodity Index; Mortgage: We choose the Bank of America Merrill Lynch US Mortgage Backed Securities Index (M0A0). Daily returns on all of these indices are collected over the 10 year period beginning on 28 June 2002, and ending on 28 June 2012 (see Section 4.3 for the detailed analysis). 4.2 Diversification Measures for the 1,000 Largest US Pension Funds We compute ENB using a PCA and ENB using an MLT, at the end of September 2002, at the end of September 2007 and at the end of September 2012. In order to estimate the covariance matrix between the different asset classes, we use five years of

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