Pension funds are more likely to rebalance their portfolios following a market crash than after a period of strong equity returns, research has shown.
“To develop effective rebalancing rules on a pension fund level, special attention should be paid to external and active managers.”Though it is in the best interests of long-term investors to invest countercyclically—to sell assets that have performed better in the past and buy assets that have performed poorly—the average pension fund is only contrarian some of the time, according to Dennis Bams, Peter Schotman, and Mukul Tyagi of Maastricht University.
“They appear to be momentum-type investors when the stock market is doing well, and contrarian when it is doing poorly,” they wrote.
For the study, the trio analyzed the asset allocation behavior from 1990-2011 of 978 funds, including public and corporate pensions and some sovereign wealth funds, using data from CEM Benchmarking.
The research found that fund managers on average “strongly rebalance towards their long-term strategic allocations… to stabilize the risk-return profile of the pension fund.” However, rebalancing behavior was not consistent across market cycles.
Funds were found to rebalance 90% of the passive equity variation caused by falling markets, limiting the decline in their equity portfolios. However, when stocks outperformed, funds only rebalanced 62% of equity variation, taking on more risk rather than reverting to the original strategic allocation target.
“Pension funds tend to rebalance considerably less following a year with a good stock market performance,” the authors wrote. “This ‘moving with the market’ and behaving procylically can be detrimental both to their own performance and for the stability of the financial system.”
Asymmetric rebalancing behavior is partially caused by misalignment of interests with asset managers, argued Bams, Schotman, and Tyagi. Since manager compensation is generally determined by short-term performance, asset managers are “unlikely to tolerate temporary short-term losses for long-term gains.”
“Most of the passive change that is not rebalanced is attributed to externally managed equity,” they wrote. “To develop effective rebalancing rules on a pension fund level, special attention should be paid to external and active managers.”
Read the full report: Asset Allocation Dynamics of Pension Funds
Related: Investors Aren’t Countercyclical—But They Should Be