What proportion of
shares should be held
in a long-term portfolio
?
BUY-AND-HOLD PORTFOLIO MANAGEMENT VERSUS DYNAMIC
PORTFOLIO MANAGEMENT
The asset allocation of institutional long-term investors varies
according to the changing expectations of returns along the cycle.
It should take into account the signals statistically correlated with
future returns. These investors should have a relatively higher
exposure to systematic short-term risk.
OEE Partners
ISSUES AT STAKE
After the financial crisis of 2008, many pension funds and long-term investors
have lowered their exposure to equity. Were they right?
Eric Jondeau
(Lausanne University)
Michael Rockinger
(Lausanne University)
Olivier Garnier
(Société Générale)
Two researchers from the University of
Lausanne, Eric Jondeau and Michael
Rockinger, compared the long-term
investment strategies in two models
- static or buy-and-hold and dynamic
- for ten European countries (United
Kingdom, Germany, Spain, France,
Sweden, Italy, Switzerland, Denmark,
Netherlands and Norway) from 1975
to 2008. In the dynamic model, they
take into account the economic situation and the predictive nature of
certain indicators to vary the share of
equities in a portfolio over time.
Models built by E. Jondeau and
M. Rockinger test five predictors of
stock returns: short-term interest rate,
long-term interest rate (government
bonds), the spread of short- / longterm interest rates, the dividend/share
price ratio and the annual inflation
rate. Among these variables, the dividend/share price ratio and the annual
inflation rate are the most critical in
predicting equity returns, which positively correlated with the ratio dividend/price and negatively correlated
with the annual inflation rate.
While econometric models used to
predict returns show low performance
in the short-term, returns are still predictable in the long-term:
• In the case of the United Kingdom,
estimations over the period January
1975 - December 2004 predicted the
“right sign“ of performance in 59%
of cases and the “right change“ of
performance in 51% of cases.
• In the case of France, these values are 64% and 36%.
The authors then show that this predictability (though limited) of equity
returns has a significant effect on the
optimal portfolio, because in the
long-term, equities have a higher
profitability than bonds.
An optimal dynamic allocation
strategy should include a higher
proportion of shares than suggested by a static buy-and-hold
allocation type. Indeed, due to the
phenomenon of “mean reversion“
of returns, stocks are less risky in the
long-term than in the short-term.
While the model finds an “optimal“
proportion of shares in the portfolio of long-term investors (10 years)
equal to 40-50% in a buy-and-hold
static portfolio, the dynamic allocation model concludes that the
optimal proportion is 60-70% (depending on the country) even when
considering the uncertainty of the
estimated parameters.
On the occasion of a seminar organized by the OEE on this study,
Olivier Garnier, Chief Economist at
Société Générale, presented three
observations that would require further research, taking into account
the experience of the financial crisis
of 2008:
Lessons
for investors
Strategic asset allocation should
be reviewed over time to take
into account the macro-economic situation and implement good “market timing“.
Lessons for
regulators
• An investor must take into account extreme risks, which have a
low probability but high impact.
Prudential regulations should
take into account the phenomena of “mean reversion“ to
weigh the capital requirements
related to the holding of each
asset class.
• It is necessary to analyze the risk
of each asset class; the equity risk
decreases relative to bonds over
time.
Research done for the OEE
• The different asset classes (equities, bonds) have experienced in the
past, alternatively or simultaneously,
long periods of gains or losses. The
dynamic investment strategy should
take into account these cycles of valuation.
Eric Jondeau & Michael
Rockinger,“Portfolio Allocation
for European Markets with
Predictability and Parameter
Uncertainty“, August 2009
Olivier Garnier, “La crise a-t-elle
remis en cause l’investissement
à long terme en actions ?“,
Presentation at a conference
organised by the OEE, January
2010