Portfolio Asset Allocation. Exploring the Case for Continued Reliance on Financial Economic Models by Asset Managers

Master's Thesis, 2009
66 Pages



1. Introduction

2. Problem Statement

3. Pension Funds - Background

4. Research Objectives

5. Literature Review

6. Overview Etfs Industry

7. Research Design
7.1 Vanguard Group Inc

8. Portfolio Building
8.1 Step 1(Age)
8.2 Step 1(Asset Class)

9. Application Of Financial Economic Models
9.1 MPT
9.1 CAPM

10. Results
10.1 Priority Ranking Matrix
10.2 Pension Fund Portfolio

11. Interpretation And Analysis
11.1 Challenges & Critique
11.2 Future Perspective

12. Conclusion

13. Bibliography

14. Appendix
14.1 Interview
14.2 Description of Vanguard Index Funds & ETFs
14.3 List of Vanguard Passive Funds & ETFs
14.4 Regression Analysis Results


In this paper, I address the theme of asset allocation in a pension fund portfolio using passive index funds and exchange-traded funds (ETFs). To illustrate this, I have created five model portfolios according to CAPM (Capital Asset Pricing Model) and MPT (Modern Portfolio Theory) models. My results are interesting because one of the five portfolios comes on top of the rest as a suitable portfolio for the pension fund. Since many investors are not experts, they usually leave the responsibility of managing their asset portfolios to asset managers. And in order to attract as many investors as possible to their boutiques, asset managers will harp on about their superior portfolio returns that beat the market. To beat the market they incur transaction costs which lower returns for investors. Most investors have come to acknowledge that capital markets are efficient thus the idea about beating them is a false proposition. In the face of this reality, asset managers and investors have turned to passive investment strategies. I conclude that superior asset allocation and passive index investing through exchange-traded funds form a unique set of tools for pension fund investment managers.

KEYWORDS: asset allocation, CAPM, MPT, pension fund, passive index funds, ETF funds, passive strategies, active strategies



Ibrahim Mbithi

This thesis proposal is submitted in partial fulfillment of requirements toward a Master of Business Administration degree in International Business and Finance to the Graduate School of Schiller International University

Fall Semester 2009

Date of Submission: November 10, 2009

Heidelberg Campus 2009


The writing of this thesis would not have been possible without the support of a few people. I am deeply in debt to Dr. Harvey Utech, my professor at Schiller International University, whose thought-provoking insights on managerial finance and accounting motivated me to write this thesis. I would also like to thank the Fund Managers from the Department of Equity Derivatives at Commerzbank who answered my questions on passive index investing and exchange-traded funds. In the same vein, I would also like to thank my personal friend Mr. Laziz Alidjanov of the Department of Fixed Incomes at Deka Investment Management for his encouragement throughout this enterprise. While they may not agree with all of the conclusions in this paper, they have strengthened my arguments in important ways.


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Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve.

-Talmud (c. 1200 BC-500 AD)

The idea about asset allocation is not new to the modern world. The quote above suggests that risk and diversification are old concepts – even 2000 years ago scholars of the day, such as Talmud preached wealth diversification and is considered to be the first acclaimed proponent of asset allocation[1]. The concept of diversification today is widely used by both institutional and private investors.

In today’s investment world, one could paraphrase Talmud’s advice into: “let every investor create a diversified portfolio that allocates one third to real estate investments, one third in common stocks, with the remaining one third allocated to bonds”. In designing an investment strategy for a portfolio, investors today have to make sure that they cover as many asset classes as possible[2]. One inference we could learn from Talmud’s investment advice is that the idea of risk and return as understood by merchants and investors of the old, is still comparable to the investing practices of today.

If we put Talmud’s advice into practice, we would see that such a portfolio would consist of two thirds equity investments and one third fixed income. In the words of investor Charles Schwab, one third allocated to fixed income investments would mitigate the risks inherent in the two thirds allocated to equity investments[3]. When you look at the overall picture, such a balanced portfolio leaning towards equities is appropriate for an investor with a longer investment horizon who is concerned about risk and return. Experienced investors understand that the most important decision in investment is the long-term mix of assets – how much in stocks, real estate, bonds or cash[4].

Investors are often looking for above average market returns which can only be achieved using active investment strategies. Consequently the integration of passive investments into investor portfolios has been slow. One primary reason is simply the knowledge gap. This paper begins by giving a brief outline of how institutional investors such as pension funds function, and examining the major strategic drivers of investors towards either passive or active investment strategies. It then examines how passive index funds and/ or Exchange-Traded Funds (I acknowledge similarities and differences between ETFs and passive index funds although henceforth I will use both terms interchangeably in contrast to mutual funds) invested in a pension fund portfolio for strategic and tactical reasons can reduce volatility to bring average risk adjusted returns. I also look at the modern argument for adding international equity exposure to investor’s portfolios, and then examine how much of diversification benefits achieved by these investments achieve are driven by the underlying non-US stocks.

A central theme in my thesis is the examination of asset allocation in pension funds[5] according to very well-known financial theories of Modern Portfolio Theory (MPT) and Capital Asset Pricing Model (CAPM). In my paper, the issue of asset allocation will be illustrated using five model portfolios of passive index funds being managed by an asset manager. The performance of each portfolio would be evaluated against a benchmark i.e. market portfolio[6]. Since the success of a portfolio is determined by the asset allocation process, I will make a recommendation of the most suitable portfolio for the pension fund[7].

The hypothetical investment advisor is expected to select the “right” portfolio for the pension fund with reasons. My paper is designed as an overview piece of institutional investing, discussing if theoretically and practically a pension fund could invest 100 percent of its resources in passive index funds or and ETFs. Whether they do so in practice, how would the portfolio returns look like and how could asset managers assist institutional investors to design investment strategies that could earn average market returns without extreme losses?


In recent times, asset managers have come increasingly under pressure from institutional investors who are looking for alpha i.e. rate of return above the market. In order to earn above average returns for investors, many portfolio managers have traditionally invested in mutual funds[8]. But what these asset managers and investors have ignored is a growing literature indicating that there is nothing like “above average returns”. The very active strategies which are trusted by asset managers have had an opposite effect of decreasing returns for many investors followed by eventual collapse of some portfolios in worst cases. The number of asset managers who have lost investors’ principal and interest amounts as they fleetingly chased after alpha returns is growing[9].

With growing evidence from studies indicating that markets are too efficient for anyone to beat, many investors are awakening to a reality that the active investment strategies practiced by portfolio managers are a major cause of their underperforming the market. Basically active investing incurs high transaction costs, which eat into portfolio margins. The investment landscape is slowly changing with some investors looking for investments that use the market as a frame of reference[10].

But how do you achieve average market returns? Thanks to index investing, there is a robust debate about the merits of actively and passively managed funds. Passive investment strategies are becoming popular among investors. This is one reason why smart asset managers are increasingly pursuing passive investment management strategies exemplified by passive index funds instead of cost-laden mutual funds. Many institutional investors are realizing that passive investment strategies are better investment alternatives in the long-term.

Meanwhile, both ETFs and passive index funds have drawn mixed reactions – some investors have embraced them while others have been cautious[11]. The reasons for the continuing interest of institutional investors in passively managed index funds and exchange-traded funds are complex. With the kind of market volatility seen in the recent years, alternative investments have become appealing to institutional investors who are searching for stable returns. While institutional investors are embracing passively managed investments, pension funds have fallen under a unique group which has taken precaution[12]. When you compare institutional investors who had portfolio holdings of ETF funds in 2008, you will realize that pension funds only ranked fourth behind investment advisors, hedge funds and banks and trusts respectively. Exhibit 1 below illustrates this point.

Exhibit 1

Abbildung in dieser Leseprobe nicht enthalten

Source: ETF Research & Implementation Strategy Team, Barclays Global Investors, Thomson Financial 2008

While acknowledging that the reasons why pension funds have shied away from passive index funds are complex to be covered in this paper, I will attempt to demonstrate, with a portfolio built using data from the period between 1998 and 2008, some of the benefits that pension funds could be potentially missing. My paper is an attempt to prove that a careful selection of ETF funds combined with superior asset allocation could make a solid investment for a pension fund.


Over the past fifty years, the pension fund industry has mushroomed into the largest concentration of managed money in the world[13]. As a result, the decisions of fund managers reverberate throughout the global financial markets. A pension fund is a legal entity separate from the employer, which holds and invests funds to pay benefits to participants. Pension schemes are designed to provide incomes to retired workers.

As pension funds began to assume importance among corporate assets over the past quarter century, pension fund portfolio management concentrated on the trade-off between the expected returns on their investments and market volatility[14]. As a result managers of pension funds are responsible for the allocation of assets to the portfolio and the overall strategy to achieve superior returns.

The traditional function of a pension fund is to invest in a portfolio of assets that will earn a return to pay off the pension benefit obligation[15]. Throughout my paper, I will focus on employer-defined benefit plans[16]. In the US, employer-sponsored pension programs date back to the 19th century when pension funds supported police officers, teachers and fire fighters[17]. The popularity of employer-sponsored pension schemes in the US was fostered by the fact that corporations could generally deduct contributions to a pension fund from the taxable income, and assets in a pension could grow tax-free. The pension fund industry today is mature with assets under management of more than $9 Trillion – it is a diversified industry encompassing money managers, consultants, and mutual funds with investments in equity, real estate, commodities, start-up ventures and overseas markets[18].

Since 1948 in the US, employers are required to include pensions in a contract negotiation with employees if wished by the workers’ union. If offered, however, pension plans and sponsoring firms are subject to complex rules and regulations overseen by a government agency, the Pension Benefit Guaranty Corporation[19]. Through the years the US government regulation of pension plans through the Employee Retirement Income Security Act[20] (ERISA) has put checks and balances to ensure pension funds are neither underfunded nor misused by their sponsors. Companies are free to terminate pension schemes at anytime. A pension fund sponsor is required by law to appoint fiduciaries who control and manage pension plan operations, administrations and assets. The fiduciary manager’s legal duties include managing assets solely in the interest of participants according to the investment policy statement[21] and to diversify pension fund assets to minimize the risk of large losses from any single investment.


[1] Gibson, R. (2008). Asset Allocation: Balancing Financial Risk. (4th Ed.). New York: McGraw Hill.

[2] Ibid.

[3] IFA Canada, Changing the Way Investors Invest. Retrieved from 29-09-2009 from: http://www.ifacanada.com/steps/step1.asp

[4] Ibid

[5] Arnott, R. and Bernstein, P. (January/February, 1988). The Right Way to Manage Your Pension Fund. Harvard Business Review. Harvard Business Publishing: Massachusetts.

[6] A concept used in Modern Portfolio Theory which refers to a hypothetical portfolio containing every security available to investors in a given market in amounts proportional to their market values.

[7] Securities Exchange Commission, Beginners Guide to Asset Allocation, Diversification and Rebalancing. Retrieved on 06-11-2009 from: http://www.sec.gov/investor/pubs/assetallocation.htm

[8] Brunel, J. (2006). Integrated Wealth Management: The New Direction for Portfolio Managers. Euromoney Institutional Investor Plc: London.

[9] Whitelaw, R., Bruno, S. & Davidow, A. (2009). Alpha/Beta Separation. Journal of Indexes, 12(2), 24-29.

[10] Yao, F., Xu, B., Adams, P. & Doucet, K. (2002). Planning for the Future. In Street Smart Guide to Managing Your Portfolio, (pp.73-92). McGraw Hill: New York.

[11] Fuhr, D. (2009) ETF Landscape: Industry Review. Barclays Global Investors: ETF Research & Implementation Strategy, End of Q3 2009.

[12] Financial Times, (April 2005). Low Cost, Less Risk and Global Spread. Retrieved on 29-10-2009 from: http://www.ftmandate.com/news/fullstory.php/aid/588/Low_cost,_less_risk_and_global_spread_.html

[13] Clowes, M. (2000). The Money Flood: How Pension Funds Revolutionized Investing. John Wiley & Sons: New Jersey.

[14] Arnott, R. & Bernstein, P. (January/February, 1988). The Right Way to Manage Your Pension Fund. Harvard Business Review. Harvard Business Publishing: Massachusetts.

[15] Pozen, R. (March 2004). Fixing the Pension Fund. Harvard Business Review. Harvard Business Publishing: Massachusetts.

[16] Broadly speaking there are two general types of retirement plans – defined contribution plans, which define the level of employer contributions to be placed in the individual employee accounts, and defined benefit plans, which provide employees with benefits determined by a defined formula.

[17] Clowes, M. (2000). The Money Flood: How Pension Funds Revolutionized Investing. John Wiley & Sons: New Jersey.

[18] Ibid

[19] Retrieved on 29-09-2009 from: http://www.pbgc.gov/

[20] ERISA has been replaced by the PBGC. Retrieved on 29-09-2009 from: http://www.dol.gov/dol/topic/health-plans/erisa.htm

[21] A document drafted between a portfolio manager and a client that outlines general rules for the manager. Retrieved on 29-09-2009 from: http://www.investopedia.com/terms/i/ips.asp

Excerpt out of 66 pages


Portfolio Asset Allocation. Exploring the Case for Continued Reliance on Financial Economic Models by Asset Managers
Schiller International University
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portfolio, asset allocation, CAPM, MPT, pension fund, passive index funds, ETF funds, passive strategies, active strategies, ETF, Exchange Traded Fund
Quote paper
Ibrahim Mbithi (Author), 2009, Portfolio Asset Allocation. Exploring the Case for Continued Reliance on Financial Economic Models by Asset Managers, Munich, GRIN Verlag, https://www.grin.com/document/282441


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