Modern Portfolio Theory (MPT) has revolutionized how investors think about asset allocation by offering groundbreaking ideas on how to allocate investments quantitatively. MPT suggests that investors can achieve superior returns and lower risks by holding international diversified portfolios. Despite this, empirical studies suggest that investors tend to overweight domestic equities, which adversely affects the risk-return relationship. This thesis investigates home equity bias in Danish pension funds to see if they act in accordance with theory and exploits the positive effects of international diversification. Inefficient investments by the pension funds negatively affect people’s economic wealth, and have direct consequences on the economic growth. This makes Danish pension funds particularly interesting, as we know that a sub-optimal asset allocation will represent a significant efficiency loss for the whole Danish society. A correlation analysis showed that international diversification still provides risk reduction possibilities. The analysis confirmed that Danish pension funds could still significantly reduce their portfolio risk through international diversification without compromising return, even though correlations have increased over time. It would therefore be surprising if the Danish pension funds do not make use of these opportunities. Applying three benchmark models on Danish pension funds showed that the home equity bias in Danish pension funds has sharply decreased over the last decade, but that the sector still exhibits significant home equity bias. Consequently, the overweight of domestic equities corresponds to a welfare loss for the Danish society through Danish citizens bearing unnecessary portfolio risk. From a rational perspective it was surprising to find that large institutional investors, represented by Danish pension funds, exhibits significant home equity bias. Our findings suggest that the negligence of international diversification within the Danish pension fund sector can be explained by a combination of factors. Pension fund managers appear to direct investments to countries with a high ranking in corporate governance and transparency, a factor where Denmark is ranked at the very top. In addition, they also appear to suffer from behavioral bias in the form of over-optimism, and a lesser extent herding. Thus, similarly to previous studies on this subject we conclude that the home equity bias cannot be explained by a single factor. Rather, the home equity bias within Danish pension funds is attributable to both institutional and behavioral factors.
|Educations||MSc in Applied Economics and Finance, (Graduate Programme) Final Thesis|
|Number of pages||143|