Home bias in Danish pension funds: Do Danish pension funds optimize their equity portfolios?

Lars Nørregaard

Student thesis: Master thesis


Portfolio diversification theory has been known for many years, stating that unsystematic risk can be eliminated by holding the world market portfolio. Thus dispersing ones investments among different industries and different countries will minimize the risk of a portfolio. However the stated benefits of diversifying among different countries many studies still find institutional investors investing too heavily in the domestic equity market than theoretical optimal. Thus home bias should increase risk and lower return according to diversification theory. One thing is to behave as proscribed by theory, but it would not be rational to expect the institutional investors, represented by the Danish pension sector, to hold a larger proportion of foreign equity than actually optimal. Thus by applying mean-variance framework the historical optimal portfolio allocation was indentified. Because the risk tolerance of the individual pension fund is not known this results in an optimal interval in which to hold foreign stocks. This makes it possible to indentify if the Danish pension funds are optimizing their stock allocation with regards to county allocation. 4 of 26 funds were found to be home biased by investing to heavily in the Danish market. 5 funds were found to invest too heavily in foreign stocks. Having identified the home biased funds it is interesting to identify the plausible explanations of this inefficient equity allocation. By analyzing several reasonable explanations asymmetric information, investment in domestic multinationals and conservatism seemed to be able to explain the observed bias. When analyzing the performance of the individual funds it turned out that almost all funds performed better on its Danish investments compared to its benchmark than for the foreign investments, thus indicating asymmetric information. It turned out that the home biased funds had been so for a five year period while the industry as a whole had increased their investments within foreign stocks heavily, thus indicating conservatism. Lastly the funds’ domestic stock allocation is largely made up by multinational companies that gain the most of their sales outside Denmark. They are therefore heavily exposed to the world market. Thus Danish multinational companies also contribute to foreign diversification. The explanations that were identified as explanations of the foreign bias were currency hedging and liquidity risk.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2010
Number of pages97