On the Temptation to Time the Market: Asset Allocation Strategies of Swiss Pension Funds in a Low Interest Rate Environment

Maximilian Fuchs & Eric Lichtsteiner

Student thesis: Master thesis


In an asset-liability management setting, this study explores potential asset allocation strategies a pension manager under Swiss regulation may consider in an environment where interest rate levels are low. We analyse four distinctive strategies that are benchmarked against market-based pension liabilities: a market-timing strategy that is based on a mean-variance optimal portfolio with liabilities as a short-position asset, an immunisation strategy that is solely based on fixed-income assets and dedicated to hedge against the interest rate risk of pension liabilities, as well as naïve buy-and-hold and fixed-weights strategies. As the recent period of low interest rates is relatively short, we expand the sample size by adjusting return time-series to a common negative level of interest rates using a theoretical asset pricing approach. Moreover, we model relevant regulatory requirements for Swiss pension funds. Using a simple one-factor return estimator, we find the market-timing strategy to deliver superior returns out-of-sample. However, the market-timing investor may also face substantial funding risk depending on her risk preference and initial funding level. Alternative and international assets with unhedged currency exposure add relatively less value to a market-timing portfolio. While slightly inferior to the market-timing strategy, the fix-mix and buy-and-hold strategies exhibit good financial performance. The fix-mix strategy appears to outperform a buy-and-hold strategy in terms of both generated returns and funding risk. This is robust to changes in risk preference and initial funding levels. Moreover, our results suggest that a fix-mix strategy often exhibits less funding risk than a market-timing strategy, even though it does not allow for an active management of pension liabilities. The immunisation portfolio is found to be inferior. It exhibits poor financial performance and appears to structurally underperform its liability benchmark, leading to high funding risk. We relate this underperformance to a regulatory minimum interest requirement that is set above the riskless market rate, creating incentives to allocate towards riskier assets. Our results suggest a market-timing strategy may be attractive due to the high returns generated. However, we find the performance of the market-timing strategy to be considerably sensitive to errors in return estimation. Depending on the exposure to estimation risk, a market-timing pension manager may be better o˙ to hedge her liabilities using an immunisation strategy.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
Publication date2020
Number of pages150
SupervisorsMarcel Fischer