Journal of Banking & Finance 34 (2010) 21582167

Contents lists available at ScienceDirect

Journal of Banking & Finance

journal homepage: www.elsevier.com/locate/jbf

The efciency of Greek public pension fund portfolios

Timotheos Angelidis a, Nikolaos Tessaromatis b,*
a
b

University of Peloponnese, Department of Economics 22100 Tripolis, Greece

ALBA Graduate Business School, Athinas Ave., 2a Areos Street, Vouliagmeni, Greece

a r t i c l e

i n f o

Article history:
Received 27 October 2008
Accepted 2 February 2010
Available online 6 February 2010
JEL classication:
G23
Keywords:
Portfolio efciency
Idiosyncratic risk
Asset allocation
Utility loss
Pension funds

a b s t r a c t
Greek public pension funds can invest up to 23% into risky assets and are not allowed to invest outside
Greece. This paper seeks to investigate the costs of investment constraints on pension fund portfolios. In
particular we try to quantify the losses that portfolios suffer due to under-diversication and sub-optimal
asset allocation. We nd that the high concentration of Greek equity portfolios imposes a substantial
return and utility loss which is further increased when the lack of international diversication is taken
into account. Restricting the weight of equities to 23% of the total portfolio, leads to sub-optimal
asset allocation that costs as much as 2% (3%) per annum compared to a balanced domestic (global)
benchmark.
2010 Elsevier B.V. All rights reserved.

1. Introduction
Modern portfolio theory provides a framework to build efcient
portfolios. Portfolio efciency requires that asset weights reect
optimally investors risk return expectations1. Regulatory or self
imposed constraints which limit the investment universe, prohibit
short sales, impose maximum allowable weights per asset or limit
absolute or relative risk could lead to inefcient portfolios i.e. portfolios whose return can be improved without increasing risk or portfolios which do not provide a good match for the investors liabilities.
Constraining portfolio choice could lead to inefcient portfolios and
could potentially impose signicant costs to investors.
Academic evidence on the issue of portfolio inefciency and the
associated costs are rather limited. Binsbergen and Brandt (2007)

* Corresponding author. Tel.: +30 210 8964531; fax: +30 210 8964737.
E-mail addresses: tangel@uop.gr (T. Angelidis), ntessaro@alba.edu.gr (N. Tessaromatis).
1
The classic mean variance models provide a simple and intuitive approach for
portfolio construction and asset allocation. Recent papers extent the single period
asset allocation model and provide advice on how to build long term (strategic)
asset allocation using variations in preferences, opportunities and return dynamics
(for example see Campbell et al., 2003). For investors like pension funds, the optimal
asset allocation weights ought to reect, in addition to risk and return expectations,
the structure of the pension funds liabilities. Sharpe and Tint, (1990) and Hoevenaars
et al., (2008) solve the asset allocation problem for investors whose asset allocation
decision is largely driven by their long run liabilities. Malliaris and Malliaris (2008)
contrast the principles of institutional investing with the management of individual
retirement accounts.
0378-4266/$ - see front matter 2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankn.2010.02.003

in their study of the effect of regulations on the investment decisions of pension funds nd that preventive constraints such as risk
constraints, limits on maximum holdings and short sale constraints reduce substantially the gains from dynamic investment
strategies. Davis (1996) nds that pension funds operating in countries that impose few constraints on investments achieve higher
returns than pension funds from countries with stricter quantitative portfolio restrictions. Regulatory restrictions force pension
funds to hold inefcient portfolios whose returns are consistently
less than average real wage earnings. In contrast Almazan et al.
(2004) who study the effects of investment constraints on mutual
fund performance, nd that constraints do not inuence performance. Clarke et al. (2002) examine the effect of investment constraints on a portfolio managers ability to convert successful
return forecasts into appropriate portfolio positions. They nd,
using simulation, that commonly used constraints like no short
sales, constraints on turnover and constraints that force portfolios
to have the same characteristics as a benchmark could, if used in
combination, reduce valued added signicantly.
Holding under-diversied portfolios in world were idiosyncratic
risk receives no reward in equilibrium is another form of portfolio
inefciency. Standard asset pricing theories like the CAPM or APT
predict that only systematic risk is priced in equilibrium. Accordingly investors will hold well diversied portfolio so that idiosyncratic risk is minimized or completely eliminated. Evidence in
Blume and Friend (1975) and Polkovnichenko (2005) suggest that
individuals hold portfolios that are poorly diversied. In contrast,

T. Angelidis, N. Tessaromatis / Journal of Banking & Finance 34 (2010) 21582167

using evidence from Swedish investors, Calvet et al. (2007) nd

that only a few households are very poorly diversied and that
the costs of diversication mistakes are rather small. Evidence on
the diversication decisions and the cost of diversication mistakes of institutional investors is rather scant.
Expanding the domestic investment opportunity set to overseas
investments brings further diversication benets2. Constraining
investors to invest only in domestic assets could lead to both lower
returns and higher risk portfolios compared to portfolios diversied
internationally. According to Driessen and Laeven (2007) international diversication benets more investors from less developed
countries compared to investors from developed markets. Baxter
and King (2001) argue that in addition to the diversication benets
of foreign investments, another benet is the ability of foreign assets
to hedge the risk from non-traded assets and in particular human
capital. They also show empirically that human capital returns are
more highly correlated with domestic returns rather than international returns. Investors with domestic wage-based liabilities should
hold a signicant part of their portfolios in international assets to
diversify risk.
The aim of the paper is to provide empirical evidence on the effects and costs of portfolio constraints and under-diversication on
institutional portfolios, a topic where there is little research. The
evidence is relevant to policymakers in many countries where
investment constraints are still the norm, forcing pension funds
to invest most of their portfolios in bonds. Quantifying the signicant costs constraints entail would perhaps help authorities in
countries where pension fund investments are heavily regulated
decide whether they should dismantle gradually detailed quantitative restrictions in favor of the prudent man rule.
The research is based on a unique database of Greek pension
fund portfolios. To protect pensions, pension fund investments
operate under strict quantitative restrictions. Pension funds are allowed to invest up to 23% in domestic equities while investments
outside Greece are not allowed. Equity portfolios tend to be concentrated into a small number of recently privatized stocks.
We estimate that the under-diversication of the average Greek
pension fund equity portfolio, compared to a domestic benchmark
costs as much as 0.91% per annum. The return loss is multiplied by
ve when the benchmark is the world equity portfolio. In monetary terms the total cost of all pension funds is 49 million against
the domestic benchmark and 328 million when the benchmark is
the world equity index. Investing in a small number of domestic
stocks imposes signicant nancial costs to the Greek state pension fund system. When we calculate the utility loss (the certainty
equivalent return) due to sub-optimal asset allocation we nd that
it costs about 2% (3%) per annum compared to a balanced local
(global) benchmark. Our results are robust to alternative assumptions about expected returns and risk aversion.
The paper is structured as follows. Section 2 describes Greek
pension funds and the investment constraints imposed by the
Greek state while Section 3 measures and decompose the risk of
equity portfolios and study its determinants. In Section 4 we calculate the return and utility loss suffered by Greek pension funds because of under-diversication and sub-optimal asset allocation. In
Section 5 we assess the sensitivity of cost estimates to various
2
See Grubel (1968) and De Santis and Gerard (1997). Most of the literature on the
diversication benets of overseas investments takes a US perspective. Evidence in De
Roon et al. (2001) show that the benets to the US investor are perhaps smaller than
initially thought once short sale constraints and transaction costs are taken into
account. You and Daigler (2010) show that the diversication benets are timevarying. Despite the strong academic support, in practice portfolios tend to
concentrate in the domestic markets. Karlsson and Norden (2007), using data from
the Swedish pension system, nd that the home bias of the Swedish investor reects
their need for hedging domestic ination, and is related to their sophistication and
overcondence.

2159

assumptions of return and risk aversion. Section 6 presents the

conclusion.

2. Pension funds in Greece

The Greek pension fund system operates on the basis of the
pay-as-you-go system. It is mandatory, covers practically 100% of
the population, is run by the wider public sector and pays benets
based on nal salary. Pension benets are provided by a large number of social insurance funds classied as primary, auxiliary and
provident funds. According to the Social Budget issued by the Ministry of Labor and Social Security in 2006, there are 175 funds of
which 25 are primary funds and the remaining auxiliary and provident funds. In addition to pensions, most primary funds provide
health insurance through special funds.
Although the system is nanced on the pay-as-you-go basis a
number of funds have signicant assets accumulated when the
system was paying less than the contributions it received. For most
funds the state is obliged to nance any gap between the income to
the fund from the contributions of working members and the benets paid to retirees. According to the Social Budget of 2006, total
public pension spending was expected to be 12.6% of GDP. Without
changes, public spending on pensions is expected to increase to
24.8% in 2050.3
The investment framework under which Greek pension funds
can manage their assets has changed signicantly over time. For
most of the 1950s and 1960s pension fund reserves where invested
in mandatory deposits managed by the Bank of Greece. Prior to
1973 deposits with the Bank of Greece earned 4.3% per annum,
an interest rate well below commercial deposit rates (Milonas,
2009). The rate earned on deposits was adjusted upwards following the 1973 oil shock, albeit being less than ination. In the beginning of the 1990s Greek pension funds were given more freedom to
invest their assets into treasury bills, bonds and stocks. The basic
investment framework under which Greek pension funds operated
at the end of 2005, after many piecemeal liberalization measures,
allows pension funds to invest up to 23% in Greek equities, property and mutual funds and the remaining in Greek government
bonds and cash deposits. The rules did not allow investment in
stocks or bonds outside Greece.4

2.1. Dataset
Data on pension fund holdings are taken from the Ministry of
Employment and Social Protection for all funds regulated by the
Ministry. The database includes 24 primary, 32 auxiliary, 33 provident, 18 health and 13 other social security organizations. Given
that the same organization might manage more than one type of
fund the database contains 82 funds in total. For each fund we collect 2005 year-end equity, bond, and mutual fund and cash
holdings.
The total value of the Greek pension system at the end of 2005
was 29.5 billion. Of that 43% was invested in cash deposits, 33% in
Greek government bonds, 17% in Greek equities, 5% in mutual
funds and 2% in Greek property. The average Greek pension fund
invests 59% in cash, 17% in bonds and bond mutual funds and
24% in equities and equity mutual funds.
3
The threat to public nances from increasing pension obligations is a problem
faced by many countries. According to Peterson (1999) 25% of total population in the
world will be over 65 in 2030, the ratio of working taxpayers to nonworking
pensioners will fall to 1.5:1 and liabilities due to todays workers are projected to a
minimum of $64 trillion.
4
The new law 3586 allows Greek pension funds for the rst time to invest in
European stocks and European government bonds within the 23% maximum.

2160

T. Angelidis, N. Tessaromatis / Journal of Banking & Finance 34 (2010) 21582167

Table 1
The cross-sectional distribution of Greek pension fund standard deviation.
Statistics

Portfolios
Total
(%)

Risky
(%)

Equity
(%)

Bond
(%)

Average
Median
Standard deviation
Maximum
Minimum
Aggregate portfolio

8.62
5.84
8.68
37.89
0.23
5.72

19.93
22.15
12.10
41.52
0.08
10.54

31.00
31.70
5.34
42.40
18.05
29.53

2.74
2.92
1.14
5.16
0.08
3.41

Total risk of possible benchmarks

ASE-60
JPM Greek bonds
MSCI world hedged US$
MSCI world sovereign hedged
US$

23.57
3.25
14.77
2.85

This table shows the distribution of total fund portfolio risk as well as the distribution for the risky, equity and bond portfolios. For each fund we consider four
types of portfolios: the direct equity and equity mutual fund portfolio, the direct
bond and bond mutual fund portfolios, the risky portfolio combining bonds and
equity but no cash and the total portfolio, which contains stocks, bonds, mutual
funds and cash. It also shows the total risk of possible benchmarks for Greek (JP
Morgan Greek Government Bond Index, the Athens Stock Exchange 60 Stocks Index
(ASE-60 Index)) and foreign (MSCI World Equity and Sovereign Bond indices both
hedged in dollars) equity and bond portfolios.

Greek pension funds in aggregate invest almost as much as they

are allowed in risky assets (equities, property and mutual funds).
However, compared with pension funds from other countries, the
average allocation to risky assets is very low. The average occupational pension scheme invests in equities, 59% in Australia, 54% in
Canada, 52% in Japan, 41% in the Netherlands, 68% in the UK and
64% in the USA. Public reserve funds also have large strategic exposures to risky assets. For example the Swedish AP funds allocated
between 54.5% and 61% to equities. High strategic exposure to
equities can also be found at the New Zealand Superannuation
fund (50%), the Irish National Pension Reserve Fund (69%), the
French Fons de Reserve (60%) and the Government Pension Fund
of Norway (40%).
3. The risk of pension fund portfolios
3.1. The cross-sectional distribution of risk
For each fund we consider four types of portfolios: the direct
equity and equity mutual fund portfolio, the direct bond and bond
mutual fund portfolios, the risky portfolio combining bonds and
equity but no cash and the total portfolio, which contains stocks,
bonds, mutual funds5 and cash.
At the end of year 2005 we observe the holdings, wi, of fund i.
We use ve years of monthly data (from 31/12/2000 to 31/12/
2005) to calculate monthly excess returns for all assets held by
the pension funds. Fund i total risk is calculated as the annualized
standard deviation of the funds returns using the end of year 2005
weights and the last ve years of the funds assets monthly excess
returns. We use the same methodology to create all four portfolios
per pension fund. We also calculate the aggregate pension fund
portfolio by pooling all pension fund assets. We use Effect, a Greek
equity database, to calculate Greek stock returns. The data for the
stock and bond indices, Greek government bonds and the one
month risk free rate are obtained from Datastream International.
Table 1 shows the distribution of total fund portfolio risk as well
as the distribution for the risky, equity and bond portfolios. For
5
From total mutual fund holdings, 41.7% represent balanced mutual funds, 49.5%
bond funds and the remaining Greek equity and money funds.

comparison purposes the table also shows the total risk of possible
benchmarks for Greek (JP Morgan Greek Government Bond Index
and the Athens Stock Exchange 60 Stocks Index (ASE-60 Index))
and foreign (MSCI World Equity and Sovereign Bond indices both
hedged in dollars6) equity and bond portfolios.
The average standard deviation across all portfolios is 8.62%,
while the median standard deviation is 5.84%. The standard deviation of the aggregate portfolio of the Greek pension fund system is
close to the median (5.72%). However, there is a lot of variation
across pension funds (the standard deviation of the standard deviation is 8.68%). The pension fund with the lowest risk has a standard deviation of 0.23% (invested wholly in cash) while the fund
with the highest risk has a standard deviation of 37.89% (invested
wholly in Greek equities).
Although the investment rules do not allow investment in risky
assets above 23% it is interesting to know how does the total risk of
the Greek pension fund portfolios compare with a portfolio invested half in Greek government bonds and half in Greek stocks.
Compared to a portfolio invested half in the ASE-60 index and half
in the JPM Greek bonds index with standard deviation equal to
11.56%, the average Greek pension fund has almost half the risk.
Obviously, the low riskiness of the average Greek pension fund total portfolio reects the 43% invested in risk-less cash.
Similarly although Greek pension funds are strictly forbidden to
invest in equities outside Greece, it is interesting to know how
fund risk compares against the risk of an internationally portfolio
of equities and bonds. The standard deviation of a portfolio invested half in the MSCI world index and half in the MSCI world sovereign index is 6.9%, a little more than one percent higher than the
standard deviation of the aggregate portfolio. This small difference,
despite the fact that the benchmark portfolio has no cash, reects
the much higher volatility of the Greek equity part of the aggregate
portfolio (29.53%) compared with the volatility of the world index
(14.77%).
Table 1 also shows the cross sectional distribution of the standard deviation of the bond, equity and risky portfolio. For the
aggregate risky portfolio, which invests 58% in bonds and 42% in
equities, the standard deviation is 10.54%. On the other hand the
average standard deviation of the average risky portfolio is
19.93% because the average equity portfolio is less diversied compared with the aggregate equity risk portfolio. There is however
signicant cross sectional variation in the riskiness of the risky
portfolios with the most risky portfolio having a standard deviation
of 41.52%.
The volatility of the equity part of the Greek pension funds portfolio provides evidence on the degree of diversication of the equity
portfolio. Highly concentrated portfolios would have much higher
volatility compared to volatility of the ASE-60 index. As Table 1
shows the average standard deviation of equity portfolios is 31%,
close to the standard deviation of the aggregate equity portfolio
but signicantly higher than the volatility of the ASE-60 index.
We take a closer look at the diversication properties of the Greek
pension fund equity portfolios in the next section, but the evidence
presented so far are consistent with signicant active risk taking.
The average and aggregate risk of the bond portfolios is close to
the risk of the JPM Greek bond index. Since pension funds cannot
hold foreign or corporate bonds, the small risk difference between
portfolios and the index is due to differences in duration.

3.2. Decomposing the risk of equity portfolios

The alternative to the equity portfolios actually held by the
Greek pension funds is an investment in a passive benchmark. Gi6

As in Calvet et al. (2007) we assume that the investor hedges currency risk.

2161

T. Angelidis, N. Tessaromatis / Journal of Banking & Finance 34 (2010) 21582167

Table 2
The distribution of total, systematic and idiosyncratic risk of equity portfolios.
Statistics

Total risk

Beta

Systematic

Idiosyncratic

Idiosyncratic share

Panel A: ASE-60 index benchmark

Average
Median
Standard deviation
Max
Min
Skewness
Kurtosis
Aggregate portfolio

31.00%
31.70%
5.34%
42.40%
18.05%
0.50
0.25
29.53%

1.18%
1.22%
0.22%
1.52%
0.63%
0.76
0.28
1.19%

27.71%
28.82%
5.19%
35.84%
14.79%
0.76
0.28
28.07%

13.16%
13.30%
4.72%
24.21%
3.85%
0.32
0.08
9.18%

19.47%
16.23%
12.98%
55.67%
4.26%
1.51
1.56
9.67%

Panel B: MSCI equity world index benchmark

Average
31.00%
Median
31.70%
Standard deviation
5.34%
Max
42.40%
Min
18.05%
Skewness
0.50
Kurtosis
0.25
Aggregate portfolio
29.53%

1.18%
1.25%
0.22%
1.45%
0.54%
0.83
0.08
1.16%

17.35%
18.40%
3.27%
21.38%
7.95%
0.83
0.08
17.16%

25.59%
26.38%
4.84%
37.59%
14.38%
0.28
0.21
24.04%

68.00%
66.72%
6.65%
93.11%
53.34%
1.19
2.70
66.25%

This table presents the distribution of total, systematic and idiosyncratic risk of equity portfolios. The monthly excess return of fund i is given by Ri,t = ai + biRB,t + ei,t, where Ri,t
and RB,t are the monthly excess return of fund i and the benchmark. The total variance of2 funds i is dened as: r2i b2i r2B r2e;i . Systematic (idiosyncratic) risk is calculated as
r
jbi rB jr2e;i ). The percentage of total risk due to idiosyncratic volatility is dened as: b2 r2e;i r2 . In Panel A (B) the ASE-60 Index (MSCI World Equity hedged in dollars) is used as
i B
e;i
the benchmark index.

ven a benchmark, the excess return of a pension funds equity portfolio can be decomposed as follows:

Ri;t ai bi RB;t ei;t ;

where Ri,t and RB,t are the monthly excess return of fund i and the
benchmark. The total variance of fund i risky portfolio total excess
returns can be written, using Eq. (1), as:

r2i b2i r2B r2e;i

Eq. (2) breaks total portfolio risk into a systematic component

(|bi|rB) and an idiosyncratic component (re,i). We use Eq. (2) to
decompose the total risk of all pension fund equity portfolios and
present the results in Table 2. In panel A we assume that the benchmark is the ASE-60 index and in panel B the MSCI World Equity Index. Column 2 shows the distribution of total risk, column 3 the
distribution of beta and columns 4 and 5 the distribution of systematic and unsystematic risk.
As Table 2 shows, on average, the equity portfolios are more
aggressive than the index. Both the average and median beta is
greater than one. Beta is also greater than one for the aggregate
equity portfolio. The average systematic risk of equity portfolios
is 27.71% while the average idiosyncratic risk is 13.16%. For the
aggregate equity portfolio, idiosyncratic risk is 9.18% and represents a sizeable part of overall equity portfolio risk. The lowest idiosyncratic risk equity portfolio has idiosyncratic volatility of 3.85%
while the highest idiosyncratic risk portfolio assumes as much as
24.21% active equity risk.
The equity portfolios of Greek pension funds take signicant
non-market risk. Portfolio idiosyncratic risk is due to three factors:
the riskiness of the assets making up the portfolio, how concentrated is the portfolio and the correlation between the assets included in the portfolio (see Calvet et al., 2007). When we
decompose idiosyncratic risk to its components using Calvet
et al. (2007) methodology, we nd that by far the most important
inuence on average idiosyncratic risk is portfolio concentration.
Looking at the number of stocks held per portfolio we nd that
on average each equity portfolio holds seven stocks (the median
is 5.5 stocks per portfolio). Of the 65 equity funds 53 hold 10 or less
stocks. The above results support the conclusion that the high idi-

osyncratic risk of Greek pension fund equity portfolios is mainly

due the small number of stocks they are holding.
Column 6 in Table 2 shows the percentage of total risk due to
idiosyncratic volatility calculated as:

r2e;i
r2e;i
2 2
2
ri bi rB r2e;i

Idiosyncratic risk contributes, on average 19.47% to the risk of equity portfolios. As expected for the aggregate equity portfolio idiosyncratic risk makes up a smaller but still signicant part of overall risk.
Idiosyncratic risk of 13.20% for an active portfolio represents very
aggressive stock selection bets. If stock picking does not add value
to Greek equity portfolios, the risk assumed but not rewarded will
impose a signicant cost on the portfolios. We look at this issue
in Section 4 of the paper.
Fig. 1 shows the relation between portfolio beta and portfolio
standard deviation. The high total risk equity portfolios tend to
be more aggressive than the market portfolio. The fact that equity
portfolio betas are different than one adds7 almost 1% to the idiosyncratic risk of those portfolios.
Although Greek pension funds were until recently8 forbidden to
invest in foreign equities, it is of interest to use as an alternative to
the currently held risky portfolios an investment in an internationally diversied portfolio as represented by the MSCI world equity index. On average Greek equity portfolios as well as the aggregate
equity portfolio of all funds are more aggressive than the world equity benchmark. Since Greek pension funds are not allowed to invest in
foreign stocks, it is to be expected that the idiosyncratic risk of equity portfolios measured against a world equity benchmark will be
greater compared to the idiosyncratic risk measured against a purely
domestic benchmark. As panel B of Table 2, column 5 shows the idiosyncratic risk of the average equity portfolio at 25.59% per annum is
almost twice the idiosyncratic risk when the ASE-60 is used as the
benchmark. Using the MSCI world equity index as benchmark raises
the idiosyncratic risk of the aggregate portfolio to 24.04%, almost 2.5
times larger than the idiosyncratic risk measured with the ASE-60 as
7
The average tracking error, dened as 1  bi 2 r2B r2e;i , across all equity
portfolios is 14.60%. The idiosyncratic risk of the same portfolios is 13.20%.
8
See footnote 4.

2162

T. Angelidis, N. Tessaromatis / Journal of Banking & Finance 34 (2010) 21582167

1.60

1.40

Beta of Equity Portfolios

1.20

1.00

0.80

0.60

0.40

0.20

0.00
15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

Standard Deviation of Equity Portfolios

Fig. 1. Graphical representation of beta and total risk of pension funds presents the relation between pension fund beta and standard deviation.

benchmark. The highest risk portfolio assumes an astonishing

37.59% idiosyncratic risk while even the lowest risk portfolio carries
very signicant active risk (14.38%). Forbidding pension funds to invest in foreign stocks force Greek pension funds to assume signicant amounts of idiosyncratic risk which could be avoided, as
country specic risk can be diversied away.

4. The cost of inefcient investment strategies

The basic characteristics of Greek pension fund portfolios are (a)
equity portfolios hold a few stocks and are therefore under-diversied (b) no investments outside Greece whether in equities or
bonds and (c) low exposure to equities. Each of these characteristics could potentially cost pension funds in terms of lower returns
and/or higher risk.

4.1. Loss due to under-diversication

The analysis of the portfolios held by Greek pension funds
shows that the vast majority of funds hold a small number of
stocks. Poor diversication within the Greek equity market could
result in portfolios with inferior ratios of return to risk i.e. inefcient portfolios compared with well diversied portfolios. Modern
portfolio theory and most equilibrium asset pricing models suggest
that investors will not be compensated for assuming diversiable,
idiosyncratic risk. The loss from poor diversication can be assessed by comparing the Sharpe ratio of a pension funds portfolio
with the Sharpe ratio of a benchmark index.9 In particular we assess the return to risk loss that a pension fund incurs when it invests its equity portfolio in a few stocks rather than a passive
index fund.
As in Calvet et al. (2007) we calculate the relative Sharpe ratio
loss (RSRL) as:
9
Zakamouline and Koekebakker (2009) argue that when returns distributions are
non-normal use of the Sharpe ratio in portfolio performance might be misleading and
propose instead the generalized Sharpe ratio which accounts for all moments of the
return distribution. Our analysis of monthly pension fund returns, available upon
request, suggests that returns are approximately normally distributed. Furthermore,
the reader is referred to the work of Darolles and Gourieroux (2010) who review the
ratings based on Sharpe performance measures and rank hedge funds whose portfolio
returns are non-Gaussian.

RSRLP 1 

SP
;
SB

where SP rRPP is the Sharpe ratio of the pension funds portfolio, RP

the portfolios excess return and rP is the standard deviation of the
portfolios return. SB rRBB is the Sharpe ratio of the benchmark, and
RB and rB the mean and standard deviation of the benchmarks excess return. We calculate the expected excess return of the equity
portfolio using the following single factor expected excess return
model:

ERP bP ERB

We assume that the expected world equity and bond premia are the
long term arithmetic average premia of the seventeen countries
studied by Dimson and Marsh (2006). The expected world equity
premium is 6.10% p.a. and the expected world bond premium
1% p.a. The expected Greek equity and bond premia are based on
a single factor model where the factor is the world equity and bond
portfolios. Using data for the MSCI world equity index as the world
equity factor and the MSCI world sovereign index for the world
bond factor over the 20012005 period we estimate the Greek equity premium coefcient as 1.07 and the Greek bond premium coefcient as 1.08. Therefore, the Greek equity premium is estimated
as 6.53% p.a. (1.07  6.1%) and the Greek bond premium as
1.08% p.a. (1.08  1%). Estimating the future equity premium is controversial (see Dimson and Marsh, 2006 and Campbell, 2007). We
perform sensitivity analysis in Section 5 to assess the impact of
different inputs on the results.
Table 3 shows statistics from the cross sectional distribution of
the relative Sharpe ratio loss of the equity and bond portfolios. For
the aggregate equity portfolio the lack of diversication leads to a
Sharpe ratio loss of 4.96% when measured against the ASE-60 index. Against the MSCI world equity index the relative Sharpe ratio
loss increases substantially to 37.83%. For the average equity portfolio the relative Sharpe ratio loss is 10.60% when measured
against the domestic benchmark and rises to 43.81% against the
world equity index. The relative Sharpe ratio loss for the least
diversied portfolios is 33.42% against the domestic index and
73.75% against the world index. The corresponding losses for the
most diversied portfolios are 2.16% and 31.69%, respectively.
The relative Sharpe loss of a portfolio invested only in the
domestic stock market measured against a global stock index reects (a) the loss due the under-diversication in the domestic
market and (b) the loss due to the decision not to invest interna-

2163

T. Angelidis, N. Tessaromatis / Journal of Banking & Finance 34 (2010) 21582167

MSCI index has the lowest volatility among all portfolios and yet
its expected return is higher than a number of pension fund equity
portfolios. The ASE-60 index is also a low variance portfolio. The
question is whether the expected return differential between the
higher risk equity portfolios and the benchmark is an adequate
compensation for the risk taken.
Assuming the benchmark has a Sharpe ratio of SB, a portfolio
with a standard deviation of ri which has the same Sharpe ratio
as the benchmark would have a return of SBri. Therefore the return
loss can be calculated as:

Table 3
Relative Sharpe loss due to insufcient diversication.
Statistics

Average
Median
Standard deviation
Max
Min
Skewness
Kurtosis
Aggregate portfolio

Benchmark
Equity portfolio

Bond portfolio

ASE-60

MSCI world

JPM Greece

MSCI world

10.60%
8.48%
7.81%
33.42%
2.16%
1.67
2.06
4.96%

43.81%
42.31%
6.58%
73.75%
31.69%
1.90
5.82
37.83%

1.35%
0.31%
2.96%
13.13%
0.25%
2.91
7.55
0.29%

1.53%
2.49%
2.62%
7.69%
2.59%
2.83
6.90
2.46%

RLP SB ri  Ri SB  Si ri

This table shows statistics from the cross sectional distribution of the relative
Sharpe ratio loss of the equity and bond portfolios.
The

 relative Sharpe ratio loss is
calculated as: RSRLP 1  SSPB , where SP rRPP SB rRBB is the Sharpe ratio of the
pension funds portfolio (benchmark), RP(RB) the portfolios (benchmark) excess
return and rP(rB) is the standard deviation of the portfolios (benchmark) return.
The expected excess return of the equity portfolio is calculated using the following
single factor expected excess return model: E(RP) = bPE(RB). The expected world
(Greece) equity premium is 6.1% (6.53%) p.a. and the expected world bond premium
1% (1.08%) p.a. The ASE-60 Index and the MSCI World Equity hedged in dollars are
used as the benchmark index.

Table 4 shows the return loss for Greek pension fund equity and
bond portfolios. Against the ASE-60 index the aggregate equity
portfolio loses 0.41% per annum. This is almost half the return loss
of the average equity portfolio (0.91%). The least diversied equity
portfolio loses 2.93% whilst the most diversied equity portfolio
loses only 0.11% per annum. Return loses are almost ve time higher when the benchmark is the MSCI world index.
The aggregate equity portfolio loses 4.62% while the average
equity portfolio 5.64%. Even the most diversied equity portfolio
loses 2.95% while the least diversied portfolio loses as much as
9.41%. The results above suggest that Greek pension funds suffer
a signicant loss due to under-diversication in their domestic
equity market and a return loss almost ten times as much due to
the no foreign stock constraint.
The return loss of the aggregate and the average bond portfolios
is almost zero whether we use the domestic bond index or the
international bond index as benchmarks. This is not surprising as
Greek bond portfolios invest only in government bonds with similar duration to that of the benchmark.
The monetary value of the loss due to poor diversication is signicant. The sum of individual pension fund equity portfolio losses
is 49 million when measured against the Greek benchmark. The
cost rises to 328 million when international diversication opportunities are taken into account. For the aggregate equity portfolio
(the equity portfolio of all pension funds) the cost is less but still
signicant: 23 million for the Greek benchmark and 260 million
if pension funds could diversify internationally. The decrease of the
monetary value of the loss is due to the more diversied portfolio
that is generated when we combine all the assets of the pension
funds. Investing in a small number of domestic stocks imposes sig-

tionally. As Table 3 shows, the aggregate equity portfolio relative

Sharpe loss of 37.83% is mainly due to the lack of international
diversication and less because the portfolio is not well diversied
locally.
The relative Sharpe ratio loss is insignicant for bond portfolios.
Since these are predominantly government bond portfolios with
little idiosyncratic risk the loss from under-diversication is
minimal.
4.2. Return loss
An alternative measure of the economic costs of poor diversication is the difference in expected excess returns between a pension funds portfolio and that of a benchmark with the same
standard deviation. In other words, the return loss that a pension
fund will experience if it had invested in the benchmark levered
up or down, to have the same volatility as the currently held portfolio. Fig. 2 depicts the relation between expected returns and standard deviations for all pension fund equity portfolios, the aggregate
pension fund portfolio, the ASE-60 index and the MSCI index. The

10.00%

9.00%

Expected Returns

8.00%

Pensions
MSCI
Aggregate Portfolio
ASE-60

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%
0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

Standard Deviation
Fig. 2. Total risk and expected returns of pension funds shows the relation between pension funds expected return and standard deviation. It depicts three equity portfolios:
the aggregate pension fund, the ASE-60 and the MSCI index.

2164

T. Angelidis, N. Tessaromatis / Journal of Banking & Finance 34 (2010) 21582167

Table 4
Return loss due to insufcient diversication.
Benchmark
Equity
portfolio

Bond
portfolio

Statistics

ASE-60

MSCI
world

JPM Greece

MSCI
world

Average
Median
Standard
deviation
Max
Min
Skewness
Kurtosis
Aggregate
portfolio

0.91%
0.75%
0.65%

5.64%
5.65%
1.40%

0.01%
0.00%
0.01%

0.01%
0.03%
0.03%

2.93%
0.11%
1.47
1.98
0.41%

9.41%
2.95%
0.39
0.24
4.62%

0.05%
0.00%
2.87
7.11
0.00%

0.13%
0.05%
2.95
10.66
0.03%

This table shows the return loss for Greek pension fund and bond portfolios dened
as: RLP SB rP  r ep SB  SP rP , where SB(SP) is the Sharpe ratio of the benchmark
(portfolio) dened in Table 3. rP is the standard deviation of the portfolios
(benchmark) return.

nicant nancial costs to Greek pension funds and the Greek state
pension fund system.
4.3. Loss due to sub-optimal asset allocation
In theory, the optimal asset allocation of pension fund assets
should reect the pension funds expectations of asset risk and return and the structure of their liabilities. Information about the
structure of Greek pension fund liabilities or the appropriate long
term investment strategy is not publicly available. Without information about the funds risk and return forecasts and the structure
of its liabilities it is not possible to calculate the optimal portfolio
and hence create an appropriate benchmark for each pension fund.
The appropriate asset allocation of public pension funds is an
unsettled question. Bader and Gold (2007) argue against equity
investments in public pension fund portfolios. Lucas and Zeldes
(2009) suggest possible reasons for holding equities in public pension fund portfolios. As discusses in Section 2, in practice public reserve funds invest a large part of their assets in equities. According
to Munnell and Soto (2007) state and local public pension plans in
the USA hold on average, approximately 70% in stocks.
In the absence of pension fund specic information about long
term investment strategy or liability structure in this section of
the paper we assume that pension fund liabilities are uncorrelated
with asset returns. In this setting and assuming pension funds have
the same risk and return expectations and the same attitude towards risk, the strategic asset allocation benchmark which maximize return for a given level of risk, is the same for all funds.10
In particular we assume that the funds are meanvariance investors with quadratic utility function and a risk aversion parameter
of 3.11 We assume that the expected world equity and bond premia
are the long term arithmetic average premia of the seventeen
countries studied by Dimson and Marsh (2006). Based on a single
factor model where the factor is the world equity and bond portfolios we estimate the Greek equity premium to equal 6.53% and the
bond premium 1.08% (see also the discussion in Section 4). Using
these forecasts of future premia and the historical variance covariance matrix estimated over the period 20012005, the optimal
10

To examine the robustness of our ndings to different assumptions about

expected returns, degrees of risk aversion and liabilities in Section 5 we use
sensitivity analysis to calculate utility loss.
11
According to Bodie et al. (2008), based on a broad range of studies, a reasonable
range for the risk aversion parameter of the average investor is 2.04.0. We use 3.0 in
our calculations but assess the sensitivity of our results to other values in Section 5.

portfolio for a mean variance investor12 with a risk aversion parameter of 3 would have 35% in Greek equities and 65% in Greek bonds.
The same investor with access to the world equity and bond indices
would have invested 25% in bonds and 75% in equities.
To calculate the loss due to sub-optimal asset allocation of
Greek pension funds risky and total portfolios, we estimate the expected utility loss to a mean variance investor who is forced to invest under constraints and compare it to the expected utility
generated by the benchmark. In particular we calculate the certainty equivalent return (CER), dened as the risk free return that
an investor is willing to accept rather than holding a particular
portfolio. We compute the CER of portfolio i and the benchmark as:

r2i
c
CERB ERB  r2B

CERi ERi 

where E(Ri) and r2i are portfolio is excess return and variance, E(RB)
and r2B are the benchmarks excess return and variance and c is the
coefcient of risk aversion. The utility loss is therefore calculated as:


c  
c 
CERB  CERi ERB  r2B  ERi  r2i
2
2

The loss in utility calculated using Eq. (9) could be attributed to suboptimal asset allocation and poorly diversied asset portfolios. In
particular Eq. (9) can be broken in the following three terms13:
(a) Asset allocation

wb;B  wb;i ERb;B we;B  we;i ERe;B  r2b;B w2b;B

2
 b2b;i w2b;i r2e;B w2e;B  b2e;i w2e;i

10

(b) Idiosyncratic

wb;i ERb;B  ERb;i we;i ERe;B  ERe;i

c
2

 w2b;i r2b;e;i w2e;i r2e;e;i

11

(c) Interaction term

c
2

2wb;B we;B rbe;B 2wb;i we;i rbe;i

12

where the subscript b(e) stands for the bond (equity) portfolio.
The asset allocation term quanties the utility loss due to the
fund having different asset allocation than the benchmark. Similarly, the idiosyncratic risk term gives the utility loss due to holding equity and bond portfolios different to those of the respective
benchmarks. Finally the interaction term attributes the utility loss
to the non-zero correlation between the assets.
Table 5 shows statistics about the utility loss of the risky portfolios (panel A) and total portfolios (panel B) of all Greek pension
funds due to sub-optimal asset allocation and under-diversication. On average the risky portfolios of Greek pension funds suffer
a utility loss of 4.98% per annum measured against the Greek
benchmark or 6.36% per annum if the benchmark includes foreign
assets due to sub-optimal asset allocation and under-diversication. In the worst cases the loss is as high as 18.13% (20.99%) for
the Greek (foreign) benchmark.
12

The optimal investment in bonds is given by: W b

Erb Ere cr2e reb

cr2b r2e 2reb

where E(Eb),

E(re) are the expected return of bonds and equities respectively, r2b ; r2e are the bond
and equity variances and reb is the covariance between bonds and equities (see Bodie
et al. (2008, p. 216)). The weight invested in equities is we = 1  wb.
13
Due to space limitations, the derivation of Eqs. (10)(12) are available from the
authors upon request.

2165

T. Angelidis, N. Tessaromatis / Journal of Banking & Finance 34 (2010) 21582167

Table 5
The cost of sub-optimal asset allocation and under-diversication.
Average (%)

Median (%)

Standard deviation (%)

Maximum (%)

Minimum (%)

Skewness

Kurtosis

Panel A: Risky portfolio

Utility loss
Greek benchmark
Foreign benchmark

4.98
6.36

4.32
5.14

4.72
4.95

18.13
20.99

0.33
0.87

0.74
0.78

0.52
0.36

Loss due to asset allocation

Greek benchmark
Foreign benchmark

3.77
1.34

1.97
1.29

4.12
1.21

13.96
3.74

1.35
2.17

0.95
0.24

0.30
0.55

1.15
4.96

0.34
4.86

2.30
4.63

9.10
18.38

0.96
0.68

2.17
0.67

3.93
0.43

0.06
0.06

0.09
0.09

0.07
0.07

0.39
0.38

0.12
0.13

0.36
0.36

4.16
4.16

1.92
3.11

1.37
2.57

2.07
2.31

14.66
17.37

0.00
1.47

3.81
0.17

18.75
18.47

Loss due to idiosyncratic risk

Greek benchmark
Foreign benchmark
Loss due to interaction terms
Greek benchmark
Foreign benchmark
Panel B: Total portfolio
Utility loss
Greek benchmark
Foreign benchmark

Loss due to asset allocation

Greek benchmark
1.86
Foreign benchmark
1.97
Loss due to idiosyncratic risk
Greek benchmark
0.02
Foreign benchmark
1.08

1.34
1.97

1.77
0.69

11.44
3.08

0.17
0.29

3.15
0.31

12.02
0.36

0.07
0.14

0.58
2.40

3.23
15.16

0.82
0.40

4.28
3.49

22.00
15.28

Loss due to interaction terms

Greek benchmark
0.08
Foreign benchmark
0.06

0.09
0.09

0.04
0.46

0.20
2.11

0.03
3.14

0.85
2.95

1.06
34.53

This table presents statistics about the utility loss of the risky portfolios of all Greek pension funds due to sub-optimal asset allocation and under-diversication. The utility
loss is calculated as CERB  CERi ERB  ERi  2c r2B  r2i and can be broken in three parts that are described in Eqs. (10)(12). In panel A (B) statistics are shown for the
risky (total) portfolio.

In the case of the Greek benchmark, most of the utility loss is

due to the asset allocation decision (3.77%) while under-diversication costs on average 1.15%. In contrast, using the foreign benchmark, the utility loss due under-diversication is on average 4.96%
and the loss due to sub-optimal asset allocation 1.34%. There is a
lot variation of utility losses across funds and at the extremes there
are funds that could gain as much as 13.96% by adopting a more
optimal asset allocation. Similarly, diversifying abroad could add
18.38% to annual performance.
At the total pension fund portfolio level the average utility loss
1.92% if the benchmark is made up solely by Greek assets and
3.11% for the foreign based benchmark (see panel B in Table 5).
The maximum utility loss suffered is 14.66% and 17.37% using
the Greek and foreign benchmarks respectively. Most of the utility
loss is due to sub-optimal asset allocation rather than under-diversication, especially if the benchmark is Greek based. Of the 3.11%
total utility loss when the benchmark is a world equity and bond
portfolio, 1.97% is due to sub-optimal asset allocation and 1.08%
due to under-diversication.
5. Robustness analysis
The evidence on the utility loss depends critically on the benchmark portfolio whose composition is a function of the assumptions
we make about expected returns, risks, risk aversion and liabilities.
It is therefore important to examine the sensitivity of the results
we obtain using alternative assumptions. Table 6 presents utility
loss under alternative assumptions about the expected equity premium and the risk aversion parameter. In particular we assume
that the expected equity premium takes values between 3% and
8%. This range contains the equity premiums suggested by the historical estimates of Dimson and Marsh (2006) and the estimates
reported in Fama and French (2002) and Claus and Thomas
(2001). We also assume risk aversion parameters in the 1 to 6

Table 6
Sensitivity of utility loss calculations to equity premium and risk aversion estimates.
Risk aversion
3

Panel A: Risky portfolio (Greek benchmark)

Equity
3.00% 1.58% 4.09%
premium
4.00% 1.29% 3.60%
5.00% 1.17% 3.19%
6.00% 1.22% 2.87%
7.00% 1.43% 2.63%
8.00% 1.81% 2.48%

6.69%
6.14%
5.64%
5.19%
4.80%
4.47%

9.33%
8.74%
8.19%
7.68%
7.22%
6.80%

11.97%
11.36%
10.78%
10.24%
9.73%
9.25%

14.62%
14.00%
13.40%
12.83%
12.29%
11.78%

Panel B: Total portfolio (Greek benchmark)

Equity
3.00% 1.03% 1.52%
premium
4.00% 1.17% 1.46%
5.00% 1.48% 1.49%
6.00% 1.95% 1.59%
7.00% 2.60% 1.78%
8.00% 3.41% 2.06%

2.12%
1.99%
1.92%
1.90%
1.94%
2.04%

2.74%
2.58%
2.46%
2.38%
2.35%
2.35%

3.37%
3.19%
3.04%
2.93%
2.85%
2.80%

4.01%
3.81%
3.65%
3.51%
3.40%
3.32%

Panel C: Risky portfolio (global benchmark)

Equity
3.00% 2.08% 4.38%
premium
4.00% 2.38% 4.22%
5.00% 3.05% 4.24%
6.00% 4.10% 4.45%
7.00% 5.51% 4.84%
8.00% 7.30% 5.42%

6.93%
6.62%
6.42%
6.35%
6.40%
6.58%

9.55%
9.15%
8.85%
8.64%
8.52%
8.50%

12.19%
11.75%
11.38%
11.08%
10.86%
10.72%

14.84%
14.37%
13.95%
13.60%
13.32%
13.09%

Panel D: Total portfolio (global benchmark)

Equity
3.00% 1.53% 1.81%
premium
4.00% 2.26% 2.08%
5.00% 3.37% 2.54%
6.00% 4.85% 3.18%
7.00% 6.70% 4.01%
8.00% 8.92% 5.02%

2.35%
2.46%
2.70%
3.06%
3.55%
4.16%

2.94%
2.98%
3.11%
3.33%
3.65%
4.06%

3.56%
3.55%
3.62%
3.76%
3.97%
4.26%

4.19%
4.15%
4.17%
4.26%
4.40%
4.61%

This table shows utility loss under alternative assumptions about the expected
equity premium and the risk aversion parameter. Panels A and B (C and D) use the
Greek (Global) asset as a benchmark.

2166

T. Angelidis, N. Tessaromatis / Journal of Banking & Finance 34 (2010) 21582167

Table 7
The cost of sub-optimal asset allocation and under-diversication using the aggregate pension fund portfolio as benchmark.
Average (%)
Utility loss
3.52

Median (%)

Standard deviation (%)

Maximum (%)

Minimum (%)

Skewness

Kurtosis

0.35

7.14

41.19

0.47

2.99

10.42

Loss due to asset allocation

0.93
0.25

1.71

9.16

0.24

2.73

7.95

Loss due to idiosyncratic risk

3.12
0.67

5.86

33.91

0.00

2.90

10.04

Loss due to interaction terms

0.53
0.37

0.50

0.03

1.88

0.90

0.19

This table presents statistics on the total utility loss and its components assuming that the aggregate allocation of all Greek pension funds is the optimal allocation for all
pension funds. At the end of 2005, the aggregate asset allocation was 24% in equities, mutual funds and property, 33% in bonds and 43% in cash.

range. The combination of the different assumptions we make creates a wide range of benchmarks which are consistent with a variety of liability structures.
The results in panels A and B of Table 6 use the Greek benchmark while those in panels C and D the global benchmark. The evidence in panel A of Table 6 suggest that for all combinations of
equity premium and risk aversion estimates, the utility loss from
not investing in the Greek benchmark is between 1.17% and
14.62%. At the total fund level, panel B of Table 6, the utility loss
ranges between 1.03% and 4.01%. Against a globally diversied
benchmark, the utility loss is always positive for both the risky
and the total portfolio (Table 6, panels C and D). Even when we assume very low risk aversion and very low equity premium forecasts the utility loss is signicant.
The minimum value of the utility loss is observed when the actual equity and bond weights of the pension funds are close to
bond-equity mix of the benchmark. As the pension fund asset allocation diverges from the benchmark allocation, the utility loss increases. In fact the utility loss is a U-shaped function of risk
aversion with the lowest values when the optimal benchmark is
close to the average allocation of the funds. For low values of the
equity premium, as risk aversion increases the proportion of funds
in bonds in the benchmark increases and as a result the utility loss
rises. For high values of the equity premium and low values of risk
aversion, the optimal portfolio contains a higher proportion of
equities than the average allocation of Greek pension funds and
the utility loss is also at its maximum.
If pension fund liabilities are like a government bond (Bader and
Gold, 2007), hedging liabilities would suggest a bond based investment strategy. To nd the appropriate benchmark in this case we
use the surplus optimization methodology developed by Waring
(2004). Specically suppose RS is the surplus return dened as:

RS

A0
RA  RL ;
L0

13

where A0 is the value of the assets at the begging period, L0 is the

value of the liabilities at the beginning period, RA is the return of
the assets and RL is the return of the liabilities. The objective function is to maximize the surplus mean-variance utility U S RS  kr2S ;
where k is the surplus coefcient of risk aversion and r2S is the surplus variance. To nd the optimal weights we assume that A0 = L0,
k 3 and the underlying asset that best describes the liabilities is
the JP Morgan Greek Government Bond Index. On average the risky
portfolios of Greek pension funds suffer a utility loss of 4.64% per
annum measured against the Greek benchmark or 5.63% per annum
if the benchmark includes foreign assets. At the total pension fund
portfolio level the average utility loss 1.57% if the benchmark is
made up solely by Greek assets and 2.38% for the foreign based
benchmark. These losses14 are within the range presented in Table
14

Detailed results are available upon request from the authors.

5 and reinforce the conclusion that sub-optimal asset allocation

and holding under-diversied portfolios causes signicant nancial
losses to Greek pension funds.
Another possible benchmark, which does not require any
assumptions about future returns, risks and risk aversion, is to assume that the aggregate allocation of all Greek pension funds is the
optimal allocation for all pension funds. Since the Greek state guarantees all pensions, one might reasonably argue that the allocation
of the aggregate funds, driven as it is by the strict investment
framework imposed by the state, reects the states expectations,
risk aversion and total liabilities. At the end of 2005, the aggregate
asset allocation was 24% in equities, mutual funds and property,
33% in bonds and 43% in cash.
Table 7 presents statistics on the total utility loss and its components. The average utility loss is the loss in utility suffered by
Greek pension funds which hold portfolios and allocated their assets differently to that of the aggregate pension fund portfolio.
The average utility loss is 3.52% of which 0.93% due to asset allocation and 3.12% due to idiosyncratic risk. The much lower value of
the median utility loss (0.35%) and the positive skeweness suggests
that while the utility losses for most funds are moderate for some
funds the losses are much higher (the maximum utility loss is
41.19%).
6. Conclusions
Greek pension funds invest most of their funds in either bonds
or cash with equities limited to domestic stocks and only 23% of total funds. The empirical evidence suggests that average total portfolio risk is relatively low reecting the high percentage invested in
bonds and cash. However, there are funds which carry signicant
total risk due to investment in high risk equity portfolios. Equity
portfolios have signicantly higher risks than either a domestic
equity index or an internationally diversied portfolio of equities.
They tend to have more systematic risk (high beta) than the benchmark and signicant idiosyncratic risk. Idiosyncratic risk is substantially higher when equity portfolios are measured against the
global equity benchmark. Restricting equity investments to only
domestic stocks force Greek pension funds to assume risk that
might not be rewarded and could be diversied away. The main
reason for the high idiosyncratic risk is the concentration of the
equity portfolios in a few names.
In theory, investment constraints should impose a cost on constrained portfolios. Our empirical evidence suggests that poorly
diversied portfolios have signicantly lower Sharpe ratios than
well diversied benchmarks. In terms of return loss, under-diversication costs on average 0.91% per annum compared to an investment in a well diversied domestic benchmark and 5.64% per
annum if the benchmark is the world equity index. Against a portfolio invested in the world equity index the monetary loss of all
equity fund portfolios is as much as 328 million and ranges from

T. Angelidis, N. Tessaromatis / Journal of Banking & Finance 34 (2010) 21582167

161 to 430 million per year, depending on the risk premium

assumption.
To study the loss due to sub-optimal asset allocation we use
meanvariance analysis to create appropriate benchmarks for
Greek pension funds. The average utility loss (certainty equivalent
return) for a quadratic utility investor with a domestic benchmark
is 1.92% per annum. The utility loss rises to 3.11% per annum when
the benchmark is well diversied portfolio of world equities and
bonds. Using the world bond and equity portfolio as benchmarks,
two thirds of the utility loss is due to suboptimal asset allocation
and about a third due to assuming diversiable idiosyncratic risk.
References
Almazan, A., Brown, K., Carlson, M., Capman, D., 2004. Why constrain your mutual
fund manager. Journal of Financial Economics 73, 289321.
Bader, L., Gold, J., 2007. The case against stock in public pension funds. Financial
Analysts Journal 63, 5562.
Baxter, M., King, R., 2001. The role of international investment in a privatized social
security system. In: Campbell, J., Feldstein, M. (Eds.), Risk Aspects of
Investment-Based Social Security Reform. University of Chicago Press.
Binsbergen, J., Brandt, M., 2007. Optimal Asset Allocation in Asset Liability
Management. Working Paper, National Bureau of Economic Research.
Blume, M., Friend, I., 1975. The asset structure of individual portfolios and some
implications for utility functions. Journal of Finance 30, 585603.
Bodie, Z., Kane, A., Markus, A., 2008. Investments, seventh ed. McGraw-Hill Irwin,
Boston.
Calvet, L., Campbell, J., Sodini, P., 2007. Down or out: assessing the welfare costs of
household investment mistakes. Journal of Political Economy 115, 707747.
Campbell, J., 2007. Estimating the Equity Premium. Working Paper, National Bureau
of Economic Research.
Campbell, J., Chan, Y., Viceira, L., 2003. A multivariate model for strategic
asset allocation. Journal of Financial Economics 67, 4180.
Clarke, R., de Silva, H., Thorley, S., 2002. Portfolio constraints and the fundamental
law of active management. Financial Analysts Journal 58, 4866.
Claus, J., Thomas, J., 2001. Equity premia as low as three percent. Journal of Finance
56, 16291666.
Darolles, S., Gourieroux, C., 2010. Conditionally tted Sharpe performance with an
application to hedge fund rating. Journal of Banking and Finance 34, 578593.

2167

Davis, P., 1996. Pension fund investments. In: Steil, B. (Ed.), The European Equity
Markets: The State of the Union and an Agenda for the Millennium. The Royal
Institute of International Affairs, London.
De Roon, F., Nijman, T., Werker, B., 2001. Testing for meanvariance spanning with
short sales constraints and transaction costs: the case of emerging markets.
Journal of Finance 56, 721742.
De Santis, G., Gerard, B., 1997. International asset pricing and portfolio
diversication with time-varying risk. Journal of Finance 52, 18811912.
Dimson, E., Marsh, P., Staunton, M., 2006. The Worldwide Equity Premium: A
Smaller Puzzle. Working Paper, London Business School.
Driessen, J., Laeven, L., 2007. International portfolio diversication benets: crosscountry evidence from a local perspective. Journal of Banking and Finance 31,
16931712.
Fama, F., French, K., 2002. The equity premium. Journal of Finance 57, 637659.
Grubel, H., 1968. Internationally diversied portfolios: welfare gains and capital
ows. American Economic Review 58, 12991314.
Hoevenaars, R., Molenaar, R., Schotman, P., Steenkamp, T., 2008. Strategic
asset allocation with liabilities: beyond stocks and bonds. Journal of
Economic Dynamics and Control 32, 29392970.
Karlsson, A., Norden, L., 2007. Home sweet home: home bias and international
diversication among individual investors. Journal of Banking and Finance 31,
317333.
Lucas, D., Zeldes, S., 2009. How should public pension plans invest. American
Economic Review 99, 527532.
Malliaris, A., Malliaris, M., 2008. Investment principles for individual retirement
accounts. Journal of Banking and Finance 32, 393404.
Milonas, N., Papachristou, G., Roupas, T., 2009. Fund management and its effect in
the Greek social security system. Journal of Pension Economics and Finance 4,
485500.
Munnell, A., Soto, M., 2007. State and Local Pensions are Different from Private
Plans. Working Paper, Boston College.
Peterson, P., 1999. Gray dawn: the global aging crisis. Foreign Affairs 78, 4255.
Polkovnichenko, V., 2005. Household portfolio diversication: a case for rankdependent preferences. Review of Financial Studies 18, 14671501.
Sharpe, W., Tint, G., 1990. Liabilities: a new approach. The Journal of Portfolio
Management 17, 510.
Waring, B., 2004. Liability-relative investing. Journal of Portfolio Management 30,
820.
You, L., Daigler, R., 2010. Is international diversication really benecial. Journal of
Banking and Finance 34, 163173.
Zakamouline, V., Koekebakker, S., 2009. Portfolio performance evaluation with
generalized Sharpe ratios: beyond the mean and variance. Journal of Banking
and Finance 33, 12421254.