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DISCUSSION PAPER PI-0012

International Asset Allocation with Time-varying Investment Opportunities

Allan Timmermann and David Blake

ABSTRACT

This paper analyzes the international equity holdings of a large panel
of UK pension funds. We find considerable evidence of market timing
activity, as illustrated by the fundsí decision to scale back their investments
in the US stock market during the 1990s. To explain this we model portfolio
weight dynamics as a function of time-varying conditional moments.
We find that a substantial part of the evolution in portfolio weights is
explained by time-varying conditional expected returns, volatilities and
covariances with domestic equity returns. Consequently, controlling for
the effect of state variables that track time-variations in investment
opportunities significantly affects estimates of returns from international
market timing. Our estimates suggest that the portfolio movements that were
orthogonal to such state variables accounted for a net loss of 0.2 per cent
per annum for the median fund.