Question
Viktoria Johansson is newly appointed as manager of ABC Corporation’s pension fund. The current market value of the fund’s assets is $10 billion, and the present value of the fund’s liabilities is $8.5 billion. The fund has historically been managed using an asset-only approach, but Johansson recommends to ABC’s board of directors that they adopt a liability-relative approach, specifically the hedging/return-seeking portfolios approach. Johansson assumes that the returns of the fund’s liabilities are driven by changes in the returns of index-linked government bonds. Exhibit 1 presents three potential asset allocation choices for the fund.
Exhibit 1
Potential Asset Allocations Choices for ABC Corp’s Pension Fund
| Asset Class | Allocation 1 | Allocation 2 | Allocation 3 |
|---|---|---|---|
| Cash | 15% | 5% | 0% |
| Index-linked government bonds | 70% | 15% | 85% |
| Corporate bonds | 0% | 30% | 5% |
| Equities | 15% | 50% | 10% |
| Portfolio Statistics | |||
| Expected return | 3.4% | 6.2% | 3.6% |
| Expected standard deviation | 7.0% | 12.0% | 8.5% |
Determine which asset allocation in Exhibit 1 would be most appropriate for Johansson given her recommendation. Justify your response.
Determine which asset allocation in Exhibit 1 would be most appropriate for Johansson given her recommendation.
(circle one)
Allocation 1 Allocation 2 Allocation 3
Justify your response.
Solution
Determine which asset allocation in Exhibit 1 would be most appropriate for Johansson given her recommendation.
(circle one)
Allocation 1 Allocation 2 Allocation 3
Justify your response.
- Allocation 3 is most appropriate.
- To fully hedge the fund’s liabilities, 85% ($8.5 billion/$10.0 billion) of the fund’s assets would be linked to index-linked government bonds.
- Residual $1.5 billion surplus would be invested into a return-seeking portfolio.
The pension fund currently has a surplus of $1.5 billion ($10.0 billion − $8.5 billion). To adopt a hedging/return-seeking portfolios approach, Johansson would first hedge the liabilities by allocating an amount equal to the present value of the fund’s liabilities, $8.5 billion, to a hedging portfolio. The hedging portfolio must include assets whose returns are driven by the same factors that drive the returns of the liabilities, which in this case are the index-linked government bonds.
So, Johansson should allocate 85% ($8.5 billion/$10.0 billion) of the fund’s assets to index-linked government bonds. The residual $1.5 billion surplus would then be invested into a return-seeking portfolio. Therefore, Allocation 3 would be the most appropriate asset allocation for the fund because it allocates 85% of the fund’s assets to index-linked government bonds and the remainder to a return-seeking portfolio consisting of corporate bonds and equities.
Does anybody know why can’t we choose Allocation 1? It is 85% in safer instruments (for the hedging portfolio), and has overall higher Sharpe ratio than Allocation 3.
Many thanks.