answer the questions on the files
Q1. Norwegian Fisherman Pension Plan (NFPP) is the pension fund of a Norwegian-based fishing company. NFPP is fully funded with 8 billion Krone (NOK) in assets and has the following investment policy objectives: • Earn a 10.3% annual portfolio return. • Have a maximum Roy’s safety-first ratio with a minimum return threshold of 8%. • Maintain a cash balance sufficient to meet liquidity requirements. • Maintain a maximum of 10% of assets in a passively managed sub-portfolio that is indexed to the S&P GSCI Precious Metals Index (SPGSPM). NFPP expects to pay NOK 380 million in pension benefits this year. At an investment committee meeting regarding possible changes to NFPP’s strategic asset allocation policy, the committee reviews five alternative portfolio allocations that meet NFPP’s return objectives. These alternatives are shown below in Exhibit 1. Exhibit 1 Alternative Portfolio Allocations (%) Asset Class Portfolio Allocations A B C D E Cash equivalents 3 5 6 5 6 SPGSPM 10 12 8 7 9 Global Bonds 40 40 47 45 41 Global Equity 47 43 39 43 44 Total 100 100 100 100 100 Portfolio Measures A B C D E Expected Total Annual Return 11.26 11.19 10.44 10.6 10.87 Expected Standard Deviation 14.90 14.82 13.93 14.15 14.52 Determine the most appropriate portfolio for NFPP. State, for each portfolio not selected, one reason why it is not the most appropriate. Q2. USF is a private, tax-exempt, educational institution and has an endowment with the purpose of providing financial support to the university budget. Currently, the spending rule for the endowment is 4 percent of the market value of its investment portfolio as of the previous year-end. Based on the endowment’s 2018 year-end market value of $1.2 billion, the annual distribution represents 5 percent of the operating budget for USF, just meeting USF’s desired level of endowment support. USF expects a similar dollar level of endowment support, indexed to inflation in its costs, in future years. The university’s operating expenses are expected to grow at a nominal rate of 3.25 percent per year for the foreseeable future. The inflation rate in the U.S., as measured by the Consumer Price Index (CPI), is expected to be 2.0 percent per year for the foreseeable future. The endowment investment committee is concerned because the endowment has not met its stated return requirement over the last four years. The investment committee has hired George Burns, CFA, as an investment consultant. Burns prepares Exhibits 1 and 2 in his review of the endowment and suggests the committee formulate an investment policy statement (IPS). Exhibit 1 Spending History of USF Endowment Year Ending 31 December Market Value of Endowment 4% Spending Allowance for the Following Year 2014 $850,000,000 $34,000,000 2015 $975,000,000 $39,000,000 2016 $925,000,000 $37,000,000 2017 $1,010,000,000 $40,400,000 2018 $1,200,000,000 $48,000,000 Exhibit 2 Comparison of USF Endowment and the Average University Endowment Portfolio Characteristics as of 31 December 2018 USF Endowment Average University Endowment Market Value $1,200,000,000, $1,080,000,000 5 Year Annualized Rate of Return 9.04% 11.2% Investment Management Expense 0.55% 0.58% A. Formulate the return requirement for USFs endowment’s IPS. Show your calculations. B. Indicate if each factor below increases or decreases the endowment’s ability to take risk: a. USF endowment’s role in the university’s operating budget b. The USF endowment’s past performance as reflected in the year-end market values of the endowment Justify each of your responses with one reason. C. Prepare the liquidity and time horizon constraints of USF endowment’s IPS. Two years have passed since Burns was hired, and the endowment’s investment portfolio now has an asset allocation of 55 percent global equities, 40 percent global fixed income, and 5 percent cash. A newly established goal of USF is to enhance its scholarship program in order to attract a larger number of top- rated students. The endowment investment committee asks Burns to develop a funding strategy for the additional scholarships. Burns suggests the USF endowment adopt a rolling three-year average spending rule, in which the 4 percent spending calculation is based on the average ending market value over the previous three years. D. Justify the adoption of a rolling three-year average spending rule by the USF endowment. Burns suggests the endowment investment committee consider adding alternative investments to improve the portfolio’s returns and to offer greater diversification benefits. The endowment investment committee is willing to assume additional risk, but is opposed to investing in asset classes that significantly reduce the liquidity of the overall portfolio. Burns suggests reducing global equities to 45 percent of the portfolio and global fixed income to 35 percent of the portfolio, and investing the proceeds equally in indirect real estate, commodity futures, and hedge funds. He compiles the data on the historical performance of the asset classes shown in Exhibit 3 and adjusts the data to approximate “net-of-fees” returns for a client of USF’s size. Burns expects these data will be representative of future investment performance. Exhibit 3 Historical Data for the Period 2000 – 2018 Measure MSCI World Equity Barclays Global Agg Bond NAREIT Indirect Real Estate GSCI Commodity HFRI Hedge Funds Annualized Return (net) 10.45% 6.54% 11.50% 6.89% 13.24% Standard Deviation 16.93% 4.31% 13.08% 21.61% 7.64% Sharpe Ratio 0.44 0.82 0.65 0.18 1.34 Correlation with MSCI World Equity 1 0.12 0.38 -0.09 0.51 Correlation with Barclays Global Agg Bond 0.12 1 0.18 0.04 0.15 E. Evaluate the impact of Burns proposed asset allocation with reference to the portfolio’s: a. Return b. Risk c. Liquidity Note: No calculations are required.