Thurlow Corporation is a U.S.-based manufacturer of skis and snowboards that began operations
in 1995. In order to attract skilled labor, Thurlow offers employees attractive benefits which
include a defined benefit pension plan and annual wage increases above the rate of inflation. An
asset only (AO) approach to strategic asset allocation is currently used for the investment
management of the pension plan. Tino Beveridge is a consultant to the board of trustees of
Thurlow’s pension plan. The board asks Beveridge to recommend a strategic asset allocation for
the pension plan given the following investment policy objectives:
Return requirement: Earn an average annual return of 8.7 percent plus management and
administration fees of 0.7 percent.
Risk objective: A maximum standard deviation of portfolio returns of 10.0 percent.
For the strategic asset allocation analysis, Beveridge has generated the corner portfolios shown in
Exhibit 1. The Thurlow pension plan investment policy statement (IPS) prohibits short positions
and the use of leverage. The IPS allows investment in any single portfolio or combination of
portfolios described in Exhibit 1.
Exhibit 1
Corner Portfolios
(Risk-free Rate = 4.5%)
Corner
Portfolio
Number
Expected
Return
(%)
Expected
Standard
Deviation
(%)
Sharpe
Ratio
Asset Classes (Portfolio Weights, %)
U.S.
Equities
Non-
U.S.
Equities
Intermediateterm
U.S.
Bonds
Non-
U.S.
Bonds
U.S.
Real
Estate
1 10.8 16.1 0.39 100.0 0.0 0.0 0.0 0.0
2 10.4 14.2 0.42 82.4 0.0 0.0 0.0 17.6
3 10.3 12.7 0.46 74.1 4.0 0.0 0.0 21.9
4 9.1 9.1 0.51 33.7 12.0 36.7 0.0 17.6
5 8.0 7.4 0.47 25.0 11.8 45.3 3.4 14.5
6 6.9 5.2 0.46 0.0 13.7 53.0 27.1 6.2
7 6.6 4.8 0.44 0.0 11.2 53.0 31.5 4.3
A. Using traditional mean-variance analysis:
i.
Select
themostappropriate portfolio or combination of portfolios for the strategic
asset allocation of the Thurlow pension plan.Justifyyour response withone
reason other than meeting Thurlow’s return requirement.
ii.
Determine
the weight of total equities (U.S. and non-U.S. combined) in themost
appropriate strategic asset allocation.
(5 minutes)
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Level III
Beveridge proposes that the IPS be changed to allow borrowing or lending at the risk-free rate,
currently 4.5 percent. He suggests that this change would enable Thurlow’s pension plan to
minimize its expected standard deviation of return while achieving the plan’s required return.
B. i.Determine
themostappropriate strategic asset allocation for the Thurlow pension
plan based on Beveridge’s proposal.
ii.
Explain
how this allocation improves the plan’s risk-adjusted return.
iii.
Determine
the weight of total equities (U.S. and non-U.S. combined) in themost
appropriate strategic asset allocation.
(6 minutes)
In addition to traditional mean-variance analysis, Beveridge also estimates one other form of
portfolio optimization: the resampled efficient frontier approach. The board of trustees also asks
Beveridge whether an asset/liability management (ALM) approach to strategic asset allocation
would be appropriate. The board notes that the pension plan has below-average risk tolerance.
C. i.Identify
two
advantages of the resampled efficient frontier approach relative to
the traditional mean-variance efficient frontier approach.
ii.
Identify
one
advantage in Thurlow’s situation of the ALM approach compared to
the AO approach.