Sabonete Case Scenario
Sabonete, S.A., is a multi-national consumer products company headquartered in Lisbon, Portugal, with annual revenue of approximately €2 billion. Over the past several years, the company’s growth strategy has centered on expanding market share in emerging markets. Over half of revenues are from emerging markets, and the remainder are from developed European economies. Oni Falana serves as the chief investment officer of Sabonete’s defined benefit pension plan (SPP).
Falana has engaged an outside consultant, Isabel Horvath, for assistance with asset allocation. Falana describes to Horvath the company’s key objectives with respect to the SPP:
- reach fully funded (100%) status in five years, at which point the liabilities will be fully hedged,
- minimize fluctuations in expected year-to-year required contributions, and
- minimize the administrative and investment costs associated with managing the fund.
Falana provides Horvath with the following key facts and assumptions regarding Sabonete and the SPP:
- The fund is closed to new employees, but existing employees continue to accrue benefits under the original terms.
- The fund is 90% funded (€5 billion in assets and an accrued benefit obligation of €5.55 billion).
- A €75 million contribution will be made to the fund at the end of this quarter. Future contributions are likely to be substantially smaller.
- The average participant is 45 years old, and employee turnover has been low.
- The salary growth rate is 3.2%
- The liability discount rate, currently 3.5%, is benchmarked to 10-year AA corporate bonds.
- The risk-free rate is currently 3.0%, and short-term interest rates are expected to remain stable.
- The current asset allocation and other statistics (expected return, volatility, and correlation with global equities) of each asset class are indicated in Exhibit 1.
Exhibit 1 SPP Current Asset Allocation and Other Statistics by Asset Class
Statistics by Asset Class | ||||
Asset Class | Current Asset Allocation | Expected Return | Expected Volatility | Correlation with Global Equities |
Global fixed income | 30% | 3.5% | 3.5% | 0.10 |
Global developed market equity | 30% | 6.0% | 18.0% | 1.00 |
Emerging market equity | 25% | 7.0% | 22.0% | 0.86 |
Real estate | 10% | 4.5% | 10.0% | 0.48 |
Private equity | 5% | 7.5% | 25.0% | 0.85 |
Hedge funds | 0% | 5% | 6.5% | 0.81 |
Horvath starts by preparing an economic balance sheet for the SPP and makes the following notes:
- Emerging market equities have a 10% weight in the global market portfolio. However, given the firm’s familiarity with and the opportunities they perceive in emerging markets, the SPP has historically been over-weighted (25%) in this asset class.
- 60% of company revenue is from sales in emerging markets, of which half is attributable to sales in Africa. The revenue growth rate for Sabonete’s African business is high but very volatile. The firm’s revenues and profitability are quite sensitive to emerging markets.
- The firm has significant investments in African real estate. It recently acquired several large parcels of land in Africa for €200 million and is planning to make a major investment in new manufacturing facilities to boost margins.
Based on these factors and the information from Exhibit 1, Horvath presents the current asset allocation of the plan along with two other options for consideration (see Exhibit 2).
Exhibit 2
Current and Proposed Asset Allocation Options
Asset Class | Current | Option 1 | Option 2 |
Global fixed income | 30% | 25% | 35% |
Global developed market equity | 30% | 20% | 30% |
Emerging market equity | 25% | 20% | 15% |
Real estate | 10% | 10% | 5% |
Private equity | 5% | 10% | 5% |
Hedge funds | 0% | 15% | 10% |
Expected return | 5.4% | 5.5% | 5.1% |
Expected volatility | 14% | 13% | 12% |
Sharpe ratio | 0.17 | 0.19 | 0.175 |
Recee Radell, an analyst in SPP’s pension office, makes the following statements regarding Option 1:
Statement 1 | Based on its Sharpe ratio, Option 1 is most consistent with Sabonetes objectives. |
Statement 2 | The 10% allocation to real estate is too high given the companys recent real estate acquisitions in Africa. |
Statement 3 | The 20% allocation to emerging market equity is too high given the sensitivity of the firms revenues to emerging markets. |
Q. Which of Radell’s statements regarding asset allocation Option 1 is most appropriate?
A. Statement 1
B. Statement 2
C.Statement 3
Answer given by CFAI
Solution
B is incorrect because Sabonete’s land holdings outside of the pension fund are not considered a part of the extended balance sheet for the SPP and should not affect its asset allocation decisions.
Sabonete’s recent acquisition of land in Africa are outside of the pension fund and, therefore, should not be considered a part of the extended balance sheet for the SPP and should not affect its asset allocation decisions.
MY doubt is:
Why B is wrong. My doubt stems from the fact that we did one EXAMPLE 3 of the first chapter of Asset Allocation and I copy the same here:-
EXAMPLE 3
The Economic Balance Sheet of Auldberg University Endowment
- Name: Auldberg University Endowment (AUE)
- Narrative: AUE was established in 1852 in Caflandia and largely serves the tiny province of Auldberg. AUE supports about one-sixth of Auldberg University’s CAF$60 million operating budget; real estate income and provincial subsidies provide the remainder and have been relatively stable. The endowment has historically had a portfolio limited to domestic equities, bonds, and real estate holdings; that policy is under current review. Auldberg University itself (not the endowment) has a CAF$350 million investment in domestic commercial real estate assets, including office buildings and industrial parks, much of it near the campus. AUE employs a well-qualified staff with substantial diverse experience in equities, fixed income, and real estate.
- Assets: Endowment assets include CAF$100 million in domestic equities, CAF$60 million in domestic government debt, and CAF$40 million in Class B office real estate. The present value of expected future contributions (from real estate and provincial subsidies) is estimated to be CAF$400 million.
- Liabilities: These include CAF$10 million in short-term borrowings and CAF$35 million in mortgage debt related to real estate investments. Although it has no specific legal requirement, AUE has a policy to distribute to the university 5% of 36-month moving average net assets. In effect, the endowment supports $10 million of Auldberg University’s annual operating budget. The present value of expected future support is CAF$450 million
Q2.
Describe elements in Auldberg University’s investments that might affect AUE’s asset allocation choices.
The solution to 2:
AUE’s Class B real estate investments’ value and income are likely to be stressed during the same economic circumstances as the university’s own real estate investments. In such periods, the university may look to the endowment for increased operating support and AUE may not be well-positioned to meet that need. Thus, the AUE’s real estate investment is actually less diversifying than it may appear and the allocation to it may need to be re-examined. Similar considerations apply to AUE’s holdings inequities in relation to Auldberg University’s.
Hope I have made my point clear. When we contrast the two questions, we find that in the latter(AUE), the core has brought into consideration the assets of Auldberg University while deciding the asset allocation of Auldberg University Endowment (AUE).
Then why, in Sabonete Case Scenario, shouldn’t we bring into consideration the investments of sponsorer -Sabonete, S.A.- into African real estate while considering the Asset allocation of the pension fund SPP
The answer gives the rationale for b being incorrect that the real estate investment made by the sponsor firm are not to be included in the economic balance sheet. I think they are hinting that the real estate investment for fund are different in characteristics compared to the real estate investments of the sponsor. And the real estate as an asset class is heterogeneous.
If the allocation to real estate was infact made to earn higher returns, this goal would be hurt if real estate underperformed and the investment is common for both (which seems nit to be the case here) the sponsor would not be able to contribute to the fund during bad times.
Also the core example states an endowment which is different from a pension fund and has a very different set of goals. The endowment in the example will not be able to provide for the university’s expenses in case common investment in real estate underperformed.