Presentation Transcript

1. Asset Allocation Study and Discussion of Asset Classes University of Missouri April 2009 Joe Nankof 203.621.1722 Robin Pellish 203.621.1723Gary Veerman 203.621.1739 t
2. Table of Contents Section I: Introduction Section II: The Strategic Asset Classes and Capital Market Expectations Section III: Allocation Strategy Alternatives Section IV: Asset Class Descriptions & Correlation Matrix u
3. Section I: Introduction v
4. Introduction Primary objective of Retirement Plan assets Meet future benefit commitments Secondary objectives Maximize returns on invested assets at an acceptable level of risk Minimize required contributions to the Plan Purpose of this asset-liability analysis Examine the Plan’s liabilities and investment assets in a variety of scenarios to determine the best asset allocation policy for the Plan to accomplish the above objectives Initial stage of the asset-liability analysis (this Board meeting) Review various asset classes Review various capital market assumptions (outlook for the future) Present for discussion several possible asset allocation mixes to incorporate into the second and final stage analysis The second and final stage of the analysis (next Board meeting) Examine the funded status and contribution projections for a range of possible asset allocation mixes. Determine the asset allocation policy for the Plan assets w
5. What We Know About the Plan Assets and Liabilities An important part of the analysis is the expected growth of the portfolio assets relative to the expected growth of the liabilities. As of 9/30/08, the Retirement Plan was overfunded at 103% of liabilities on an actuarial (smoothed) basis, but, given the magnitude of the market decline in the 4th quarter 2008, it is likely that there is a gap between the Plan liabilities and assets as of calendar year-end 2008. If the Plan were fully funded, the annual budgeted Plan contribution would approximately cover the service cost earned by plan participants each year. Given this contribution level, the Plan assets would have to grow by 8% to meet the liability discount rate assumption of 8%. However, assets have declined significantly on a market value basis over the past year. Therefore, we project that assets would have to grow by about 10.7% per annum to maintain the current funded status. Given asset class return expectations, it seems unlikely that a 10.7% average annual return will be achieved over a multiple year time frame. Therefore, unless contributions rise or we realize a higher than expected return for the portfolio, the funded status of the Plan will decline. x
6. Growth of Funding Deficit Note: the analysis above should be used for illustrative purposes only and does not reflect current or projected UM asset and liability values. y
7. Asset-Liability Study Process Identify alternative asset mixes Detailed projections of liabilities Stage 1 Today Scenario Testing Thousands of simulations under a variety of economic and market conditions Stage 2 June 4-5, 2009 Board Meeting Long-Term Strategic Policy z
8. Section II: The Strategic Asset Classes & Capital Market Expectations aa
9. No Clear Winners… Benefits of Diversification bb
10. We Still Believe in Diversification In 2008, allocations away from traditional U.S. equity/U.S. fixed income portfolios were punished as other equity, bond and alternative asset classes generally underperformed. Diversifying a traditional portfolio with 10% Non-U.S. Equities and 5% Real Estate would have detracted approximately 0.8% from performance in 2008. A very diversified portfolio, as shown in the accompanying chart, would have produced returns that lagged the traditional portfolio by 5.4% in 2008. Over the past ten years, the very diversified portfolio added 3.0% on an annualized basis above the traditional stock/bond portfolio. cc
11. Strategic Asset Classes The University is broadly diversified across a wide variety of asset classes Expected funded status risk could be reduced with a modest reduction in return by reducing the allocation to public market equities There are other asset classes which could improve the diversification of the Fund although significant allocations would be required to have a material impact on the expected risk and return of the Fund. dd
12. Strategic Asset Classes UM currently has exposure to the asset classes in bold. Blue highlighted asset classes are being proposed as additions to the current investment structure. Equities U.S. Equity Non-U.S. Developed Equity Emerging Equity Fixed Income Core U.S. Fixed Income Non-U.S. Developed Fixed Income Treasury-Inflation Protected Securities High Yield & Bank Loans Long Bonds Emerging Market Debt (EMD) Convertibles Alternatives Private Real Estate Public Real Estate (REITs) Private Equity (Buyouts & Venture Capital) Commodities Absolute Return ee
13. Why Invest in High Yield? Incremental returns over investment grade fixed income with some incremental pick up in volatility, but less volatility than U.S. equity. Rocaton expected long-term passive return = 8.0% and risk = 8.3%. Lack of perfect correlation with the other strategic asset classes, hence acting as a diversifier. Generally a pro-cyclical investment class; not necessarily deemed a defensive strategy. Market dislocation has presented an interesting entry point for high yield investors. Additional information can be found in section IV. ff
14. Why Consider Bank Loans? Bank loans are a floating rate asset which is expected to provide better protection than traditional high yield and most other fixed income in a rising interest rate environment. Also, bank loans have historically exhibited lower correlations to other major asset classes. Recent market technicals have been unfavorable. Bank loans have significantly underperformed high yield bonds in the recent market stress. In the summer of 2007 as credit markets around the world rapidly deteriorated, the bank loan market suffered due to the unwind in leverage from CLO and hedge fund investors and from technical imbalances in supply and demand. With only a limited increase in defaults, the loan market has traded down from par to approximately $65. Although the risk of higher than historical default levels are a concern, many view this as a short term phenomenon and an attractive buying opportunity. Additional information can be found in section IV. gg
15. Why Consider Emerging Market Debt? Equity-like returns with marginally less volatility. Rocaton expected passive return = 8.5% and risk = 9.3% Lack of perfect correlation with other strategic asset classes, hence acts as a diversifier. Exposure to a rapidly evolving asset class potentially offering significant opportunity to the nimble investor. Investable emerging local currency marker debt has almost doubled in market capitalization since 2005; additionally, the emerging market corporate debt market continues to grow. Sound fundamentals continue to support the emerging market debt asset class. In fact, improving fundamentals have led to improved credit quality of the emerging debt index over the past several years. EMBI Global Diversified is an index of dollar denominated emerging market debt Source: JPMorgan. Additional information can be found in section IV. hh
16. Why Invest in Commodities? Diversification: Commodities have exhibited low correlation against equity markets since the commodity indices were established. Rocaton expects that over the long-term commodities will continue to diversify portfolios. Potential inflation hedge: Statistical analysis of commodity returns with respect to inflation suggests that commodities provide a modest hedge of expected and unexpected inflation. Commodities represent “real” inputs to the economy. Market inefficiencies exist and active management can add value. Commodities markets are highly segmented with a variety of participants who have differing economic objectives (hedging, short term speculation, global macro players, trend followers). Pension investors can profit from bearing volatility and taking a longer term time horizon. Additional information can be found in section IV. ii
17. Asset Class Market Assumptions Next 10 year return assumptions reflect the higher overall level of risk premiums currently priced into the global financial markets. Sources: GMO, Rocaton jj
18. Defining Risk All investors have become more conscious of portfolio risk over the last two years. Risk is multi-dimensional and should be viewed from a number of perspectives. Some of the important metrics of risk are noted below: Standard Deviation: A common approach towards characterizing the risk in asset classes and portfolios is the use of “standard deviation.” This is a quantitative expression designed to show the volatility of returns over time. One issue with this calculation is that it doesn’t distinguish between “positive” volatility and “negative” volatility. Also, it assumes that asset returns follow a normal distribution, which is not always true. Funded status: Evaluating the assets relative to the liabilities provides plan sponsors with a more complete measure of the plan’s financial position. Macro Environment Risk: Another way to assess portfolio risk is by understanding the portfolio’s exposure to various market environments and economic factors. For example, one could evaluate how a portfolio might perform in an inflationary environment. Other factors: Other risk factors which should be considered when constructing candidate portfolios are liquidity risk, credit risk, and interest rate risk. kk
19. Asset Class Market Assumptions – U.S. Equity Equity Market High October, 2007 Reach New Highs August, 2016 Rocaton Forecast 10%/year Based on our expected annual compound return of 10%, the broad equity market will take approximately 7 years and 6 months to reach October, 2007 highs. Sources: GMO, Rocaton ll
20. Section III: Allocation Strategy Alternatives mm
21. Model Assumptions of Assets We have applied a series of asset class constraints when constructing candidate portfolios to take into consideration some of the risks identified earlier in today’s discussion. Our modeling included the following constraints to target specific portfolio level risks: Credit Risk: Bank Loans + High Yield + Emerging Market Debt ≤ 30% Liquidity Risk: Private Equity + Private Real Estate + Absolute Return ≤ 15% Inflation Risk: Commodities + TIPS ≤ 25% In addition, our modeling includes the following general assumptions: U.S. Equities = Non-U.S. Developed Equities Private Equity = 67% Buyout + 33% Venture Capital Emerging Market Equities = 20% Developed Market Equities For each asset class that was selected as part of the UM opportunity set, we did not allow any allocation to an individual asset class to be less than 3 percent across the candidate portfolios, unless the allocation was zero. nn
22. Efficient Frontier Analysis oo
23. Possible Candidate Asset Mixes pp
24. Asset Class Environmental Exposures qq
25. Portfolio Environmental Exposures rr
26. Section IV: Asset Class Descriptions & Correlation Matrix ss
27. U.S. Treasury Inflation Protected Securities (“TIPS”) These high quality investments are owned to diversify equity and conventional bond risk and to provide a better long-term hedge against expected and unexpected inflation than other asset classes through a real return that is known and fixed at maturity. While government guaranteed, TIPS are mechanically different to U.S. nominal treasuries in that both the interest and principal are index to the CPI-ALL Urban Consumers (CPI-U) so that increases in consumer prices are directly translated into higher principal and interest payments over the life of the bond. Absolute volatility level expected to be lower than that of core U.S. fixed income of the same duration given investment’s sensitivity to real interest rates as opposed to nominal interest rates. A relatively new asset class with a short track record, U.S. TIPS were first issued in January 1997. The apparent U.S. Treasury’s commitment, size of market and continued growth as well as liquidity of this market demonstrate its likely long-term viability as a strategic asset class. Compared many other asset classes, the U.S. TIPS market is relatively small with limited supply. Compared to commodities, another inflation-hedging asset, TIPS are highly sensitive to changes in real interest rates. Opportunity for active management is limited. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent tt
28. Core U.S. Fixed Income Fixed income is the primary asset class owned by institutional investors to diversify equity risk given its low absolute risk levels and low correlations with other traditional strategic asset classes. Recent performance of government and credit securities have diverged and has led many investors towards implementing the two components as distinct asset classes. The role of fixed income is primarily one of diversification and, in some cases, to hedge interest rate risk inherent in liabilities. The diversification benefit versus equities has been highlighted in recent years as the bond/equity correlation has been low and even negative so as equity losses occurred, bonds produced positive returns. This is the one asset class expected to do reasonably well during deflationary periods. Given that interest rates are at or near 45 year lows, some question performance prospects for this asset class nearer term. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent uu
29. Non-U.S. Core Fixed Income The non-U.S. Core fixed income market is comprised primarily of investment grade, sovereign government debt of the international developed countries. The market represents approximately 40% of the world bond markets and inherently, a well-diversified investment class given exposure to multiple markets. On an unhedged basis, risk levels are increased as currency volatility swamps fixed income volatility requiring careful thought about currency management. With the advent of the Euro, member countries must adhere to similar economic guidelines suggesting the interest rate cycles going forward will be more highly correlated than in the past. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent vv
30. Bank Loans Bank loans are floating rate, privately placed high yield bonds. Because of their floating rate nature they have little to no interest rate risk and are appealing investments in rising interest rate environments. Exhibit low levels of volatility – historically has been between cash and core fixed income – and low correlation to other asset classes. Offer attractive yields over cash as compensation for credit risk and low liquidity. Bank loans contain default risk, but recovery rates in default are much higher than for high yield bonds (70% vs. 35%) due to seniority in the capital structure. The loan market has exploded in the last few years and is now the size of the high yield market. An inefficient and clubby market where good credit analysis and a manager’s relationships with syndicate banks can generate strong returns from active management. Portfolio uses can be varied: as a complement to high yield allocation, as a low volatility investment, or as a return enhancement strategy if leverage is employed. Recent performance has been very poor (-30% in 2008) and volatility has picked up significantly. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent ww
31. Market Profile – Bank Loans Source: CSFB xx
32. Bank Loans – A Historical Perspective Avg. = 7.1% Avg. = 4.3% Avg. Return = 6.5% Avg. Risk = 2.3% Avg. = 2.3% Source: Credit Suisse yy
33. High Yield Debt High yield bonds exhibit both debt and equity characteristics. Like stocks, high yield bond prices are more sensitive to the economic outlook and corporate earnings than day-to-day interest rate fluctuations. While high yield bonds share some behavioral characteristics with stocks, their overall return has been and is expected to be less volatile because their income is normally much higher and they have a senior claim on corporate assets. Expected to provide greater income than their investment grade counterparts which comes with increased risk of issuer default. The lack of perfect correlation with other strategic asset classes and relatively high expected risk-adjusted returns over a full market cycle make high yield an attractive addition to an investment portfolio. Results tend to follow the economic cycle doing poorly during recessionary environments and well during expansionary times. An inefficient market where good credit analysis should achieve strong active management premium. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent zz
34. Market Profile – U.S. High Yield Index Source: Merrill Lynch aaa
35. High Yield Bonds – A Historical Perspective AVG. = 10.30 AVG. = 568 AVG. = 4.82 Avg. Return = 6.2% Avg. = 3.8% Source: Merrill Lynch *Annualized bbb
36. Emerging Market Debt Investments in this asset class are generally made via U.S. dollar denominated, sovereign country debt, though investments in local currency-denominated and corporate debt are becoming more and more common. A highly liquid market that continues to evolve. Expected to provide higher income than investment grade U.S. fixed income albeit with greater volatility due to credit, political and economic risk. Expected long-term performance driven by the ability and willingness to pay down debt on the part of developing nation. Unlike emerging equities, emerging market sovereign debt is not a claim on any company’s assets, thus subjecting it to different risks and thereby providing for some diversification benefits. Emerging market local currency debt is growing rapidly and approximately half of the total EMD market. Inefficient market with high potential for value-added active management. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent ccc
37. Emerging Market Debt Profile Source: JP Morgan *Investment Grade **Residual Other Includes: Lebanon, Peru, China, Ukraine, Uruguay, Argentina, Chile, Ecuador, South Africa, Poland, El Salvador, Iraq, Hungary, Bulgaria, Egypt, Pakistan, Gabon, Serbia, Ghana, Vietnam, Trinidad & Tobago, Tunisia, Dominican Rep., Kazakhstan, Jamaica, Sri Lanka, Belize, and Cote d’voire ddd
38. External Debt Spreads Russia Defaults August 1998: 1,485 bps JPMorgan EMBI Global Index January 1998 – February 2009 Brazil Devalues Run-up to Lula election in Brazil; generally volatile credit markets Argentine Crisis October 2008: 891 bps Ukraine Defaults Argentina defaults, drops out of the index Ecuador Defaults Source: JPMorgan. Spreads have widened by 365 bps since 2/28/2008 to 672 bps as of 2/28/2009. The precipitous decline in prices represents potential opportunity in the asset class as credit fundamentals have improved meaningfully over the past ten years. A large portion of external sovereign debt is now investment grade. Current market conditions also present Emerging Market Debt investors with the opportunity to diversify out of the dollar denominated external debt markets. eee
39. U.S. Equities U.S. equities are the asset class of choice for U.S.-based investors willing to take extra risk in pursuit of greater returns than U.S. fixed income. Equities can decline significantly and over prolonged periods of time. The asset class is very liquid and generally efficient although managers of mid/small cap stocks in particular have added value through stock selection over market cycles. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent fff
40. Non-U.S. Equities Owned to tap into companies domiciled outside the U.S. and markets that may exhibit different cycles than the U.S. market. Non-U.S. Investing has been practiced by U.S. institutions since the 1970’s. Long-term returns are expected to be not too dissimilar to U.S. stocks but in somewhat different cycles. Currency exposure from these investments is another element of the diversification benefit and another risk, though currency exposure may be hedged. The diversification rationale behind non-U.S. investing changes overtime as the world’s markets and economies evolve. Given the convergence caused by the Euro currency and the subsequent homogenization of economic cycles in continental Europe, as well as the advent of intense global industrial competition, correlations across the developed equity markets appear to be rising. These correlations have not risen to the point where investing outside the U.S. is no longer compelling. A period of rising trade barriers potentially could make economies more insular and their markets less correlated. The growing trend of investing in global vs. non-U.S. portfolios reflects investor interest in gaining access to a wider opportunity set. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent ggg
41. Emerging Markets Equity These assets are held for potentially high returns due to higher expected growth rates of the emerging economies which are undergoing sustained periods of rapid development. Public companies have a great opportunity to benefit from the economic growth and to translate that benefit into shareholder value. These markets are susceptible to capital flight in times of either country specific or regional panic. The result is that this is one of the most volatile of the asset classes. Over short-term periods, emerging markets equity can provide diversification benefits versus U.S. and developed international equity. However, this is likely not reliable over every cycle. This asset class lends itself to active management due to its inefficient nature. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent hhh
42. Commodities Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent Commodity-driven inflation has been one of the major sources of higher prices. Commodity exposure is typically achieved via a passive index in financial futures (not physical commodities) weighted to reflect world production and is therefore 60% energy related. Because of this, the index is also highly volatile and not necessarily the best measure of inflation. Alternative indices with less energy exposure are available. Both statistically and economically, commodities are highly uncorrelated with stocks and bonds. Research suggests that commodities do particularly well late in economic cycles after stocks typically have run out of steam. Commodities are expected to have a very low real return longer-term. iii
43. Commodities Portfolio Mechanics Commodity exposure is generated through derivatives such as commodity futures contracts, commodity index total return swaps, or structured notes. A small amount of margin (~5%) is required to establish an exposure. The remaining capital is invested in a money market portfolio or a longer duration portfolio such as TIPS. For passive strategies, index total return swaps are used predominantly in separate accounts and commingled funds whereas mutual funds have to use structured notes. Actively managed strategies can use swaps, futures, options, exchange traded funds and commodity-related equities. Commodity Indices Sector Weights Most recently available weights were used. Source: Dow Jones, Standard & Poor’s jjj
44. Timing Considerations Commodities went from boom to bust in less than 6 months as expectations of future demand decreased sharply. However, the long-term fundamentals which led to the steady price increase over the past 6 years are still there, and have been augmented by a number of other factors as a result of lower prices and a credit crunch: Years of underinvestment in exploration, processing, and production mean that suppliers will be hitting capacity limits once again when the demand returns. Expanding the supply capacity will prove problematic going forward as the easy-to-reach and well-developed sources deplete and the new ones are increasingly more expensive to develop and/or process. Alternative energy sources have been slow to develop and for the most part are uneconomical at today’s oil prices. Current prices are below the marginal cost of production for a significant number of producers, particularly in oil, natural gas and zinc* The extremely tight credit environment will exacerbate underinvestment in exploration & production. While demand may remain sluggish enough to offset the supply pressures for some time, the current entry point appears attractive. *Source: Wellington kkk
45. Private Equity This asset grouping encompasses all investments (except real estate) that are not publicly traded. Venture capital relates to financing new and growing companies; buyout funds relate to buying all or part of a company to improve its operations or pay down its debt; mezzanine debt involves subordinated loans to companies; other forms could include oil and gas investments. Because terms of private equity are generally negotiated deal by deal and unique to each company, opportunities exist to select companies or deal structures capable of delivering very high returns. Individual deals have a high failure rate and very high investment management fees. They are illiquid over long periods. Private equity investing is most successful when there is a robust stock market into which to sell mature deals. Because of their dependence on the ability to raise debt cheaply and quickly, buyout investments are also highly sensitive to credit cycles. As a result, these asset categories are highly risky and rely on a sustained investment year by year to achieve above average returns. Superior active management is needed to meet expected returns. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent lll
46. Real Estate Real estate investing for institutional investors began in the early 1970’s just in time for early adoptersto benefit from the burst of inflation that occurred from 1973-1982. Because of this real estate has been recognized for its inflation protection when resources (including commercial space) are scarce and rental rates increase. The institutional real estate market has undergone significant change since the early 70’s leading to more diverse opportunities along the risk/return continuum. Over the past ten years of declining inflation, real estate investments have been very rewarding. They also proved to be a major diversifier of equity risk. Private real estate investments are mostly illiquid and management is moderately expensive. Basic asset class Low institutional use Major risk diversifier Superior returns High Volatility Reserve for benefits Inflation protection Low Costs Liquid Inefficient Transparent mmm
47. Absolute Return Strategies Absolute return strategies are structured so that the major driver of investment returns is active management; market exposure (or beta) is intended to be low. Absolute return strategies are, therefore, designed to produce positive returns regardless of the direction of the market. Absolute return strategies generally promise to deliver LIBOR plus a spread with varying degrees of risk. Historically, absolute strategies have performed well with both strong absolute and risk-adjusted results. Advantages of absolute return strategies include diversification, breadth and flexibility of the opportunity set, strong Sharpe ratios and exposure to top investment talent. Absolute return strategies also come with higher fees, less liquidity, typically less transparency, more complexity and strategy drift . Absolute return strategies encompass a wide array of investment categories. Common strategies include convertible arbitrage, merger arbitrage, fixed income arbitrage, long/short equity and credit, global macro, and statistical arbitrage. Basic asset class Low institutional use Major risk diversifier Superior risk-adjusted returns High Volatility Reserve for immediate liquidity Inflation protection Low Costs Liquid Inefficient Transparent nnn
48. Correlation Matrix ooo
49. Summary The analysis shows that the Fund: Is broadly diversified across a wide variety of asset classes. Could reduce expected funded status risk with a modest reduction in return by reducing its fairly significant allocation to public market equities. Does not currently allocate to four asset classes (commodities, emerging market debt, high yield bonds, bank loans) which, if included, could improve the diversification of the Fund. Would have to make significant allocations to the new asset classes to have a material impact on the expected risk and return of the Fund. Will have to finance an expected funding deficit through a combination of increased contributions and investment returns. The next stage of this analysis will examine the impact on expected funding status and contributions caused by moving from the current target asset allocation to any one of the candidate allocations. ppp
50. Disclosures The analysis contained in this document may contain historical information which may not be indicative of future experience. The analysis contained in this document may contain long-term, forward-looking assumptions regarding risk and/or return. These assumptions are used for modeling purposes only and may not be realized. The potential impact of active management may not be included in the analysis. This analysis was prepared on a best-efforts basis and no warrantees or guarantees are made with respect to any reliance made on this analysis. qqq