Changing Paradigms for Public Investors Docs/Annual... · Fund of Hedge Funds 6.8% 7.6% Equity Activist 11.3% 18.0% ... “Constrained” and “non-constrained” investing approaches

Julian M. Regan Vice President & Senior Consultant

The Marco Consulting Group May 5, 2015

Changing Paradigms for Public Investors Constrained and Unconstrained Investment Strategies

NCPERS 2015 Annual Conference and Exhibition

The Marco Consulting Group

Challenges & Opportunities

Market Environment

Definitions, Terms, Examples

Constrained and Unconstrained Investment Strategies*

Potential Benefits & Risks

Risks Oversight Tradeoffs

Conclusions


Public Pension Funds: Challenges and Opportunities

Funding Levels – Improvement from market meltdown

Assets and Liabilities – Asset growth outpacing liability growth

Pressure on Contributions – Lingering impact of 2007 - 09 recession

Risk and Liquidity Challenges – Strengthened risk oversight

Market Environment – Changing capital market assumptions

2,093,614

3,337,400

Mar 2009

Dec 2014

100 Largest U.S. Public Pension Fund Holdings (millions)*

Source: U.S. Census Bureau, March 26, 2015

“Confidence continues to rise among public pension plan administrators about the sustainability of their funds and readiness to address future retirement issues.” - NCPERS, November 24, 2014

The Marco Consulting Group 3

Annualized Investment Returns and Asset Growth Due to sound decisions and favorable markets public pension funds asset growth

has outpaced liability growth in recent years. Challenges include accounting rules, demographics and pressure on contributions.

Source: National Association of State Retirement Administrators. Wilshire Associates.

Net Annualized Investment Returns (%)

State Funds Assets & Liabilities ($)

7.75%

8.80%

Median Public Return Assumption Median Public Annualized Return

Median Public Pension Annualized Returns 25 Years ended 6/30/2014*

2,824,300 2,897,400 1,961,000 2,117,700

6/30/2012 6/30/2013

State Pension Plans Assets & Liabilities ($millions)

Liabilities Market Value of Assets


Global Economic and Market Environment

4

Modest projected growth in mature economies. Decelerating growth in many emerging economies.

Changing capital market assumptions for many core asset classes.

Modest bond yields and elevated interest rate risk in the aftermath of a 30-year plus bull market for bonds.

Moderate U.S. economic recovery, low inflation, corporate profits.

Uncertain means of Federal Reserve exit from unprecedented accommodative monetary policy.

Focus on U.S. equity valuations following the near tripling of the S&P 500 index between March 2009 and February 2015.

Asset Class Assumptions

Expected Return

Standard Deviation

US Large Cap 8.4% 18.6%

US Mid Cap 9.0% 21.1%

US Small Cap 9.9% 24.4%

Int'l Equity (unhedged) 8.8% 21.1%

Int'l Emerging Mkt 11.2% 30.3%

FI - Core 3.4% 6.9%

FI - High Yield 7.6% 10.5%

FI - Int'l (hedged) 2.8% 4.1%

FI - Global TIPS 3.4% 7.0%

FI - Long 5.2% 11.5%

FI - Bank Loans 5.5% 8.0%

FI - Emerging Mkt 7.0% 15.0%

Real Estate Equity - Core 6.8% 8.5%

Private Equity 11.1% 22.0%

Fund of Hedge Funds 6.8% 7.6%

Equity Activist 11.3% 18.0%

Commodities 6.9% 16.6%

Market environment summary is for illustrative purposes. Not all inclusive.


Active vs. Passive Management Increased use of passive

management to gain exposure to efficient equity market segments

Examples: low-cost equity index funds, enhanced index funds

5

Asset Management Industry Trends*

Unconstrained / Absolute Return Managers invest across multiple

sectors or asset classes without regard to traditional benchmarks

Examples: Global multi-sector fixed income, long-short equity

Risk Management Strategies Portfolio construction based on

quantifiable risk or volatility targets Examples: risk parity, low volatility,

tail risk hedging strategies

Alternative Investments Investment managers further

developing, enhancing and/or acquiring capabilities

Hedge funds, private equity, real estate, infrastructure* Alternative

Investments

Risk Management

Products

Active vs. Passive

Unconstrained / Absolute

Return

Trends are for illustrative purposes. Not all inclusive.


Unconstrained and Constrained Investing Definitions

Unconstrained (outcome-based investing): An investment approach that seeks to achieve its goals by accessing opportunities across an array of sectors, markets and/or asset classes without limitations imposed by a traditional benchmark.

Constrained (benchmark-based) investing: An investment approach that seeks to achieve its objectives by investing in sectors, markets, styles and/or asset classes that are set by a traditional benchmark index.

There are a number of terms used to describe constrained and non-constrained (“unconstrained”) investing. They meet the same basic definition . . .

Note: Unconstrained investing may refer to equity and debt strategies or to a larger category that includes alternative investments.


Industry Terms and Investment Categories “Constrained” and “non-constrained” investing approaches encompass a broad array

of strategies, styles and terms Some investment strategies include elements of both approaches.

“Passive” “Enhanced Index”

“Benchmark Aware” “Core”

“Growth” “Value”

“Multi Sector” “Unconstrained”

“Outcome-based” “Go Anywhere”

“Absolute Return” “Benchmark

Agnostic”

Constrained Investing Unconstrained Investing

“Investors are getting a hard sell from mutual-fund companies on so-called unconstrained or go-anywhere bond funds” — Wall Street Journal, March 3, 2014

Terms are for illustrative purposes. Not all inclusive.


History

Timeline is for illustrative purposes. Not all inclusive.

Historically, investors have employed constrained strategies to implement their investment programs. That is changing . . .

Portfolio Implementation: 1970-2000* Portfolio Implementation: 2000’s-

Balanced Funds Constrained Equity Constrained Fixed Income Alternatives

Constrained Equity Unconstrained Equity Constrained Fixed Income Unconstrained Fixed Income Alternatives


Projected Asset Flows: A Changing Landscape? One industry consultant projected that between 2013-2018, institutions will allocate a

total of $3.4 trillion to “risk factor” and “outcome-based” strategies, while withdrawing $1.8 trillion from “benchmark-based” approaches.

$3.4T

$(1.8)T (3.0)

(2.0)

(1.0)

-

1.0

2.0

3.0

4.0

Risk Factor & Unconstrained Strategies Constrained Strategies

Projected Investor Asset Flows: 2013-2018*

“Many firms that remain committed to the traditional core equity and fixed income strategies…will continue to struggle.” – Greenwich Associates, 2013

Casey, Quirk & Associates, November 2013. Risk factor and outcome based strategies include alternative investment strategies, risk parity, unconstrained and othrers.


Passive and Unconstrained Bond Sector Weightings Unconstrained bond portfolios typically include sector, credit and duration allocations

that vary widely from the index. Core (constrained) portfolios more closely resemble the index.

Sample unconstrained bond portfolio only. Barclays Capital U.S. Aggregate Index Weightings are as of September 30, 2014.

Passive vs. Unconstrained Bond Manager Weightings

US Treasury 37%

Investment Grade Credit

27%

ABS/RMBS 30%

US Agency 4%

CMBS 2%

Barclays Capital U.S. Aggregate Index

US Treasury

5%

Investment Grade Credit

26%

High Yield 26%

Non-U.S. 21%

Convertible 11%

Cash 4%

ABS/RMBS 3%

Preferred/ Equity

2% Bank Loan

1% CMBS

1%

Unconstrained Bond Manager


Unconstrained Global Equity Regional Weightings Unconstrained global equity managers invest across regions and industry sectors

with allocations that vary widely relative to one another and to the index. The investment objective is to maximize return relative to active risk taken (alpha).

Examples are for illustrative purposes.

0% 10% 20% 30% 40% 50% 60% 70%

North America

UK

Continantal Europe

Japan

Asia ex-Japan

Other

Unconstrained Global Equity Manager Allocations Manager AManager BMSCI ACWI Index


Fixed Income Strategies: Investment Manager Flexibility Constrained bond strategies (e.g. core) provide the manager with less flexibility,

while unconstrained ( e.g. global multi sector) strategies provide greater flexibility.

Examples for illustrative purposes. Does not include all categories of constrained and unconstrained bond strategies.

Opportunistic Bond Portfolio

Core Plus Bond Portfolio

Core Bond Portfolio

Passive Bond Portfolio

Flexibility

Low

er

Hig

her

More Less

Unc

onst

rain

ed

Con

stra

ined

Fixed Income Strategies*

Global Multi Sector Bond Portfolio


Board of Trustee Decisions: Asset Allocation A decision of whether to select a constrained or unconstrained approach should be

made within the framework of a fund’s asset allocation structure and risk tolerances.

Examples for illustrative purposes.

Asset Allocation Portfolio Structure

Fixed Income

Alternatives

Equity Active

Constrained

Unconstrained

Passive Constrained


Board of Trustees Decisions: Portfolio Implementation Consideration of constrained and unconstrained approaches includes the question of

whether the strategy should play a complementary or primary role.

Sample asset allocation structure for illustrative purposes.

Asset Class Target*

Total Equities 50.0%

Total Fixed Income 25.0%

Alternatives 25.0%

Total 100.0%

I. Asset Allocation Structure* Identify asset mix to meet risk/return objectives Key determinate of long-term returns Balances risk and return II. Portfolio Structure Framework for implementing asset mix Consider number of managers, strategies, etc. Consider

passive vs. active management

III. Investment Manager Selection & Strategy Identify specialist roles Consider constrained vs. unconstrained Select and monitor investment managers


Global Equity 35%

Non - U.S. Equity 10%

U.S. Fixed Income

17%

Global Fixed Income

8%

Alternative Investments

30%

Asset Allocation

Asset Allocation and Portfolio Structure Although investors are allocating assets to unconstrained approaches, traditional

constrained portfolios still account for the majority of equity and debt strategies. Unconstrained approaches typically play a modest-sized complementary role to

larger core (constrained) equity and fixed income allocations.


Portfolio Structure

U.S. Large Cap Equity Managers U.S. Small Cap Equity Managers Global Unconstrained Equity Manager Non-U.S. Equity Managers

Core Fixed Income Manager Core Plus Fixed Income Manager Unconstrained Bond Manager

Real Estate Managers Private Equity Managers Hedge Fund Managers


Constrained & Unconstrained Investing: Characteristics

Examples for illustrative purposes. Not all inclusive.

Characteristic Constrained Unconstrained

Relative Return Objective (outperform benchmark) ■Total Return Objective (maximize risk-adjusted return) ■Well-defined controls over market and sector allocations ■Greater flexibility in allocating assets vs. benchmark ■Greater variability in returns vs. benchmark index ■Lower expected variability in returns vs. benchmark index ■Viable option to implement asset allocation ■ ■

Constrained vs. Unconstrained Investing: Characteristics

“Unconstrained bond funds have the ability to limit interest rate risk, while adding alpha through diversification and access to a broad opportunity set.” – Forbes, June 13, 2013


Constrained Investing: Potential Benefits & Risks

Note: Potential benefits and risks are examples only. Not all inclusive.

Potential Benefits

Inflexibility in mitigating risks embedded in a benchmark index

Distorted index weightings may force a manager to hold overvalued sectors

Incentives may encourage building index-like portfolios at higher fees.

Potential Risks

Greater control over market, credit, currency and liquidity risk

Ease of measuring performance

Facilitates monitoring of asset class exposures across the portfolio

Effective, predictable means of diversifying portfolio risks.


Unconstrained Investing: Potential Benefits & Risks

Access to a broader investible universe

Ability to change allocations as market conditions change

Management or avoidance of risks that may be embedded in the index

Potential for higher expected return and portfolio efficiency.

Potential Benefits

A higher probability of losses due to investment manager decisions

Potential for overlapping positions and risk exposures with other managers

New strategies have not demonstrated performance through market cycles.

Potential Risks

Note: Potential benefits and risks are examples only. Not all inclusive.


Constrained and Unconstrained Investing Tradeoffs

Examples for illustrative purposes. Not all inclusive.

Risk Management Controls

Measurement Flexibility Diversification

Opportunity Set


Investment Policy Guidelines


Core bond managers are governed by guidelines that dictate the amount of credit, currency and interest rate risk they may take. Unconstrained bond managers may take greater credit risk, which

should increase yields, but may also increase portfolio volatility.

Risk Management

AAA AA A BAA BA B CAA &Lower

NotRated/Other

Multi Sector 17.9% 2.6% 13.6% 30.2% 17.0% 6.6% 3.4% 3.7%Core 61.0% 7.0% 16.7% 15.3% 0.1% 0.4%U.S. Aggregate Index 73.1% 3.5% 11.5% 12.0%

0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%

Credit Quality


Risk Oversight Tradeoffs


Limits on constrained managers’ ability to invest outside of the index reduce the probability of loss due to manager decisions The relative stability of a constrained portfolio’s allocations helps

trustees assess the strategies fit within the overall portfolio.

Risk Management Measurement

“Most unconstrained bond funds replace interest rate risk with corporate credit risk . . .” –Wall Street Journal, March 3, 2014


Portfolio Diversification

Examples are for illustrative purposes.

U.S. Large Cap Equity

Core Fixed Income

High Yield Fixed Income

EM Debt

U.S. Large Cap Equity 1.00 0.14 0.62 0.47

Core Fixed Income 0.14 1.00 0.18 0.19

High Yield Fixed Income 0.62 0.18 1.00 0.49

Emerging Markets Debt 0.47 0.19 0.49 1.00

Asset Class Assumptions: Correlations

Core (constrained) bond portfolios play a critical role in diversifying investors’ equity risk due to low correlations to equities.

Diversification Risk Management


Investment Opportunity

Source: The Conference Board, November 2014.

“America will do well to grow by 3% (in 2014), Japan by 2% and the euro zone by 1.2%. Most emerging economies will do better than that, but the gap is closing” –The Economist Intelligence Unit, The World in 2014

The economic environment is creating new opportunities for managers with skill sets to navigate multiple markets and sectors.

Opportunity

Global Outlook for Growth of Domestic Product*

2010-2013 Actual

2014 Actual

2015–2019 Projected

2020-2025 Trend

U.S. 2.2% 2.2% 2.4% 1.9%

Europe 0.9% 1.4% 2.1% 1.5%

All Mature Economies* 1.8% 1.9% 2.3% 1.8%

China 8.8% 7.3% 5.5% 3.9%

Emerging & Developing 6.2% 4.8% 4.5% 3.7%


Risk Oversight Tradeoffs


Characteristic Manager A Index

Average Duration 1.93 Yrs. 6.29 Yrs.

Avg. Weighted Maturity 3.56 Yrs. 8.01 Yrs.

Yield to Maturity 4.87% 2.08%

Yield to Worst 4.83% 2.06%

Current Yield 5.36% 3.16% 0.0% 10.0% 20.0% 30.0% 40.0%

AAA

A

BA

Other

Manager A: Credit Quality

Index Manager A

Unconstrained bond managers may take significantly less duration (interest rate) risk than the index, while adding potential income from higher yields.

Tradeoffs, however, may include higher levels of credit and currency risk.

Risk Management Flexibility


Investment Manager Flexibility

Source: Bloomberg. Indexes are unmanaged and do not incur fees.

0

2

4

6

8

10

12

14

16

18

1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014

Yiel

ds

Unconstrained bond managers possess flexibility to reduce duration in markets where the risk of rising rates is elevated.

“Bonds have been in a major bull market for nearly 33 years — ever since the 30-year Treasury yield hit its all-time a high of 15.20% on Sept. 29, 1981. “ - Market Watch, February 24, 2014

Flexibility


Delegation of Authority

The amount of authority (latitude) to be delegated to the consultant or investment manager should be determined through a review of objectives, risk and skill sets

Under many unconstrained strategies, trustees effectively delegate authority for asset allocation decisions for a portion of the portfolio to investment managers

If appropriate roles are delegated to skilled managers, benefits may include greater flexibility, timely implementation of decisions and management changing risks

The lower level of delegation typical of constrained strategies provides trustees with the benefits of well-defined risk controls, ease of management and transparency.


Board ofTrustees/ Executive

Staff

Custodian Bank

Real EstateManagers

Private Equity

Managers

Consultant

Fixed Income

Managers

HedgeFund

Managers

Cash Manager

Counsel

Equity Managers


Staff

Custodian Bank

Real EstateManagers

Private Equity

Managers

Consultant

Fixed Income

Managers

HedgeFund

Managers

Cash Manager

Counsel

Equity Managers

Controls Policy Guidelines

Conclusions


Conclusions

Well-executed constrained and unconstrained investment approaches provide means to implement asset allocation structures, diversify risk and utilize skilled managers.

Traditional, constrained approaches allow investors a higher degree of control over investment manager decisions, while facilitating oversight of performance and risk.

Unconstrained investment approaches provide managers with a larger investible universe, flexibility to manage risk and the potential for higher expected returns.

Despite lower expected returns for some strategies, constrained, benchmark-oriented approaches play a critical role in mitigating volatility in times of market distress.

Due to higher tracking error, many investors employ outcome based approaches for modest satellite allocations that complement larger, core equity and debt allocations.


Staff

Custodian Bank

Real EstateManagers

Private Equity

Managers

Consultant

Fixed Income

Managers

HedgeFund

Managers

Cash Manager

Counsel

Equity Managers


Staff

Custodian Bank

Real EstateManagers

Private Equity

Managers

Consultant

Fixed Income

Managers

HedgeFund

Managers

Cash Manager

Counsel

Equity Managers


Conclusions

Many investors are making allocations to unconstrained bond funds to manage interest rate risk, while adding yield in anticipation of a potentially rising rate environment.

The consequences of a failure in an unconstrained manager’s decision making process are greater than those of a constrained manager.

Many unconstrained strategies possess short track records and have not demonstrated performance through multiple market cycles.

Unconstrained approaches provide the promise of higher risk-adjusted returns, but increase liquidity, operational and manager execution risks.

Due to the latitude they provide to the manager and relatively short histories, unconstrained approaches require close monitoring.

*Sources Include: Julian M. Regan and Geoffrey Strotman, Constrained vs. Unconstrained Investing Benefits Magazine, February 2015

Appendix

The Marco Consulting Group 31

Biography

Julian M. Regan is vice president/senior investment consultant for The Marco Consulting Group (MCG) in Braintree, Massachusetts. In addition to advising boards and executives of benefit plans, he serves on MCG’s fiduciary services management committee and is an author and speaker for some of the nation’s leading labor-management and public benefit plan organizations. Regan previously served as executive director for the New York State Deferred Compensation Board, where he ran the state’s 159,000-member supplemental retirement plan and regulated 250 local plans. He also served as vice president of risk governance and strategy for Fidelity Investments and as assistant general manager and budget director for the Massachusetts Bay Transportation Authority. In 2005, the U.S. Treasury Secretary appointed Regan to the IRS Advisory Committee on Tax Exempt and Government Entities. He is a contributing author to the International Foundation’s Trustee Handbook. Regan received his M.B.A. and B.S.B.A. degrees from Suffolk University. Email: [email protected] Telephone: (617) 298-0967

Julian Regan, Vice President and Sr. Consultant

mailto:[email protected]

Documents

Changing Paradigms for Public Investors Docs/Annual... · Fund of Hedge Funds 6.8% 7.6% Equity Activist 11.3% 18.0% ... “Constrained” and “non-constrained” investing approaches