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TRS REPORT
Springfield, IL
August 14-15, 2013
Dennis Murfin, TRS Observer Chairman
** Indicates needs Board approval. Portions of this report in Italics are authored
by Don Davis.
1:30 p.m., Wednesday
AUDIT COMMITTEE
Committee Members Present: Bob Lyons, Vice Chair, presiding; Marcia
Campbell; Cynthia O’Neill; and Enrique Vasquez (via telephone). Also present
but not voting were board members Mark Bailey, Cinda Klickna, and Sharon
Leggett. There were no public comments and the third item on the agenda was
nomination of a Chair for the Audit Committee. Janice Reedus, previous Chair has
resigned from the TRS Board having taken a new position at a new firm. Bob
Lyons was elected Chairman. This left the position of Vice Chair open to which
Enrique Vasquez was immediately elected.
After approval of the June 20, 2013 minutes, the Committee then went into
Executive Session. The reason given was a section of the Illinois Code “5 ILCS
120/2 © (28) – Internal Control Weakness.” Upon the return to open hearing the
next item of business was Independence of Internal Audit Activity. Stacy Smith,
Director of Internal Audit, referred the committee to a printout already distributed
and asked if there were any questions. Hearing none she moved to the next two
items on the agenda – Quality Assurance and Improvement Program, and Audit
Completion Report. These two went the same quick way. There were no Trustee
Concerns and the Audit Committee adjourned.
INVESTMENT COMMITTEE
Upon roll call of the committee (see previous list), Investment Committee
Chair Cynthia O’Neill asked if there were any comments from the public. She also
reminded the public that comments should be limited to 5 minutes per person. .
Jim Aker, representing the Servers Union at the Caesars Gaming establishments in
Indiana and two employees made brief statements indicating that cuts in staff have
been made, placing additional burden on the remaining staff. The concern was that
Apollo Global Management that operates the gaming facilities has been assessing fees
and other charges that has affected the financial picture at Caesars. These fees have
reduced the revenue, making it difficult to maintain staff and negotiate contracts.
O’Neill indicated that the Board will consider their concerns in future dealings with
Apollo.
After their comments, Stan Rupnik, TRS Chief Investment Officer, brought
the Committee through the presentation of the Investment Manager Chart Update,
the Cash Withdrawal Update, and the Manager Search/RFP Update very quickly.
None of these reports required Board Action. However, during the Manager
Search/RFP Update, Cynthia O’Neill questioned how the staff determined what
value was gained by the use of consultants. Many comments were made, but the
clinching point seemed to come from Greg Turk’s statement that the consultants
100+ page due diligence reports helped to make the difference in most investment
decisions the staff faced.
Next on the agenda was the Investment Performance Update. The next item was a
presentation of RV Kuhns by Becky Kuhns and John McLaughlin.
current market themes, the following points were made:
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Beginning with
Driven by an improving economy, Fed Chairman Ben Bernanke in June announced
that the Fed may begin tapering its asset purchases earlier than expected. This
brought about a negative response in the market until the market was assured by
Bernanke that they would not take action in the short term.
Internationally, Japan continues to be a bright spot in the global economy,
recovering from concerns earlier in the year regarding Prime Minister Shinzo Abe’s
economic revitalization strategy.
Emerging market equities experienced a strong decline over the second quarter due
in part to a liquidity shortage in China. Initially the People’s Bank of China declined
to intervene when interbank lending rates skyrocketed. They reluctantly stepped in
to bring stability. Additionally, China, the world’s second largest economy continued
to experience slowing economic growth with a second quarter GDP growth rate of
7.5% down from 7.7% in the first quarter.
The Bureau of Economic Analysis advanced for GDP in the second quarter is1.7%
which is lower than the 20 year average.
Looking at the asset classes for the quarter, 1-year, and 3- and 5-year TRS
performance follows:
Domestic Equity returns for the quarter ending June 30, 2013 show that
despite increased market volatility at home and abroad, domestic equities still
finished close to all-time highs. The Consumer Discretionary and Financials sector
led the positive absolute performance in the second quarter, while Utilities and
Materials were the worst performers. Over the one- and five-year period stocks
generated positive returns across all market capitalizations. In the fourth 2013
fiscal quarter the portfolio beat the Russell 3000 Index by 0.92% ranking in the 4th
percentile relative to its peer group. Manager value added was a key driver. For
the fiscal year-to-date the portfolio returned 23.67%, which beat the Russell 3000
Index by 2.20%. TRS ranked in the 10th percentile, the best one-year relative
outperformance since F Y 2002. Large cap value beat its benchmark by 5.1% and
ranked in the 13th percentile.
In International Equity, sovereign debt issues during the quarter ending June
30, 2013 continued to concern investors. Emerging markets lagged behind their
developed market counterparts.
Global Fixed Income fourth quarter fiscal year 2013 returned -2.52%,
twenty basic points below the custom index and ranked in the 48 th percentile. The
largest detractors to absolute performance were the U.S. TIPS Composite and the
International and Emerging Market Debt Composite, which returned -6.83% and 4.05% respectively. In the calendar year-to-date global Fixed Income returned 0.59%, 185 basic points above the custom index and ranked in the 15th percentile.
Real Returns during the fourth fiscal 2013 quarter underperformed the
CPI+5% by 875 basic points (note: the CPI in a non-investable benchmark). The
Real Return bucket also underperformed in the calendar year-to-date and fiscal
year.
For the fourth fiscal 2013 quarter the Absolute Return Composite
outperformed the long-term benchmark (BofA ML 3-month T-Bill plus 4%) by 51
basic points . During the calendar year-to-date the Absolute Return Composite
outperformed both the long-term benchmark and peer index by 359 and 218 basic
points, respectively. For the 3- and 5-year performance the Absolute Return
Composite returned 10.24% and 5.15%, respectively, outperforming peers and the
long-term benchmark in both instances.
After RVKuhns presentation, Stan Rupnik, TRS Chief Investment Officer,
gave these figures.
TRS versus the benchmark for the:
Period
TRS
Benchmark
1-yr.
13.2%
12.5%
3-yr.
12.6%
11.9%
5-yr.
4.7%
4.8%
10-yr.
7.7%
7.4%
The POB Account of $4.6 billion
1-yr.
13.6%
IR annualized
7.3%
Cumulative
12.5%
102%
TRS Asset Class one-year return
Domestic Equity
23.7%
International Equity
13.6%
Fixed Income
6.9%
Real Estate
13.2%
Private Equity
14.9%
Real Return
Absolute Return
0.6%
12.9%
The Watch List,** which was discussed briefly discussed consisted of :
Levin Capital Strategies an Active Large Cap Core US Equity firm managing
$463.9 million for TRS, Boston Company an Active Small/Mid Growth US
Equity firm managing $190.1 million for TRS, Jarislowsky Frasier an Active
Growth International Equity firm managing $427.8 million for TRS, and Franklin
Templeton, a Global fixed Income-Emerging Market Debt firm managing $421
million for TRS. Greg Turk, TRS Director of Investments, asked the Trustees to
remove Franklin Templeton from the Watch List and to be retained in the
portfolio.** The Committee recommended the Board approve this request.
The MBE/WBE Minority Utilization Report was given by Kenyatta
Matheny, TRS Sr. Investment Officer. He reported the Domestic W/MBE brokers
garnered 6.8% more of total commissions that the 16% goal while the International
W/MBE brokers garnered 10.5% and were 1.5% below their goal. Total U.S. and
International equity MBE commissions are $2.735 million between 40 W/MBE
brokers. Fourteen Fixed Income W/MBE managers captured 13.7% of the total
market value traded at $1.4 billion.
The TRS Emerging Manager Program has reached a milestone. Since
inception, and as of the May 2013 board meeting, TRS has now invested $1billon
across 32 emerging managers. More importantly, nine managers have graduated
and been awarded an additional $1.27 billion in capital from the fund. Staff
received board approval for an Emerging Manager Program in May of 2005 and
made its first investment in May 2006.
The Northern Trust firm was submitted to the Board for removal from the pool of
Transition Managers. Motion was made and approved.
The next presentation made by Chuck Handy of the TRS staff and John McGlaughlin of
RVK was a recommendation for changes in the current structure of the TRS
International Equity portfolio. Over the last several months a study was conducted to
determine if the portfolio was meeting Staff, Consultant and Plan objectives and there
are changes that can be made to improve the portfolio’s expected risk/return profile.
The study recommends:
 Repositioning the developed passive core mandate into a separate category at a
20% target and a 5% allocation range.
 Reclassifying current core, value and growth composites into a single large cap
active composite with a target of 45% and a 10%% allocation range
 Increasing the dedicated emerging markets target from 16.5% to 20% and
increasing the allocation range from 3.0% to 5.0%.
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Be diversified by market capitalization and offer representation to large, medium and
small companies in developed and emerging countries.
Provide downside protection in the event of market declines.
Pursue active management where it will be rewarded
Have competitive fees
Add Developed Passive Target to TRS Investment Policy
A motion was made and approved to adopt the changes in the structure of the
International Equity Portfolio.**
In accordance with the Iran Divestment Law, TRS staff submitted the
following list of “scrutinized” companies that our investors should not hold.
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China National Petroleum Corporation (CNPC)
China Petroleum & Chemical Corp (CPCC) Sinopec
CNOOC Ltd. (China National Offshore Oil Corporation)
Daelim Industrial Co., Ltd. (South Korea)
Gazprom OAO (Russia)
Indian Oil Corp Ltd. (IOCL)
Oil and Natural Gas Corporation (ONGC) (India)
PetroChina Co., Ltd.
In the Transition Report Frank Russell was added to the list of firms to be
used.
Staff asked the Committee to recommend the ratification** of the allocation
of $30 million to TCW’S Emerging Market Fixed Income Fund. They were the
culmination of a fixed income emerging markets investment manager search.
The last item on Wednesday’s meeting was the Real Estate – FY 14 Tactical
Plan** presented by Jamie Shen, Callan Sr. Vice President; Avery Robinson,
Callan Vice President; and Timothy Hays, TRS Sr. Investment Officer – Real
Estate. As of March 31, 2013 the program had $4.6 billion in total invested asset
representing 11.7% of the total TRS plan. The program has a long-term target of
60% in core investments and 40% in specialty/non-core investments. The ten-year
performance return is 8.1%.
Jamie then reviewed the Fiscal Year 2013 initiatives. In the market outlook
U.S. economic activity remains at a modest pace. Capital markets have led real
estate recovery. Transaction volumes have increased substantially and are
approaching peak levels. Looking at property market sectors, the apartment sector
has benefited from strong investor interest alongside declining home ownership, an
improving employment picture and limited new supply. The vacancy rate is 5.54%
a low figure. In the office sector there is a strong demand for high-quality, core
office assets. There are improved fundamentals seen in major office markets, but
assets in secondary and tertiary markets have not seen material improvement.
Vacancy Rate is high at 14.28%. Retail fundamentals are slowly improving
alongside an improving housing sector and employment rate. The vacancy rate
below 10% (9.65%) is good. The Industrial property market led all property types
in performance over the past quarter. The vacancy rate is a good 8.50%. The hotel
market has been strong alongside favorable revenue per available room and
advanced booking trends. While exhibiting improving operations, institutional
private hotel assets have lagged all other property types, generating an 8.25% total
return. The European market has been contracting and the lending markets have
not come back. Economic activity has been relatively strong in the Asia/Pacific
region alongside strong consumer confidence in China and Southeast Asia.
Avery Robinson gave the TRS portfolio overview. The portfolio is well
diversified by geography and property type – 74% in separate accounts, 26% in
commingled funds; 63% in core investments, 37% in specialty investments. The
real estate portfolio has delivered strong performance since inception. It continues
to provide attractive diversification, inflation benefits and performance
contribution to the overall portfolio. Current exposure of 11.7% is 2.3% below the
long-term target. Staff anticipates new commitments totaling $600 million to
achieve the long-term target. Separate account investments will remain the
primary focus with fund investments targeted on an opportunistic basis.
8:30 a.m., Thursday
Thursday morning began with an education training session by RVKuhns
entitled “Investment Manager Evaluation – Some Thoughts on the Science and Art
of Investment Manager Selection, Funding, and Termination.” The purpose of the
presentation was to review common manager evaluation practices and outline
principles which define good evaluation practices.
RVKuhns believes asset allocation “drives” portfolio returns and risk. This
is where the board and committees should devote the most effort. Active risk
should be implemented where you can expect reasonable returns. Taking active
risk should result in either greater returns or reduced risk. Investment committees
should avoid investment decisions being driven by faulty though common group
dynamics – preference of action vs. caution, authority acceptance, viewing more
data as more proof, recent success means continued success. Manager evaluation
should be a combination of qualitative/quantitative factors – firm stability,
ownership, investment team, investment process evaluation, fees, appropriate peer
comparisons, multiple cycle performance, and risk assessment. RVKuhns
proposed some practices to avoid poor group biases. In evaluating documents, do
their objectives and purposes match the objectives and purposes the committee
wishes to be placed in the TRS portfolio. Do the documents define roles and
responsibilities to avoid single member reliance and/or potential conflict of
interest. Trustees should use common sense and discipline – be skeptical and
remain committed to the objective and strategy, allow for different perspectives by
welcoming candid discussion and considering all relevant factors and viewpoints.
In manager selection RVKuhns demonstrated that past performance, greater
assets under management (AUM), and great presentation ability do not predict
success in future investments. Pay attention to fees. Studies suggest lower fees
might explain some performance persistence. Unless a manager is providing an
especially active strategy then a plan should not pay an especially high fee (more
beta should be less expensive).
In the area of manager transition/termination, RVKuhns cautioned an
adherence to a disciplined process. TRS watch list policy reviews candidates over
a rolling 3-year period – not a hasty process. Common reasons for manager
termination include: poor performance, team change, and plan or asset class
allocation changes. Be sure to evaluate transition costs before termination.
RVKuhns states that no investment manager or product should be expected to
outperform their relevant benchmark(s) at all times, in all market environments.
Any manager with a superior long-term track record is virtually certain to
periodically underperform. Investors will face numerous temptations to eliminate
or reduce currently underperforming high quality managers. However, if all
managers are outperforming at the same time, the investment program/asset
class/style may not be appropriately diversified.
The first presentation under new business was the Apollo Global
Management a value oriented firm whose private equity branch deals in Buyouts,
Carve-Outs, and Distressed Debt. Before the presenters arrived Trustee Cinda
Klickna noted the prep book mentioned an issue with the management fees. Does
staff feel they are too high? Staff responded describing all the ways the General
Partners collected fees – management fees (1.5-2%), transition fees, monitoring
fees, director fees, etc. Then they introduced the market term Additive Fee Offset.
In the agreement the staff has negotiated a 100% offset. That means any added fee
to a General Partner is reduced 100% in the management fees charged to TRS.
Trustee Enrique Vasquez attending via telephone noted the large involvement with
Apollo (9.4%) already in the private equity asset class and that this commitment of
$300 million would seem to concentrate risk in one firm. Staff explained the 9.4%
is mature commitment which should be paid back in the near future. During the
presentation the main presenter stated that in regard to the Caesar Casino issue he
had every intention of cooperating with the unions. Management was ready to
settle the contract but they were waiting for the union to come back to the table.
Two of the carve-out deals they illustrated were Hostess, and McGraw Hill
Education. The Investment Committee recommended the Board grant a $300
million mandate to Apollo.**
The next presenter was New Mountain Capital LLC, a private equity firm
presenting their New Mountain Partners IV Fund. TRS currently has $100 million
invested in their Fund III. They are a midmarket firm that make 3-4 acquisitions
per year. A target enterprise is usually of the $300-$500 million value. New
Mountain will invest approximately $300 million and grow the enterprise to a
value of about $1 billion. This private equity firm has a unique “deep dive”
approach. They have already been researching/helping potential target firms long
before they approach with a proposal for purchase. Typically, they take a familyrun business and grow it to a world class firm with the original owners still
participating. The TRS Investment Committee recommended the Board offer New
Mountain Capital a $100 million mandate for its Fund IV.**
The last presenter was an existing member of the Emerging Manager
Program, ICV Partners presenting their Fund III. They typically buy a firm or
partner with the owner to grow the business. They create value through their
active management of potential market leaders. TRS Investment Committee
recommended a $20 million mandate for ICV Partners’ Fund II.**
BOARD MEETING
After Roll Call and Approval of Minutes all recommendations in committee
reports were approved by the Board. In the Executive Directors Report the Ethics
Training Annual Certification was completed.**
The Legislative Update was not truly legislation as explained during the
presentation. The discussion was about the Federal Rate paid to TRS for teacher
retirement funds for teachers hired under a federal mandate. The rate for years had
been 10.5%. Federal rate and state rate should have been the same but they
weren’t. The state had evidently been charging the Fed’s for part of the
underfunding of the retirement system, an unjust fee. The recession, and Tier 2
would have greatly increased the rate and changed the way TRS felt it should be
calculated. The Board finally decided that beginning in FY15 the Federal Rate
will be the same as the State Rate (the normal cost). The Board authorized this
change.**
The next item on the agenda was Communications Protocols** which were
presented by Dave Urbanek, TRS Director of Communications. The basic
message was “Statements need to be consistent when issued to the public. Board
members need to know how to respond.” Some discussion was about what in
internal TRS communications could be released to the public and who should do
the releasing. Dick Ingram – “This will be a standard part of subsequent Board
Meetings, a review/discussion of communications.” He also proposed internally to
TRS the generation of a topic word “Bulletin Board” where the font size of the
individual word represents the number of times it has appeared that week. This
board would tell TRS what is the current topic and also reveals when it falls out of
favor.
The Board meeting concluded with the update on the Funded Status and the
three miscellaneous reports.