The individual manager reviews follow this summary memorandum.

Transcription

1 State Universities Retirement System of Illinois Serving Illinois Community Colleges and Universities 1901 Fox Drive Champaign, IL (217) (217) (FAX) Investment Department To: Investment Committee From: Douglas C. Wesley, CFA, Kimberly K. Pollitt, CFA, Lou Ann Fillingham, CPA, and Tony J. Lee Date: January 19, 2010 Re: Executive Summary of the Fixed Income Asset Class The SURS fixed income portfolio consists of three major components: active, structured active and Treasury Inflation Protected Securities (TIPS). The following table shows the allocation to each account within the fixed income portfolio. SURS actively managed core/core plus fixed income assets are distributed among nine external managers across eleven accounts. The U.S. TIPS allocation currently consists of one actively managed account. An internally managed passive U.S. TIPS strategy was liquidated during 2009 to facilitate an asset allocation rebalance into the U.S. and International equity asset classes. However, it is anticipated that a portion of the proceeds from the 2010 pension obligation notes will be allocated to the internally managed TIPS portfolio until such time as the search is completed for one or more U.S. TIPS managers in the Manager Development Program. November-09 Incep $ millions Cash Flow Oct YR Mgr Fixed Income 1 YR B ma rk Excess Return 10 YR Mgr 10 YR B ma rk Excess Return BlackRock Core Plus May % 11.63% 4.99% 5.52% 5.67% -0.15% Davis Hamilton Jackson & Assoc. Feb % 8.98% 3.80% 12.78% 8.98% 3.80% Metropolitan West Asset Mgmt. Nov % 11.63% 11.91% 6.34% 5.31% 1.03% PIMCO Total Return Oct % 11.63% 9.42% 8.05% 6.45% 1.60% Progress Investment May % 11.63% 2.80% 7.50% 6.86% 0.64% Pugh Capital Management Apr % 11.63% 1.57% 7.60% 6.78% 0.81% Smith Graham & Company Apr % 11.63% 2.98% 6.39% 6.78% -0.39% Taplin, Canida & Habacht Apr % 11.63% 7.67% 6.79% 6.78% 0.01% Western Asset Management Dec % 11.63% 12.85% 5.93% 5.55% 0.38% Active Fixed Income Oct-81 2, % 11.63% 8.62% 7.40% 6.68% 0.72% BGI Core Active Fund May % 11.63% 5.66% 7.86% 7.00% 0.86% BlackRock Enhanced Apr % 11.63% 4.60% 6.38% 6.45% -0.07% Structured Active Fixed Income May % 11.63% 5.28% 7.23% 7.00% 0.23% Total Core Fixed Income Oct-81 2, % 11.63% 7.40% 7.24% 6.68% 0.56% TIPS PIMCO US TIPS May % 19.56% 6.03% 7.84% 7.18% 0.66% Total TIPS Jul % 19.56% 4.07% 7.99% 7.18% 0.81% The individual manager reviews follow this summary memorandum.

2 Organizational Issues Listed below are organizational issues relating to investment managers in the SURS portfolio: PIMCO In January 2009, Mark Davies was appointed head of portfolio risk management. In September 2009, Mr. Davies resigned from PIMCO due to personal reasons. Bill DeLeon has been appointed as head of portfolio risk management, reporting to Bill Gross and Mohamed El-Erian. In June 2009, PIMCO formally established PIMCO Advisory, a business unit of the firm that offers valuation, risk management, and execution services. Dick Weil began a transition from his responsibilities as PIMCO s Chief Operating Officer to become the Global Head of PIMCO Advisory. Douglas Hodge, who has been heading the firm s Asia-Pacific business for the past seven years, will assume the role of Chief Operating Officer. BlackRock/Barclays Global Investors On December 1, 2009, BlackRock completed its purchase of Barclays Global Investors (BGI) and renamed the combined entity BlackRock, Inc. As a result, Bank of America owns approximately 34.2% of BlackRock, PNC owns approximately 24.5%, Barclays owns approximately 19.8%, and institutional investors, employees and the public own approximately 21.5%. The approximate breakdown for voting common stock is as follows: Bank of America owns 3.7%, PNC owns 35.2%, Barclays owns 4.8%, and institutional investors, employees and the public own 56.3%. BlackRock, Inc. is independent in ownership and governance, with no single majority stockholder and a majority of independent directors. Western Asset Management Due to the unprecedented turbulence in global financial markets and economies during the past two years, Western Asset has implemented significant changes to the firm s overall staffing in order to more appropriately size the firm. The significant staffing changes have decreased the firm s overall cost structure. However, no senior investment professionals that manage the SURS account have left the firm in the past year. Additionally, there have been several management structure changes that have occurred in the past year in order to better align the positions of senior management with the firm s significantly decreased staff size. In June 2009, the firm made the following changes: Dennis J. McNamara was named Head of Pasadena Generalists. Mr. McNamara was previously the firm s Director of Portfolio Operations. Gavin James was named Director of Portfolio Operations. Mr. James previously served as the firm s Director of Global Client Service and Marketing. James Flick was named Director of Global Client Service and Marketing. Mr. Flick was previously a member of the firm s short duration portfolio management team. Additionally, D. Daniel Fleet, former President of Western Asset, retired from the firm. James W. Hirschmann, Chief Executive Officer, assumed the additional title and responsibility of President.

3 Metropolitan West Asset Management On December 4, 2009, TCW announced a definitive purchase agreement to acquire Metropolitan West Asset Management (MetWest). Closing of the transaction is expected in the first quarter of As a result of the acquisition, it is expected that the number of equity holders in the firm will increase to approximately 20. These newly-named principals are expected to increasingly become, over the next several years, the next generation of leadership for the High Grade Fixed Income Group at TCW. In addition, the transition to TCW will entail employment contracts, in conjunction with equity ownership, for an expanded number of MetWest investment professionals, including key members of the portfolio management, client services and operations teams. Smith Graham & Co. On February 27, 2009, Smith Graham & Co. (Smith Graham) acquired the fixed income, small cap value and midcap value assets and the respective investment teams of Ark Asset Management Co., Inc., doubling Smith Graham s assets under management and more than doubling the firm s number of investment professionals. The acquisition has allowed Smith Graham to maintain an office in New York and to expand its product offerings into a comprehensive range of fixed income products that cover the full spectrum of the yield curve as well as exposure to certain segments of the U.S. equity market. Taplin, Canida & Habacht On December 3, 2008, Marshall & Ilsley (M&I), a publicly traded regional bank based in Milwaukee, Wisconsin, completed its acquisition of majority interest in Taplin, Canida & Habacht (TCH). As a result, TCH no longer qualifies as a minority- or women-owned firm. TCH continues to operate as Taplin, Canida & Habacht and its headquarters remain in Miami, Florida. Tere Alvarez Canida continues as President. Marshall & Ilsley currently has an 80% interest in TCH. The remaining 20% is owned by the portfolio management team, Tere Alvarez Canida, Alan M. Habacht and William J. Canida. Each member of the portfolio management team has signed a long-term employment agreement through April In addition, a multi-year bonus pool has been established for TCH employees. M&I will purchase an additional 5% of TCH in 2010, with additional purchases to take place in Davis Hamilton Jackson & Associates To transition ownership to the next generation of management, Affiliated Managers Group (AMG), who had owned almost 75% of Davis Hamilton Jackson & Associates (DHJ), recently reduced its ownership to 25%. As a result of the recent equity transactions, six DHJ principals now own approximately 75% with the remaining 25% owned by AMG. The firm anticipates purchasing the remaining 25% held by AMG within the next six to eighteen months and may also affect a name change. The firm is almost 60% owned by ethnic minority and women partners. We have no organizational issues with any of the other fixed income managers in the SURS portfolio at this time. Investment Performance Issues In last year s review, only one active fixed income account, Pugh Capital Management, was able to exceed the return of the benchmark. By contrast, all active and structured active fixed income managers exceeded the benchmark during the twelve months ending November 30,

4 2009, most by a wide margin. As shown in the table on the first page of this summary, the core fixed income portfolio returned 19.03% for the year ending November 30, 2009, outperforming the Barclays Capital Aggregate Index by 740 basis points. In last year s review of the fixed income asset class, staff reported that the core fixed income portfolio lagged the benchmark by 416 basis points. The sharp divergence in relative performance of the core fixed income portfolio in 2008 and 2009 can be explained primarily by the performance of the non-treasury or spread sectors versus Treasury securities. In 2008, the financial crisis resulted in a massive flight to quality into Treasuries. All non-treasury sectors lagged Treasuries by significant amounts. Since SURS fixed income managers generally underweight Treasuries and overweight mortgages, corporates and agencies, most managers lagged the benchmark in 2008 by a wide margin. The table below (taken from BlackRock s Fourth Quarter Market Review) shows the excess return to Treasuries of various fixed income sectors over the past 12 years. The table indicates that 2008 was the worst period ever for each sector while 2009 was the best period for each sector. Managers who held their underweight Treasuries/overweight spread sectors position were rewarded in 2009 by strong relative returns as markets saw a reversal of the flight to quality trade of TIPS Mandates In the twelve-month period ending November 2009, the PIMCO TIPS portfolio returned 25.59%, exceeding the 19.56% benchmark return by 603 basis points. The strong relative performance was driven by exposure to mortgage backed securities and bonds of financial companies, which outperformed the broader corporate market. Also adding to performance was an overweight duration position. The portfolio has exceeded the benchmark in the threeand five-year periods by 51 basis points and 48 basis points, respectively. From the inception of the actively managed portfolio, performance has exceeded the benchmark by 65 basis points.

5 Recommendations SURS staff and EnnisKnupp jointly recommend: That PIMCO be retained as a core plus fixed income manager. That PIMCO be retained as a TIPS fixed income manager. That BlackRock be retained as a core plus fixed income manager. That BlackRock be retained as an enhanced index fixed income manager. That BlackRock Core Active (formerly BGI) be retained as an enhanced index fixed income manager. That Western Asset Management be retained as a core plus fixed income manager. That Metropolitan West Asset Management be retained as a core plus fixed income manager. That Pugh Capital be retained as a core fixed income manager. That Smith Graham be retained as a core plus fixed income manager. That Taplin, Canida & Habacht be retained as a core plus fixed income manager. That Davis, Hamilton, Jackson & Associates be retained as a core plus fixed income manager. That the internally managed TIPS portfolio be retained.