DEPARTMENT OF FIRE AND POLICE PENSIONS 360 East Second Street, Suite 400 Los Angeles, CA (213)

Transcription

1 DEPARTMENT OF FIRE AND POLICE PENSIONS 360 East Second Street, Suite 400 Los Angeles, CA (213) REPORT TO THE BOARD OF FIRE AND POLICE PENSION COMMISSIONERS AUGUST 5, 2010 ITEM: 5 FRONI~,~ Michael A. Perez, General Manager SUBJECT: REVIEW OF WESTERN ASSET MANAGEMENT COMPANY TREASURY INFLATION PROTECTED SECURITIES MANAGER CONTRACT AND POSSIBLE BOARD ACTION RECOMMENDATION That the Board: 1. Approve a three-year contract Western Asset Management Company for Treasury Inflation Protected Securities management; 2. Authorize the General Manager to negotiate and approve the terms and conditions of the contract with Western Asset Management Company for services for the period September 1, 2010 through August 31, 2013; 3. Authorize the President of the Board, on behalf of the Board, to execute the contract with Western Asset Management Company for Treasu ry Inflation Protected Securities management services, subject to the approval of the City Attorney as to form and legality; and, 4. Authorize Staff to negotiate a multi-user fee agreement that would include other City of Los Angeles Pension funds. BACKGROUND Treasury Inflation Protected Securities (TIPS) are securities issued by the U.S. government which are indexed to inflation in order to protect investors from the negative effects of inflation. As with other government securities TIPS pay interest twice a year. The coupon rate remains fixed throughout the life of the bond and the interest paid on the bond is based on its principal value. The principal value of TIPS increase with inflation and decrease with deflation as measured by the Consumer Price Index. In late 2004, the Board approved allocating 20% of the fixed income portfolio to TIPS. In Februa ry 2005, five firms were interviewed for this mandate of which Western Asset Management Company (WAMCO) and Bridgewater Associates, Inc. (Bridgewater) were selected. WAMCO was originally funded with $300 million and Bridgewater with $200 million. In July 2008 and again in March 2009, following Staff's review of the manager, the Board authorized separate one-year extensions of WAMCO's contract because of its concern over the manager's poor relative performance. WAMCO's most recent contract extension will expire on August 31, 2010.

2 DUE DILIGENCE REVIEW In accordance with the Investment Policy, Staff requested that WAMCO complete a comprehensive questionnaire as part of the due diligence process. The review focused on the areas of ownership, personnel, investment style, assets under management, and investment performance. OWNERSHIP WAMCO was founded in 1971 by First Interstate Bancorp of Los Angeles and became a registered investment advisor in the same year. The firm was acquired by Legg Mason, a global asset management firm, in 1986 and became a wholly owned subsidiary. The parent company subsequently made several additional acquisitions which included Lehman Brothers Global Asset Management Limited in 1996, Rothschild Asset Management (Singapore) Limited in 2003, and Citigroup's asset management business in It operates as an autonomous investment management company. PERSONNEL The Board's U.S. TIPS account is managed by a team of portfolio managers, sector specialists and other investment professionals. Peter Stutz is the lead portfolio manager and is responsible for the day to day strategic oversight of the U.S. TIPS accounts. Mr. Stutz has been with WAMCO since Typically each portfolio manager on the team is responsible for approximately 8-10 accounts with assets totaling approximately $4 billion. The TIPS portfolio team is supported by a larger fixed income team which consists of specialists dedicated to different market sectors. As a firm, the fixed income team consists of 129 members. This is a net increase of 13 members since September INVESTMENT STYLE The firm's investment style emphasizes the use of multiple strategies including active sector rotation and issue selection, while constraining overall interest rate risk relative to the benchmark. It employs a team approach which utilizes fixed income sector specialists to conduct research on sectors as well as individual issuers. WAMCO's strategy involves evaluating the relative value between TIPS and other fixed income sectors and sets a recommended portfolio structure with targets for duration, term structure, and sector allocation. This strategy is implemented on each portfolio based on its client's guidelines and constraints. WAMCO manages its investment risk by primarily focusing on the following four areas: i) concentration, ii) credit, iii) interest rate, and iv) liquidity. Concentration risk is addressed through diversification by imposing limits on market sectors and issuers. Credit risk is dealt with by placing limitations on specific issuers and average credit quality. Interest rate risk is addressed through limiting duration and controlling term structure. Liquidity risk is minimized by emphasizing larger, heavily traded issues. The firm has a dedicated risk management team to monitor these risks by performing scenario analysis and stress testing. WAMCO Due Diligence Report Page 2 August 5, 2010

3 The Board's mandate allows WAMCO to use other inflation protection securities as well as traditional fixed income securities. ASSETS UNDER MANAGEMENT On July 20, 2010, WAMCO managed approximately $367 million for the Board. Staff has completed a review of WAMCO's performance through June 30, As of September 1, 2007, WAMCO managed approximately $5.2 billion in U.S. TIPS assets for 20 institutional clients. As of March 31, 2010 the firm managed about $4.5 billion assets for 22 institutional clients. The reduction in assets is primarily due to asset allocation decisions, while the gain in clients is the result of increased institutional interest in inflation protection securities due to the expectation of long term inflationary concerns. INVESTMENT PERFORMANCE The Board's investment performance benchmark for its TIPS managers is the Barclays U.S. Inflation-Linked Bond Index. According to the Board's Investment Policies, managers will be placed on the watch list when their performance falls below the median of their peer group for a year or if there is no comparable peer group comparison, below the expected return for that manager classification. Since the median return data was not available from our previous performance provider, WAMCO was placed on watch by the Board for its poor performance relative to its benchmark for calendar years 2007 and Last year when reviewed by Staff, the WAMCO account lagged its benchmark over the trailing one, three and since inception periods. The firm's performance has improved significantly over the last 12 months. The Attachment shows WAMCO's trailing pe rformance as of June 30, The firm is now ahead of its benchmark over recent time periods, including the one-year (10.32% vs. 9.53%), three-year (7.82% vs %), and since inception (5.20% vs. 5.10%) periods. While WAMCO's performance has improved dramatically over the last year, Staff will continue to closely monitor its performance and report to the Board any negative developments concerning the account. CONCLUSION Staff recommends that the Board renew the WAMCO contract for an additional three years. The firm's investment approach has remained consistent since being hired in 2005 and there have been no key personnel changes within the TIPS product team since As indicated above, WAMCO was first placed on Watch by the Board in June 2008 due to poor performance in 2007 and kept on watch because of underperformance for calendar year WAMCO's performance has significantly improved over the last year and is now outperforming its benchmark in all periods measured. RV Kuhns has reviewed this report and concurs with Staff's recommendation. WAMCO Due Diligence Report Page 3 August 5, 2010

4 BUDGET Last year when WAMCO's contract was renewed for one-year, representatives from the firm proposed a performance fee schedule that would have a very low base fee and the ability to earn a bonus if they outperformed their benchmark. Looking back over the last 12 months we paid WAMCO more by adopting the performance based fee schedule than if we had kept the original schedule in place. Staff prefers asset based fee schedules over performance based fees because of the predictability of the fees for budgeta ry purposes and because we often pay lower overall fees with the asset based approach. WAMCO has agreed to revert back to its former asset based fee schedule. Paul Palmer Investment Officer MAP:TL:PGP Attachment WAMCO Due Diligence Repo rt Page 4 August 5, 2010

5 Attachment Los Angeles Fire & Police Pension System WAMCO (TIPS) Return Analysis Return Information as of June 30, 2010 Inception Inception Manager 3-Month I-Year 3-Years Return Date WAMCO (TIPS) 3.87% 10.32% 7.82% 5.20% 9/1/2005 Barclays US Inflation-Linked Bond Index 3.87% 9.53% 7.61`% 5.10% * Return information is From the inception date listed in the far right column. Los Angeles Fire & Police Pension System WAMCO (TIPS) Return Analysis Annual Return Information as of June 30, 2010 YTD Inception Inception Manager Return Date WAMCO (TIPS) 4.720/ % ' I I' 1.47% 5.20'%, 9/1/2005 Barclays US Inflation-Linked Bond Index 4.42% 10.48% -1.71% 11.78% 0.49% 5.10%1 1