State Universities Retirement System of Illinois

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1 State Universities Retirement System of Illinois 7333 Serving Illinois Community Colleges and Universities 1901 Fox Drive Champaign, IL (217) (217) To: Investment Committee From: Douglas Wesley, CFA, Lou Ann Fillingham, CPA, and Tony J. Lee Date: August 29, 2008 Re: Manager Development Program Fixed Income Manager Recommendation Investment Department Overview At the March 14, 2008, SURS Board of Trustees meeting, a domestic fixed income search was approved to expand the Manager Development Program (MDP). Staff initiated the search and conducted a thorough review of the fourteen request for proposal (RFP) responses that the System received. Interviews were conducted with nine semi-finalist firms in August, resulting in staff recommending Davis Hamilton Jackson & Associates and Cypress Asset Management be retained in the MDP. Additionally, staff recommends additional funding to existing MDP Fixed Income managers, Pugh Capital Management and Smith Graham & Company. Search Process An RFP was created in April and publicly disseminated in May The RFP was designed to seek qualitative information about each firm s organizational structure and investment process and quantitative information about each firm s historical performance. The RFP was posted on SURS website and was advertised in the official state newspaper, the Edwardsville Intelligencer. In addition, an advertisement was placed in Emerging Manager Monthly, a publication whose target audience is minority-owned and women-owned investment management firms, and in Pensions and Investments, a publication whose target audience is the investment manager community and plan sponsors. Eight of the fourteen firms that responded had previously contacted SURS during the past year. In addition, five of the firms are current managers for SURS through Progress. Appendix A following this memorandum lists the managers who responded to the RFP and provides reasons for elimination regarding the firms that were not selected for the MDP. All managers not selected for allocations will be notified by mail of their elimination. SURS staff reviewed the RFP responses and invited nine firms to make presentations to the investment staff during August The following firms were interviewed: Firms Interviewed Ambassador Capital Management LM Capital Group Black Knight Asset Management New Century Advisors Cypress Asset Management Piedmont Advisors Davis Hamilton Jackson & Associates The Swarthmore Group Holland Capital Management

2 Based on the RFP responses and manager presentations, staff identified two firms, Davis Hamilton Jackson & Associates and Cypress Asset, to be included in the MDP due to their experienced investment professionals, organizational stability, well defined investment process, strong performance record, and best fit to the existing MDP Fixed Income program. The following criteria were considered in making decisions related to the search process: Selection Criteria A. Organization, Structure, and Personnel B. Assets Under Management and Client Base C. Investment Philosophy, Policy, and Process D. Research Capabilities and Resources E. Historical Performance and Risk Factors F. Investment Operations, Compliance and Internal Controls G. Fee Structure H. Correlation and process relative to MDP Fixed Income managers Profiles of the recommended firms are included in Appendix B. Treasury Inflation Protected Securities (TIPS) as an Asset Class consideration in the MDP During the domestic fixed income search process, staff discovered that several of the RFP respondents had the capability to manage TIPS and had either included them in their existing strategies or currently managed TIPS only mandates. One goal of the MDP program is to mirror, where possible, the structure of the overall SURS investment program. Creating a TIPS asset class in the MDP would advance the program toward this goal. Staff believes consideration should be given to include an allocation to TIPS in the MDP. If approved, staff recommends up to $150 million be invested in TIPS, which would be allocated through a search process. Staff will study the inclusion of a TIPS allocation in the MDP and address the subject during the fixed income annual review at the February 2008 Investment Committee meeting. Additional Allocations to existing MDP Fixed Income Managers Staff also believes additional allocations to two of the existing MDP managers are appropriate at this time. The additional allocations to Pugh Capital and Smith Graham in the amount of $12.5 million each will further the goal of creating a structure that more closely resembles the overall SURS portfolio. At the completion of the MDP U.S. Equity and Real Estate searches scheduled to begin later this year, the fixed income asset allocation in the MDP is expected to be approximately 20%. Pugh and Smith Graham have also been identified for increased funding as a result of favorable relative performance. Staff recommends the additional funds for Pugh Capital and Smith Graham be transferred from Western Asset Management as part of a rebalancing of the SURS fixed income portfolio. Profiles and rationale for additional allocations are included in Appendix C.

3 Recommendation: Staff recommends the following: That Davis Hamilton Jackson & Associates be retained as a Fixed Income manager in the Manager Development Program, contingent on successful contract negotiations, with an initial allocation of $25 million, contingent upon the firm s successful designation as a Minority/Women owned firm. That Cypress Asset Management be retained as a Fixed Income manager in the Manager Development Program, contingent on successful contract negotiations, with an initial allocation of $25 million. That Pugh Capital Management be funded an additional allocation of $12.5 million. That Smith Graham & Company be funded an additional allocation of $12.5 million. That $75 million be withdrawn from the Western Asset Management account to fund the allocations to Davis Hamilton Jackson & Associates, Cypress Asset Management, Pugh Capital Management, and Smith Graham & Company.

4 APPENDIX A Firms Responding to the Request for Proposal Firm Name Firm Ownership Location 1 Ambassador Capital Management African American Detroit, MI 2 Black Knight Asset Management African American/Latino Washington, D.C. 3 Cypress Asset Management Latino Charlottesville, VA 4 Davis Hamilton Jackson & Associates Latino/Female Houston, TX 5 Fiduciary Management Associates Female Chicago, IL 6 Holland Capital Management African American Chicago, IL 7 LM Capital Group Latino San Diego, CA 8 MBIA Asset Management / Ramirez Latino Armonk, NY 9 New Century Advisors Female Bethesda, MD 10 Piedmont Investment Advisors African American Durham, NC 11 SDM Investments African American/Female Evergreen Park, IL 12 The Swarthmore Group African American Philadelphia, PA 13 Utendahl Capital Management African American New York, NY 14 Xavier Capital Management African American Largo, MD

5 State Universities Retirement System of Illinois Serving Illinois Community Colleges and Universities 1901 Fox Drive Champaign, IL (217) (217) Investment Department Eliminated firms: Name Reasons for Elimination 1 Fiduciary Management Associates Significant number of client losses in past 5 years Performance has been below the benchmark in the 1-year, 3-year, and since inception periods 2 MBIA Asset Management/Ramirez Assets under management would not qualify firm as an emerging manager Ramirez s primary line of business is its broker dealer operation and could pose a potential conflict of interest 3 SDM Investments Manager of Managers program Limited assets under management 4 Utendahl Capital Management Significant number of client losses in past 5 years Poor performance in the 1-year and since inception periods Broker dealer operation could pose a potential conflict of interest 5 Xavier Capital Management Product yet to be funded Firm history brief with less than 2-year track record

6 Eliminated Semi Finalist firms: Name Reasons for Elimination 1 Ambassador Capital Lack of product fit Limited track record with key professional Strategic redundancy with Progress account 2 Black Knight Asset High correlation with existing MDP program Firm viability a concern due to lack of resources Exposure to certain illiquid sectors a concern 3 Holland Capital Consistent underperformance in product since inception Concentrated client base 4 LM Capital Group Opportunistic rather than core product Duration limits outside SURS guidelines High correlation with existing MDP program Strategic redundancy with Progress account 5 New Century Advisors Duration management band outside SURS guidelines Utilization of risk controls in portfolio unclear Strategic redundancy with Progress account 6 Piedmont Advisors High correlation with existing MDP program Since inception performance below benchmark Strategic redundancy with Progress account 7 The Swarthmore Group Product assets under management Three-year performance below benchmark Lack of decision maker as both portfolio managers are generalists

7 State Universities Retirement System of Illinois 7333 Serving Illinois Community Colleges and Universities 1901 Fox Drive Champaign, IL (217) (217) APPENDIX B Investment Department Core Domestic Fixed Income: Cypress (Latino) Cypress Asset Management, based in Charlottesville, Virginia, was incorporated in 1995 and registered with the SEC in November The firm is 100% employee owned and controlled by President and CIO, Mr. Xavier Urpi. Cypress employs three investment professionals with a total staff of five individuals. As of December 31, 2007, Cypress managed a total of $638 million, of which $306 million was in the domestic fixed income product currently under consideration by SURS. Clients in the domestic fixed income product include the Illinois Municipal Retirement Fund and SURS via Progress Investment Management. Investment Process Cypress s objective is a conservative, diversified portfolio that focuses on security and sector analysis. The firm believes enhanced returns are achieved by controlling risk volatility and focusing on relative value among sectors and securities. Cypress utilizes a four-factor duration model and sub-sector matrix management system to measure portfolio risk. Cypress s strategy focuses on a value-added approach that utilizes a combination of top-down and bottom-up technique. Initially, an investment horizon for the duration and yield curve strategy is formulated. Each major sector of the market is then reviewed to determine whether an under- or over-weighted exposure versus the index is warranted. Opportunities within corporate and asset-backed securities are pursued for increasing the yield and value of the portfolio. All strategies and swaps are analyzed in relation to the returns that are generated versus the risks that are encompassed. Cypress s core fixed income product concentrates on finding value in two main areas: corporate and commercial mortgage backed securities (CMBS). The portfolio currently holds 120 securities with an average expected turnover of 75-90% per year. Tracking error expectations are basis points per year and standard deviation is targeted to be less than one. Cypress does not invest in futures and options, and other derivatives are rarely utilized in the firm s core portfolios. Duration is targeted within a band of +/- 10% around the duration of the Index. Performance As the charts on the following pages indicate, over its history spanning more than ten years, Cypress s core fixed income product has generally performed above the Lehman Brothers Aggregate Bond Index benchmark.

8 Core Domestic Fixed Income: Davis Hamilton Jackson & Associates (Latino) Davis Hamilton Jackson & Associates (DHJA), based in Houston, Texas, was founded in It was management-owned until 1998 when it became an affiliate of Affiliated Managers Group, Inc. (AMG). At that time, AMG purchased 65% of DJHA with the remaining 35% divided among seven principals. Small ownership transfers have occurred over the past ten years. The next transfer will occur by September 30, 2008, when DHJA will purchase approximately five to ten percent of AMG s ownership. This purchase will result in nine DHJA principals owning approximately 55% of the firm with the remaining 45% owned by AMG. The firm expects to purchase additional ownership from AMG. The target ownership goal is to reduce AMG s interest to the mid 20% range over the next six months. The firm originally registered with the SEC in July 1998 and subsequently registered in December 1998 upon becoming an affiliate of AMG. DHJA employs ten investment professionals with a total staff of 23 individuals. As of December 31, 2007, DHJA managed a total of $2.2 billion, of which $184 million was in the domestic fixed income product currently under consideration by SURS. Clients in the domestic fixed income product include Prince George s County Fire Service Pension Plan and Police Pension Plan. Investment Process DJHA follows a consistent fixed income investment philosophy that focuses on the preservation of principal while maintaining high current income. The firm s goal is to outperform the benchmark index net of fees with higher credit quality, lower risk and less volatility. DJHA s fixed income strategy employs a top-down approach. The firm s primary strategy to achieve the objective of outperforming the benchmark is attained through controlled interest rate anticipation and active sector rotation. The broad fundamental quantitative analysis of duration, yield curve, sector allocation and sector duration results in a defined set of parameters for the individual issues that fit the portfolio. This analysis uses models for liquidity, duration and spread. The qualitative component of the investment process revolves around five key factors: sentiment, monetary, economic, valuation and inflation. The portfolio typically holds between high quality securities, has expected turnover of 50-75% per year and has no tracking error target. DJHA does not invest in futures, options or other derivatives. Performance As the charts on the following pages indicate, DJHA s core fixed income product has performed above the Lehman Brothers Aggregate Bond Index benchmark since inception.

9 Manager Confidence Analysis Davis Hamilton Jackson July 1996 through March th th Median th th Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Manager Confidence Analysis Cypress Asset Management January 1998 through March th 25th Median 75th 95th Jan-98 Dec-98 Nov-99 Oct-00 Sep-01 Aug-02 Jul-03 Jun-04 May-05 Apr-06 Mar-07 Feb-08

10 Exhibit 38 Davis Hamilton Jackson Risk/ (Annualized) July March Davis Hamilton Jackson Lehman Brothers Bond Aggregate T-Bills Risk Cypress Asset Management Risk/ (Annualized) January March Lehman Brothers Bond Aggregate Cypress Asset Management T-Bills Risk

11 Cypress Asset Davis Hamilton Jackson Exhibit Davis Hamilton Jackson 3 Year s 105 Observations Lehman Brothers Aggregate 14 Cypress Asset 3 Year s 87 Observations Lehman Brothers Aggregate

12 Excess Excess Exhibit 38 DHJ Rolling 3 Year Excess Cypress Rolling 3 Year Excess

13 HISTORICAL RETURNS (BY YEAR) Davis Hamilton Jackson Lehman Brothers Aggregate Bond Difference 1996 (6 months) (2.1) (0.8) (3 months) Trailing 1-year Trailing 3-year Trailing 5-year Trailing 7-year Trailing 10-year Since Inception (6/30/96) HISTORICAL RETURNS (BY YEAR) Cypress Asset Lehman Brothers Aggregate Bond Difference (3 Months) Trailing 1-year Trailing 3-year Trailing 5-year Trailing 7-year Trailing 10-year Since Inception (12/31/97)

14 APPENDIX C Core Domestic Fixed Income: Pugh Capital (African American/Women) Pugh Capital was funded in April, 2006 as a core fixed income manager. The portfolio manager, Mary Pugh, has navigated the recently turbulent credit markets well. Pugh Capital has demonstrated consistent, steady risk adjusted returns since becoming a manager of SURS. Performance since inception as of 06/30/08 was 5.7% versus a benchmark return of 5.8%. Rationale for Additional Funding Good relative performance versus active fixed income manager peer group since inclusion in the MDP. Top performing fixed income manager in the MDP. Firm has recently added clients and received additional allocations from existing clients in the past twelve months. Has added a senior credit analyst to provide additional research coverage. HISTORICAL RETURNS (BY YEAR) Pugh Capital Lehman Brothers Aggregate Bond Difference 2006 (9 months) (6 months) Since Inception (03/31/06)

15 Core Domestic Fixed Income: Smith Graham & Company (African American) Smith Graham & Company was funded in April, 2006 as a core fixed income manager. The portfolio manager, Cyril Theccanat, has displayed the ability to deliver good returns throughout the recent turbulent markets. Additionally, despite unfavorable credit markets the past eighteen months that resulted in a large number of active fixed income core managers experiencing significant underperformance, Smith Graham has been able to generate good returns. Performance calendar year to date as of 06/30/08 was 1.2% versus a benchmark return of 1.1%. Rationale for Additional Funding Performance has been strong in 2008 on both a relative basis versus its peer group and benchmark. Firm has shown growth in assets under management in its core fixed income product by adding new clients and receiving additional allocations from existing clients. Firm has recently bought back ownership from outside investor, thereby, becoming 100% employee owned. Key investment professional will receive additional firm ownership stake as a result of the recently completed buyback. Has promoted key individuals to more senior positions and shown organizational stability and organic growth. HISTORICAL RETURNS (BY YEAR) Smith Graham Lehman Brothers Aggregate Bond Difference 2006 (9 months) (6 months) Since Inception (03/31/06)