Investment Fiduciary Governance Commission Outcomes Under the Current Governance Model

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1 As part of its role in assisting the Commission, Hewitt EnnisKnupp (HEK) was asked to provide to the Commission for its consideration as background, an independent evaluation of the outcomes under the current governance model, both from an investment performance and asset management fee perspective. HEK routinely performs similar independent evaluations for other large state investment board and public retirement system clients. Here, we summarize our independent evaluation and analysis 1 of the following: 1. Asset allocation 2. Fund investment performance (net of investment fees) 3. Asset class structure review 4. Fees HEK Consultants will present this information for discussion during the January 23, 2014 Commission meeting, and respond to inquiries. 1. Asset Allocation A. Findings Table 1-A outlines the allocation for the North Carolina Retirement System (NCRS) as of September 30, 2013 relative to the target allocation outlined in the Investment Policy Statement (IPS). 1 This evaluation reflects the work of HEK from November 2013 through January 2014, and includes independent findings, analyses, and conclusions. The review was limited primarily to the subject matter identified in the Scope of Work. For this reason, the evaluation was not an all-encompassing examination or investigation of the Department of State Treasurer (DST) or the North Carolina Retirement Systems (NCRS).The information was provided by third parties, including, but not limited to, DST staff and Bank of New York Mellon (DST Custodian Bank). Due to the scope and timeframe of this review, HEK relied on the information provided to it, and did not independently verify all of the facts that were provided by those third parties, including DST; however we did allow key sources from within DST review the facts we relied upon for our analysis. The conclusions expressed in this module reflect the independent, professional judgment of HEK. No one associated with DST attempted to unduly influence the findings, analyses or conclusions expressed in this module. 31

2 Table 1-A NCRS Asset Allocation Asset Class Allocation as of 9/30/2013 Target Allocation Difference Global Equity 47.6% 40.5% 7.1% Fixed Income (4.2) Inflation Protected (1.5) Credit Alternatives (2.0) Real Estate (0.2) B. Analysis The asset allocation decision is the single most important decision that has a bearing on a fund s success over the long term. The NCRS policy asset allocation was determined by DST staff and the Treasurer to be the most efficient portfolio given the Fund s liabilities, liquidity needs, risk tolerance, and return objective. As of 9/30/2013, the Fund held a 7.1% overweight to global equity and a commensurate underweight to the fixed income, alternatives, and inflation-protected asset classes. The policy asset allocation reflects the circumstances of NCRS and its tolerance for risk. Through our analysis, we determined that the risk profile of the actual NCRS asset allocation is more aggressive than the asset allocation detailed in the Investment Policy Statement. A comparison of the NCRS policy asset allocation to the asset allocations of other funds may be of interest in assessing a degree of reasonableness. In addition, since a fund s asset allocation has been determined to drive over 90% 2 of investment performance, it is a worthwhile exercise to examine the NCRS asset allocation versus peers to provide context. Table 1-B compares NCRS s target asset allocation as prescribed by its IPS to peer Public Funds greater than $5 billion 3. 2 Ibbotson, Roger and Paul Kaplan, Does Asset Allocation Policy Explain 40, 60 or 100 Percent of Performance? Financial Analyst Journal, Vol. 56, No.1 (January/February 2000): Greenwich Associates Market Trends, U.S. Institutional Investors,

3 Table 1-B Peer Asset Allocation Greenwich Public Funds NCRS Current Target > $5 Billion Allocation Difference U.S. Equity Active U.S. Equity Passive Total U.S. Equity International Equity Global Equity Active Emerging Market Equity Active Total International Equity U.S. Fixed Income Active U.S. Fixed Income Passive Global Fixed Income Total Fixed Income Equity Real Estate REITs Private Equity Hedge Fund Commodities Money Market Other Total Relative to peers, NCRS holds a lower target allocation to U.S. equity with a higher target allocation to fixed income. While the actual global equity target is 40.5%, NCRS actual allocation is 47.6%, which is more in line with peers. C. Conclusions The actual NCRS asset allocation exhibits a higher risk positioning than its policy allocation, but still has a lower risk positioning relative to the asset allocation of peers. 2. Fund Investment Performance (Net of Investment Fees) A. Findings NCRS s Total Fund returns and peer rankings as of September 30, 2013, for the 1-, 3-, and 5- year trailing periods is provided in Table 1-C. The peer rankings 4 are based on a universe of 68 public pension funds that have over $1 billion in assets 5. 4 A rank of "1" indicates the highest ranking, "99" the lowest. 33

4 Table 1-C NCRS Investment Returns Total Fund Actual Performance Performance Based Upon Policy Allocation 1 Yr 3 Yrs 5 Yrs Table 1-C shows that, over the trailing 1-year, 3-year, and 5-year periods the actual performance was greater than the policy allocation. However, the actual performance has been in the third quartile of peer rankings over the same periods. Looking at the longest period of time, the trailing 5-years, the Fund has outperformed its policy allocation by 0.2% per year, but has ranked in the 62 nd percentile of peers. The Total Fund Benchmark is currently a weighting of the asset classes held within the portfolio, with the weighting of the benchmark resetting monthly based on the actual asset allocation. NCRS s returns and peer rankings for each asset class and sub-asset class as of September 30, 2013, for the 1-, 3- and 5-year trailing periods are provided in Table 1-D. The benchmarks against which NCRS measures its returns are detailed in its IPS. 5 Compiled by BNY Mellon Performance & Risk Analytics as of 9/30/

5 Table 1-D NCRS Investment Returns Asset Class 1 Yr 3 Yrs 5 Yrs Domestic Equity Russell 3000 Index Non-U.S. Equity Non-U.S. Equity Custom Index Global Equity MSCI ACWI Index Total Fixed Income Fixed Income Custom Index Total Real Estate Real Estate Custom Index Total Private Equity Private Equity Custom Index Hedge Funds Hedge Fund Custom Index Total Credit Credit Custom Index Total Inflation Protection Total Inflation Custom Index Table 1-D shows the performance of the NCRS asset classes, their benchmark, and peer rankings of asset class performance based on the same universe. As shown, the Fund s 35

6 traditional asset classes (i.e., Domestic Equity, Non-U.S. Equity, Global Equity, and Fixed Income) as well as the Credit and Inflation Protected asset classes have performed very strong over time on a relative basis. NCRS s remaining alternative investment asset classes (i.e., Real Estate, Private Equity, Hedge Funds) relative performance has not been as strong. Table 1-E, which references a subset of the same peer group (18 public pension funds with greater than $10 billion in assets and 3 years of performance and benchmark history), represents the risk/return tradeoff of the Fund (red diamond) relative to peer funds (blue diamond). The NCRS IPS calls for the Fund to be measured against various risk/return ratios to evaluate risk-adjusted returns and the effectiveness of the portfolio construction. The primary ratios used are the Sharpe Ratio (return relative to standard deviation; Table 1-E) and Information Ratio (alpha 6 relative to tracking error 7 ; Table 1-F). Table 1-E NCRS Risk/Return Analysis (3 Years) Total Fund Return 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% Standard Deviation The bottom left corner of the risk\return analysis represents low risk and low return. The top right corner represents high risk and high return. The top left corner is preferred because it represents higher return with lower risk. In relation to peers, NCRS has achieved strong risk-adjusted returns. While some peers have produced higher nominal returns (blue diamonds higher on the Y axis) relative to NCRS, they have done so by taking a greater level of risk (standard deviation) than NCRS. Continuing on with the same peer group of 18 public funds and the same timeframe of the trailing 3 years, Table 1-F represents the Tracking Error/Alpha tradeoff of the Fund (red diamond) relative to peer funds (blue diamond). 6 Here, Alpha means the return of each fund minus the return of its benchmark. 7 Tracking error is reported as a "standard deviation percentage" difference. This measure reports the difference between the return an investor receives and that of the benchmark he or she was attempting to imitate. 36

7 Table 1-F NCRS Tracking Error/Alpha Analysis The Y axis represents alpha, which has been calculatedd as the return of each fund minus the return of its benchmark. In the above chart, the center line represents 0.0% alpha over the trailing 3-year period, meaning that the return of the fund matches the return of the benchmark. The X axis represents tracking error, diamonds further to the right represent higher tracking error relative to their benchmarks. Therefore, above the center line to the left is preferred because it represents excess return or alpha added at a relatively lower level of tracking error. As shown, the NCRS Fund has added alpha over the period and exhibited a relatively low level of tracking error. However, the tracking error and alpha for NCRS have likely been reduced due to the manner in which the Fund s benchmark is calculated. B. Analysis Currently, the policy weight of the underlying asset classes used in the calculation of the Fund s benchmark is reset monthly using the actual weights of Fund assets. This differs from common practice and our advice. We believe a policy asset allocation that represents the desired risk profile to meet the goals of the Fund should be set for the long term, and that the Fund s benchmark should be a passive representation of the policy asset allocation. Furthermore, we believe staff should have sufficient flexibility to implement the asset allocation as they believe is appropriate for the current market conditions. However, the relative performance due to staff s decision to deviate from the policy asset allocation should be measured and reported. The effect on the Fund due to staff s decision to deviate from the policy allocation is hidden if returns are compared to a Fund benchmark with weightss that reset to actual weights. If, instead, Fund performance was measured against the policy asset allocation, then NCRS can measure the risk-adjusted effect of the deviation, which will help to facilitate a more accurate monitoring of the investment program. Additionally, if theree is a belief that the current policy asset allocation is 37

8 inappropriate and there is a more appropriate alternative, then the IPS and benchmark weighting should be updated to reflect the new policy asset allocation. C. Conclusions NCRS has outperformed its stated benchmark over a 1-, 3-, and 5- year period; however, has experienced weaker performance relative to peers. o Underperformance relative to peers is primarily attributable to the Fund s relatively lower risk positioning o The relative performance of NCRS s traditional asset classes when compared to their benchmarks has been strong. o The performance of NCRS s Real Estate, Private Equity, and Hedge Fund asset classes have been weak relative to their primary benchmarks. Over a 3-year period at the Total Fund Level, NCRS has had strong risk-adjusted returns relative to its benchmark and peers; however its absolute returns are not as strong when compared to peers. Policy asset allocations should not be reset monthly but rather represent the policy allocation defined in the IPS. Any deviation from the policy asset allocation by staff should be measured and reported. 3. Asset Class Structure Review A. Findings and Analyses HEK reviewed the structure of the NCRS Fund and found that it reflects common practice in its use of traditional asset classes (i.e., Domestic Equity, Non-U.S. Equity, Global Equity, and Fixed Income). We identified several notable findings with respect the Fund s alternative asset classes (i.e., Real Estate, Private Equity, Hedge Funds, Credit, Inflation Protected), as follows. Real Estate Over a trailing five-year period the NCRS Real Estate portfolio has underperformed its primary benchmark by 4.3% per year. Underperformance has been primarily driven by the portfolio s noncore investments. The investment objective of the core plus portfolio as outlined in the IPS is to provide attractive risk-adjusted returns, hedge inflation, capital preservation, and portfolio diversification. Core plus generally means that a Fund s goals and primary benchmarks would consist of core real estate and Real Estate Investment Trusts (REITS). By contrast, NCRS is only 25% invested in core real estate and 7.9% invested in REITS, with the remainder in higher risk/return non-core strategies. The segment of the portfolio with the largest 38

9 allocation (37%) is opportunistic 8 ; this is also the highest risk/return strategy. The actual portfolio has higher risk than the objectives outlined in the IPS. Although NCRS has a separate policy that identifies the core, value-add, and opportunistic allocation ranges, we believe the IPS should be modified to specify targets and ranges for core versus non-core real estate strategies. Private Equity Over a trailing five-year period the NCRS private equity portfolio has underperformed its benchmark by 4.0% per year 9. While the portfolio appears to be well-diversified across sub-asset classes 10, the portfolio has a meaningful concentration of assets in private equity investments within vintages 11, which has contributed to its underperformance. Additionally, the portfolio has approximately 28% of its assets in fund-of-funds 12 which are often not utilized by larger investors due to the relatively higher fees. Due to the size of the NCRS private equity portfolio, we believe the use of fund-of-funds should be reduced. HEK believes that NCRS should perform pacing models (i.e., analysis on the appropriate amount and timing of commitments) on an annual basis to help ensure vintage year diversification. Hedge Funds Over a trailing five-year period the NCRS hedge fund portfolio has underperformed its benchmark by 2.2% per year. The portfolio is adequately diversified by strategy based on the large allocation to the manager, Franklin Street Partners, which is a fund-of-funds. However, we believe that the allocation should be more diversified to include additional managers since there is high concentration (roughly 92% of the hedge fund portfolio) with Franklin Street Partners. We believe the portfolio would benefit from direct investments with multi-strategy managers including those with a relative value focus and/or an event-driven focus. We prefer direct investments with multi-strategy managers versus investments in fund-of-funds because using the latter could result in over-diversification, additional layering of fees, and the inability to re-allocate in rapidly changing market environments. 8 A strategy characterized by targeting underperforming and/or undermanaged properties, or properties that are temporarily depressed, and then using high degrees of leverage (borrowed funds) to acquire the property, hold it for a short period of time, and then sell it at an expected profit of at least 20 percent. 9 NCRS has two benchmarks that it uses to measure performance for private equity: the Custom Cambridge Associates benchmark and the Venture Economics All Private Equity benchmark. Both of these benchmarks are reasonable. 10 Among the most common investment strategies in private equity are: leveraged buyouts, venture capital, growth capital, distressed investments and mezzanine capital. 11 The year in which the first influx of investment capital is delivered to a project or company. This marks when capital is contributed by venture capital, private equity fund or a partnership drawing down from its investors. 12 A "fund of funds" is an investment strategy of holding a portfolio of other investment funds rather than investing directly in stocks, bonds or other securities. This type of investing is often referred to as multi-manager investment. 39

10 Given the large allocation to the Franklin Street Partners fund, we view the benchmark used (HFRI FOF Conservative Benchmark) as appropriate for the strategy. However, if multi-strategy managers are added we view the HFRI Fund Weighted Composite Index as a more appropriate benchmark. Credit Over a trailing three-year period the NCRS credit portfolio has outperformed its benchmark by 8.1% per year at a lower standard deviation than the benchmark. We believe the credit portfolio is adequately diversified by manager, across strategies, and with credit sub-asset classes. While the benchmarks used within the credit portfolio seem reasonable, we believe that the HFRI ED: Distressed/Restructuring Index and HFRI Relative Value (Total) Index would be a better benchmark because it more accurately represents the hedge fund universe. Inflation Protected Over a trailing three-year period the NCRS inflation protected portfolio has outperformed its benchmark by 0.7% per year. The inflation protected portfolio is adequately diversified by strategy and sub-asset class. The portfolio s sub-asset classes are private energy and commodities; both have both outperformed their benchmark. B. Conclusions The Fund s use of traditional asset classes reflect common practice. Enhancements to the Fund s alternative asset classes could include: o Aligning the Real Estate portfolio to reflect the objectives outlined in the IPS, or updating the IPS to reflect the evolved goals of the Real Estate portfolio. o Reducing the use of fund-of-funds in the private equity portfolio, and modifying the IPS to include further direction on vintage year diversification. o Reducing the use of fund-of-funds in the hedge fund portfolio, modifying the IPS to emphasize direct investments, and adjusting the benchmark accordingly. o Modifying the benchmark used in the IPS pertaining to the credit portfolio. 4. Fees Table 1-G represents the total cost of the NCRS Fund relative to peers from the CEM Report 13. Total cost includes investment manager fees, custodian bank expenses, and other operating and administrative costs. 13 The information below was sourced from the Investment Cost Effectiveness Analysis report performed by CEM Benchmarking, a Canadian company that is considered to be a leading source for global public retirement system peer comparison data. 40

11 Table 1-G NCRS Total Cost Analysis Total Cost (Basis Points) Total Fund 90th 79 75th 73 50th 64 25th 47 10th 42 NCRS As shown in the illustration, total Fund cost for NCRS in 2012 was 0.54% of total assets. This is 0.10% below the median peer fund. NCRS is in the 40 th percentile of peer funds in total plan cost. This means that approximately 60% of peer funds have a greater total fund cost than NCRS. In other words, the median peer program pays 19% more in total fund cost than NCRS. While the NCRS fees are favorable relative to peers, we believe that the Fund could further reduce total cost and maintain current investment quality by transitioning assets from fund-of-funds investments to direct investments. However, if these type of changes were to occur, NCRS would need to ensure that staff was sufficiently resourced to perform the necessary due diligence. 41