San Diego City Employees Retirement System Asset Allocation Review July 9, 2015 Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 1
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Executive Summary Investment policy and asset allocation are the key drivers of long-term success Asset allocation reviews are conducted on an annual basis to ensure SDCERS s portfolio continues to be appropriately allocated in order to meet its investment objectives The portfolio maintains a 78/22 mix between return-seeking and risk-mitigating assets Asset allocation refers to the composition of the return-seeking and risk-mitigating allocations We anticipate a challenging investment landscape ahead, creating difficulties for institutional investors to reach return goals Over time, SDCERS s asset allocation has undergone meaningful changes, enhancing the Plan s likelihood for success through both good and bad market environments The following deck provides: A summary of the changes made to the asset allocation over the past several years A review of the public equity allocation An update on the Opportunity Fund A recommendation modify language in the IPS to align with previously approved changes (details herein) A peer asset allocation comparison Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 3
Key Take-Aways We continue to believe the strategic asset allocation remains appropriate given the expected investment environment and SDCERS s investment circumstances We have no recommendations for changes to the strategic asset allocation at this time At the October 2014 Committee meeting, the Board approved combining the Private Equity and Infrastructure asset classes from an operational perspective AHIC recommends modifying the language in the Investment Policy Statement to treat the asset allocations as a single asset class Has no impact on the overall asset allocation of the Plan Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 4
Setting SDCERS s Risk Posture The asset/liability study conducted in 2012 re-affirmed the 78/22 mix between return-seeking and riskmitigating assets as an appropriate risk posture for the SDCERS Trust Fund Potential benefits from the current 78% return-seeking asset allocation remain appropriate given the long-term investment horizon Economic Cost ($millions) for City of San Diego Plan: Risk/Reward Analysis 2,500.0 Reward: Expected Outcome (Mean) 3,000.0 3,500.0 4,000.0 Ideal 70% 60% 50% 40% 80% 30% RS assets 90% RS assets Current Allocation (78% RS assets) 4,500.0 4,500.0 5,000.0 5,500.0 6,000.0 6,500.0 Risk: Worst 5% outcome (95 th Percentile) Allocation to Return-Seeking Assets Economic Cost (in $M) 30% 40% 50% 60% 70% 78% (current) 80% 90% Expected (mean) 3,917.4 3,659.5 3,422.2 3,217.7 3,050.0 2,965.3 2,915.1 2,809.4 Worst Case (95th percentile) 5,515.7 5,439.2 5,421.0 5,452.0 5,501.8 5,528.8 5,552.6 5,635.9 Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 5
Asset Allocation: Setting the Right Strategy is Key to Success SDCERS s asset class targets determined while giving due consideration to: Long-term return expectation Diversification / risk control Inflation protection Liquidity needs Costs Resources Flexibility Over the past several years, SDCERS s asset allocation has been meaningfully altered, with a focus on: A streamlined asset allocation through economy, simplicity, and reliability Deliberate and efficient risk taking and cost management Enhanced diversification Long-term investment perspective Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 6
Summary of Changes to SDCERS s Asset Allocation Asset Class Strategic Goal Actions Taken Return-Seeking Public Equities Return-Seeking Fixed Income Alternatives Private Equity Infrastructure Real Estate Opportunity Fund Risk-Reducing U.S. Fixed Income Balance geographic allocation to be in line with global opportunity set Provide additional diversification to return seeking allocation Focus on areas of strength and conviction Allow for maximum flexibility in implementation for ideas that are purely opportunistic, transcend multiple asset classes, or those that have no persistent asset class exposure Recognize explicit diversification role of riskreducing fixed income Reduced home-country bias Created 5% global equity allocation Created dedicated 1% emerging market equity allocation Eliminated non-u.s. developed bond allocation Created dedicated allocation to emerging market debt (EMD) Increased EMD allocation from 3% to 5% Eliminated market neutral allocation Increased PE target from 5% to 10% Added 3% Infrastructure allocation Maintained real estate allocation Committed to four strategies representing 2.5% of Total Fund as of 3/15; three opportunistic real estate strategies and one opportunistic debt strategy Structured mandate to best meet objectives Shortened duration to intermediate orientation Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 7
Progress Towards Long-Term Asset Allocation Policy Asset Class Pre - 2010 Target Interim Target (3/31/15) Current Long-Term Target U.S. Equity 36.0% 26.5% 21.0% Non-U.S. Equity 17.0 17.3 14.0 Emerging Markets Equity -- 1.0 1.0 Global Equity -- 5.0 5.0 Private Equity 5.0 7.0 10.0 Infrastructure - 3.0 3.0 Non-U.S. Fixed Income 4.0 - - Emerging Market Debt - 5.0 5.0 Market Neutral Strategies 5.0 - - Real Estate 11.0 11.0 11.0 Opportunity Fund - 2.5 8.0 Total Return-Driven (Equity-Type) Assets 78.0% 78.0% 78.0% U.S. Fixed Income 22.0 23.2 22.0 Total Low-Risk (Fixed Income-Type) Assets 22.0% 22.0% 22.0% Total Assets 100.0% 100.0% 100.0% Expected Nominal Return 6.28% 6.48% 6.58% Expected Real Return 4.10% 4.29% 4.38% Risk (Standard Deviation) 11.70% 12.08% 11.90% Sharpe Ratio (Reward/Risk) 0.349 0.354 0.368 Note: Data based on AHIC s 2Q 2015 30-year Capital Market Assumptions (CMAs). The Pre-2010 expectations derived from the pre-2010 asset allocation and 2Q 2015 CMAs. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 8
SDCERS s Asset Allocation Over Time SDCERS Asset Allocation: Trailing 10-years ending 3/31/2015 Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 9
SDCERS s Public Equity Portfolio The most efficient and optimal approach to invest in world public equity markets is through exposure to the entire opportunity set Consistent with modern portfolio theory that suggests the market portfolio is the most efficient portfolio (in terms of risk/return trade-off) Since 2010, SDCERS s equity portfolio has transitioned to mostly in line with the global opportunity set Reduced home-country bias Added global equity asset class Added dedicated emerging markets equity policy Total World Market Capitalization $44 Trillion* Emerging Markets $4.7T, 11% Int'l Developed $16.8T, 31% U.S. $22.9T, 52% 70% 60% 50% 40% 30% 20% 10% 0% SDCERS Policy vs. World Allocation* MSCI ACW IMI 58% 52% SDCERS LT Policy 38% 31% 11% 11% U.S. Int'l Developed Emerging Markets *MSCI Inc. as of May 30, 2015 Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 10
Opportunity Fund Update The goal of the Opportunity Fund is to offer a compelling return enhancement and/or diversification benefits relative to the opportunity cost of capital (78% equities / 22% bonds) SDCERS s Policy includes an allowable allocation to the Opportunity Fund from 0% to a maximum of 8% As of March 2015, there was $174 million invested in the Opportunity Fund across the below four investment strategies Torchlight Debt Opportunity Fund IV: Opportunistic real estate debt strategy $50 million commitment approved 9/13; $42 million invested as of 3/15 Carlyle Realty Partners Fund VII: Opportunistic real estate $50 million commitment approved 3/14; $6 million invested as of 3/15 Grosvenor Opportunistic Credit Strategy: Customized opportunistic credit strategy with exposure to the U.S., Europe and Asia 2% allocation approved 3/14; $121 million invested 3/15 LaSalle Asia Opportunity Fund IV: Opportunistic real estate $50 million commitment approved 5/15; $5 million invested as of 3/15 Staff and AHIC continue to vet attractive investment ideas and opportunities for inclusion in the Opportunity Fund Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 11
Private Equity/Infrastructure Update Current Circumstances: As of 3/31/2015 Market Value % of Total Fund Long-Term Policy Benchmark Private Equity $520.3M 7.6% 10.0% Annualized 10% Infrastructure $113.7M 1.7% 3.0% CPI + 3% At the October 2014 Committee meeting, the Board approved combining the Private Equity and Infrastructure asset classes from an operational and back-office perspective Improves operational efficiencies and reduces costs Provides advisors greater investment flexibility, increasing potential for value-add At that time, Private Equity and Infrastructure were maintained as separate asset classes from a Policy perspective AHIC recommends modifying the language in the Investment Policy Statement to align with the change noted above Combine asset classes to a single line-item, as shown in the table below Implement an annualized 10% rate of return as the benchmark Current Infrastructure benchmark is the Consumer Price Index (CPI) + 3% annually Creates high performance hurdle and aligns advisors interests with SDCERS Consistent with current Private Equity benchmark No change to overall allocation to Private Equity and Infrastructure Recommendation Market Value % of Total Fund Long-Term Policy Benchmark Private Equity/Infrastructure $634.0M 9.3% 13.0% Annualized 10% Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 12
Asset Allocation Targets Peer Comparison Asset Class SDCERS Long Term Target SDCERS Current Allocation (As of 3/31/15) AHIC Peer Average* BNY Mellon Public > $1B Universe** Public Market Investments 68% 73% 68% 76% Global Equity 41% 50 45% 47% Fixed Income 27%*** 23 21% 28% Cash Equivalents - - 2% 2% Alternative Investments 32% 27% 32% 24% Private Equity 10% 9% 12% -- Hedge Funds/Opportunistic 8% 3% 8% 19%** Real Assets 14%**** 11% 12% 5% Public Market Investments are defined as publicly traded equity, fixed income, and cash While no universal definition exists, we categorize Alternative Investments as any asset class that is not included under Public Market Investments The table above illustrates that SDCERS s current and long-term asset allocation targets are generally in line with large public pension plan peers *Average of AHIC s 11 largest public pension plan clients with total assets ranging from $14B to $146B ** BNY Mellon peer information based on actual peer weights. The alternative investment allocation includes private equity. ***Includes SDCERS s EMD allocation ****Includes SDCERS s Real Estate (11%) and Infrastructure (3%) allocations for comparison purposes Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 13
Policy Allocation Changes (4-Year Changes in Targets) Asset Class SDCERS AHIC Peer Average* BNY Mellon Public > $1B Universe** U.S. Equity -13% -3% -5% Non U.S. Equity 1% -2% 1% Private Equity 5% 3% Alternative Investments 3%*** 3% 9%** Real Assets 3%**** 2% Real Estate 2% Domestic Fixed Income -5% -6% Int l/global Fixed Income 1% 2% 1% High Yield 2% TIPS -2% Cash -1% Color Key Allocation = Increased Allocation = Neutral Allocation = Decreased No Allocation Broadly, peers have reduced allocations to U.S. equity and fixed income asset classes to fund increases in private markets and alternative investments SDCERS s shift towards alternatives, such as private equity, infrastructure and opportunistic investments, are in line with peer trends *Average of AHIC s top 10 largest public pension plans. **BNY Mellon peer information is based on actual peer weights. The alternative investment allocation includes private equity. ***Reflects change from previous 5% Market Neutral target to 8% Opportunistic Fund allowable allocation ****Reflects infrastructure allocation for comparison purposes Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 14
Summary Anticipate greater volatility and muted return expectations looking ahead Poses challenges for institutional investors to reach return targets Changes made to SDCERS s asset allocation over years has positioned it well for upcoming challenges Enhanced diversification across major asset classes Focused on areas with greatest risk/reward trade-offs Increased private equity target to 10% Added 3% infrastructure target Added opportunity fund to take advantage of attractive and/or opportunistic strategies, allowing for maximum flexibility in implementation Remained cost conscious; spending management fees where reward potential is the greatest (ex. PE, Infra) Maintained meaningful allocation towards risk-reducing asset class (22%) We believe that the SDCERS strategic asset allocation remains appropriate and have no recommendations for changes to the asset allocation at this time We do recommend modifying the IPS language to treat Private Equity and Infrastructure as a single asset class to align with the changes that were approved at the October 2014 meeting Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 15
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Appendix Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 17
Five Year Economic Scenarios What are they? A set of economic scenarios that are designed to assess the impact on portfolio returns Each scenario describes how economic and financial factors may evolve over the next five years: Macro Factors: real GDP growth, inflation, unemployment Yields and Returns: treasuries, TIPS, corporate bonds Risk Asset Returns: equities, commodities, real estate, hedge funds, private equity, infrastructure, high yield bonds, bank loans and emerging market debt (hard and local), and cash. The central economic scenario assumes that world events unfold in a fashion consistent with our Capital Market Assumptions. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 18
Description of Scenarios The economic scenarios are split into three categories: Optimistic positive outlook for pension schemes Blue Skies robust economic recovery and moderate inflation. Low Demand negative outlook for pension schemes Below Trend Growth weak recovery but avoids recession. Recession recession followed by recovery. Black Skies deep protracted recession with no rebound. Topical captures current events that may be positive or negative High Inflation higher growth and loose money push up energy and commodity prices causing inflation. Rising Yields due to a loss of confidence in the bond markets. Ultra Loose Monetary Policy (ULMP) loose monetary policy starts to disrupt market performance in later years. Emerging Market Crisis a widespread slowdown in emerging market growth leads to a divergence of fortunes for developed and emerging markets. Stagflation a supply side shock in energy leads to high inflation coupled with slower growth. Deflation falling commodity prices and weak global demand result in a prolonged period of deflation. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 19
Summary of 5-Year Economic Scenarios Scenario (Type ) Description Score Comments Blue Skies (Optimistic) Robust economic recovery and moderate inflation 5 Robust economic growth with moderate inflation seems a long way off in most developed markets. Below Trend Growth (Low Demand ) Weak recovery but avoids recession 4 A risk to capital markets is that growth does not firmly take hold and we remain in a similar environment to present, for an extended period. Recession (Low Demand ) Recession followed by recovery 9 While global growth may be below trend next year the US is likely to avoid recession. However, there is a risk that weak growth in Europe, Japan and EMs spill over and cause a recession. Black Skies (Low Demand) High Inflation (Topical ) Rising Yields (Topical ) Ultra Loose Monetary Policy (Topical ) Emerging Market Crisis (Topical ) Stagflation (Topical ) Deflation (Topical ) Deep protracted recession with no rebound Rising energy and commodity prices cause inflation Due to a loss of confidence in the bond markets Loose monetary policy starts to disrupt market performance in later years A weaker outlook for emerging market growth leads to a divergence of fortunes for developed and emerging markets. The world economy experiences slow growth coupled with high inflation due to a negative supply side shock in oil markets. Falling energy and commodity prices cause a protratcted period of deflation. 10 6 1 2 3 7 8 A large idiosyncratic shock would be required to yield this scenario. We believe there is little chance of such a shock. Given weak global growth rates and the weak outlook for commodity prices the risk of high inflation is muted over the five year period. The primary risk to capital markets is a disruptive rise in yields a glimpse of how disruptive this could be was seen in the summer of 2013 when QE tapering was first discussed. After rising yields, the fear is that longer than expected loose monetary policy disrupts markets. The longer QE runs for the harder and potentially more disruptive exiting becomes. A negative shock to emerging markets weakens emerging market growth and hurts assets specifically related to these regions. Developed economies are adversely affected initially but then stronger economic growth supported by an accommodative monetary policy allows assets in developed regions to outperform. Given weak global growth rates and the weak outlook for commodity prices the risk of stagflation is muted over the five year period. While oil prices may cause a short period of deflation in the US, robust growth makes a prolonged period of deflation less likely. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 20
SDCERS Economic Scenario Analysis Expected 5-year Nominal Return* Central Blue Skies Recession High Inflation Rising Yield Global Equity 7.1% 15.1% -2.1% 1.9% 0.6% U.S. Intermediate Duration Fixed Income 2.3 2.2 1.8 3.0 2.7 Emerging Market Debt 6.0 6.4 4.4 6.0 5.2 Real Estate 6.8 10.8-2.3 8.0-0.2 Private Equity 8.8 16.7 0.9 3.5 2.8 Infrastructure 7.4 10.2 1.5 8.3 2.5 Total SDCERS 5.9% 10.8% -0.1% 3.5% 1.6% *Based on AHIC s expectations as of 12/31/2014 Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 21
SDCERS Economic Scenario Analysis (cont d) Expected 5-year Nominal Return* Ultra-Loose Monetary Policy Black Skies Below Trend Growth Emerging Markets Crisis Stagflation Deflation Global Equity 3.9% -14.0% 3.1% 4.3% -0.5% 0.4% U.S. Intermediate Duration Fixed Income 1.7 2.0 2.2% 2.2 3.2% 2.1 Emerging Market Debt 4.3 4.3 5.6-4.0 6.2 5.3 Real Estate 7.1-4.8 3.2 7.0 8.3 0.3 Private Equity 5.7-13.0 5.0 6.8 1.1 4.4 Infrastructure 7.2-4.7 3.8 8.6 8.7 1.5 Total SDCERS 4.1% -7.1% 3.3% 4.4% 2.3% 1.7% *Based on AHIC s expectations as of 12/31/2014 Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 22
Asset Class Expected Risk and Return 30-Year Asset Class Expected Nominal Return and Risk* 2Q 2015 Expectations Asset Class Return Risk U.S. Equities 6.7% 18.0% Non-U.S. Developed Equities 6.8 20.0 Emerging Market Equities 8.0 30.5 Global Equities 6.9 18.5 U.S. Int. Duration Fixed Income 2.8 3.4 Emerging Market Debt 5.8 12.8 Real Estate 6.6 11.9 Private Equity 8.7 24.5 Infrastructure 7.3 14.5 *Note: Returns are nominal. U.S. Inflation (CPI): 2.1% Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 23
SDCERS: Asset Allocation Relative to Peers Asset Allocation Comparison Public Defined Benefit Plans with over $5 billion in Assets SDCERS Long-Term Policy* Public Funds (Over $5 billion)** 50.0% 47.0% 47.3% 40.0% 30.0% 24.0% 20.0% 19.0% 10.0% 5.0% 4.6% 13.0% 9.4% 11.0% 8.0% 4.3% 7.5% 0.0% Global Equity U.S. Fixed Income EMD / Int'l & Global FI*** Private Equity / Infrastructure Real Estate Hedge Funds Other**** *Opportunity Fund was allocated 78/22 global equity/u.s. fixed income **Based on Greenwich Associates 2015 Market Trends survey ***Survey data includes 0.6% int l FI, 2.6% global FI and 1.4% EMD ****Other includes 1.5% multi-assets, 1% commodities, 1.6% money market and 3.4% other Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 24