Presentation to the Tobacco Settlement Investment Board May 18, 2009 Millie Viqueira Senior Vice President Jay Kloepfer Executive Vice President Callan Associates Inc. 200 Park Avenue, Suite 230 Florham Park, NJ 07932 973.593.8050 www.callan.com
Executive Summary Total Portfolio Callan is very comfortable with the number of managers represented in the portfolio and the balance between active and passive. Domestic Equity The current number managers used to gain exposure to the domestic equity market is reasonable relative to asset size. Callan concurs with the passive (& structured) implementation of the Large Cap Core portion of the portfolio. The portfolio has a good balance between its small cap growth and small cap value managers. Relative to an 80%/20% neutral split between large cap and small cap, the portfolio exhibits an overweight to small cap (75%/25%). International Equity The current International Structure is reasonable in terms of the number of managers. The current managers provide coverage of developed and developing markets. We don t believe that passive exposure is necessary. Fixed Income Setting aside manager specific issues, the portfolio has an appropriate number of managers and an appropriate allocation between active and passive mandates. 1
There is not a Single Best Structure Factors to Consider in Structure Design Financial Theory (academic literature) Empirical Evidence (capital market observations) Fund Sponsor Risk Tolerance Time horizon Total Portfolio vs. individual manager focus Understanding and support for specific styles of management Time and professional resources available to monitor program 2
Issues to Address in any Structure Design Use of Index Funds - which market subsectors, and in what percentages? Types (Styles) of Managers - specialists (e.g., growth and value managers) or generalists (e.g., core manager)? Number of Managers - driven by first two decisions and client s size. Types of Vehicles - separately managed portfolio, commingled/mutual fund or manager of managers? Cost Effectiveness - there is little or no value in building a theoretical structure that is too expensive to implement. Transition costs Monitoring costs Management fees Legal costs of contract review 3
Domestic Equity Structure Guiding Principles/Best Practices Role of equity: the portion of total portfolio where the Fund seeks long-term capital appreciation and exploits the higher expected total return for equity over fixed income. Primary determinants of equity performance: Market capitalization. Style exposure (value, core, and growth). The amount of active and passive management. Starting point given a clean sheet of paper: the total equity structure should be neutral to the broad market in regard to style and capitalization, unless the investor has a preference to tilt the structure. 80% Large Cap + 20% Small Cap Active and passive management can be complementary in different market situations. However, the case for active management varies greatly by market capitalization. Passive can be appropriate for large cap. Active management is compelling for small cap. Callan favors active management in style exposures (growth and value). Callan s overriding philosophy: keep the structure as simple as possible given the circumstances. 4
Domestic Equity Structure Active Management Premiums: Large Cap Core Percent of Three-Year Periods where Manager Beat Benchmark by More than Hurdle - by Percentile Hurdle 0.20% 0.25% 0.30% 0.35% 0.40% 0.45% 0.50% 0.55% 0.60% 0.65% Median 40% 40% 39% 39% 38% 36% 35% 35% 33% 31% 45th Percentile 55% 54% 51% 45% 45% 45% 45% 45% 43% 40% 40th Percentile 66% 66% 66% 65% 65% 65% 65% 61% 61% 56% 35th Percentile 69% 69% 69% 69% 68% 68% 68% 68% 68% 66% 30th Percentile 78% 76% 76% 74% 74% 74% 71% 70% 69% 69% 25th Percentile 83% 83% 81% 81% 80% 80% 80% 80% 78% 78% Average Annualized Excess Return - Median Manager: -0.28% Rolling 12 Quarter Excess Return Relative To S&P:500 for 20 Years Ended December 31, 2008 25.0 20.0 15.0 CAI:Lg Cap Broad Style S&P:500 Excess Return 10.0 5.0 0.0 (5.0) (10.0) (15.0) (20.0) 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 5
Domestic Equity Structure Active Management Premiums: Small Cap Core Percent of Three-Year Periods where Manager Beat Benchmark by More than Hurdle - by Percentile Hurdle 0.20% 0.25% 0.30% 0.35% 0.40% 0.45% 0.50% 0.55% 0.60% 0.65% Median 89% 89% 88% 86% 85% 85% 85% 85% 85% 84% 45th Percentile 96% 96% 96% 96% 96% 95% 94% 94% 93% 91% 40th Percentile 98% 98% 98% 98% 98% 98% 98% 98% 98% 98% 35th Percentile 98% 98% 98% 98% 98% 98% 98% 98% 98% 98% 30th Percentile 100% 99% 99% 99% 98% 98% 98% 98% 98% 98% 25th Percentile 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Average Annualized Excess Return - Median Manager: 2.81% Rolling 12 Quarter Excess Return Relative To Russell 2000 Index for 20 Years Ended December 31, 2008 Excess Return 30.0 26.0 22.0 18.0 14.0 10.0 6.0 2.0 (2.0) (6.0) (10.0) (14.0) (18.0) CAI:Sm Cap Broad Style Russell 2000 Index 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 6
Domestic Equity Structure Equity Structure Archetypes: Relative Return More COMPLEXITY Less Less RISK More Large Value (S&P 500V) Mid Value (S&P 400V) Small Value (S&P 600V) Large Growth (S&P 500G) Mid Growth (S&P 400G) Small Growth (S&P 600G) Large Value (Russell 1000V) Small Value (Russell 2000V) Large Growth (Russell 1000G) Small Growth (Russell 2000G) Passive Or Enhanced Or Core Equity Small Growth (Russell 2000G) And Small Value (Russell 2000V) Or Core Small Cap Objective Focus on low tracking error and less interest on adding value over the benchmark. 7
International Equity Structure Manager Types Passive and/or Enhanced Passive Benchmark Aware Core managers have minimal drift away from the benchmark, a blend of growth and value and some exposure to emerging markets. Core Plus managers have higher levels divergence from the benchmark. Benchmark Unaware These managers often look for absolute returns, rather than relative returns, and will differ significantly from the benchmark most of the time. Specialty Managers International Small Cap, Dedicated Emerging Markets; each provides a greater depth of coverage in these areas which can lead to exploiting greater inefficiencies and generating greater potential alpha. 8
International Equity Structure Guiding Principles/Best Practices Role of international equity: a complement to domestic equity in the total equity portion of the Fund. Increased opportunity set - 55% of global market capitalization Diversification benefits afforded by exposure to country, sector, and currency factors. Active management has proven to be successful at exploiting inefficiencies and differences between markets. A rational portfolio is constructed by allocations to strategies along a spectrum of risk, defined relative to a broad market benchmark: Passive or enhanced passive Core active Benchmark agnostic Small cap Emerging markets The ultimate structure depends on a fund s tolerance for risk. Lower volatility - relatively large active core segment. Higher alpha - reduce the allocation to core active and add benchmark agnostic, dedicated exposure to emerging markets and/or small cap. An allocation to passive may make sense as an anchor to the higher tracking error strategies. Callan s overriding philosophy: keep the structure as simple as possible given the circumstances. 9
International Equity Structure International Structure Archetypes: Relative Return More COMPLEXITY Less International International Value Growth (MSCI EAFE (MSCI EAFE Value) Growth) Emerging Markets (MSCI Emerging Markets) International Value* (MSCI EAFE Value) International Growth* (MSCI EAFE Growth) Passive Or Enhanced Or Core International Equity * Emerging Markets exposure could be part of the mandate in which case the benchmark might be changed to the MSCI ACWI ex-us Objective Focus on low tracking error and less interest on adding value over the benchmark. 10
International Equity Structure Active Management Premiums: Core International Percent of Three-Year Periods where Manager Beat Benchmark by More than Hurdle - by Percentile Hurdle 0.20% 0.25% 0.30% 0.35% 0.40% 0.45% 0.50% 0.55% 0.60% 0.65% Median 81% 80% 78% 78% 76% 75% 73% 73% 71% 68% 45th Percentile 91% 90% 90% 90% 89% 88% 84% 84% 84% 83% 40th Percentile 91% 91% 91% 91% 91% 91% 91% 91% 91% 91% 35th Percentile 93% 93% 93% 93% 93% 93% 91% 91% 91% 91% 30th Percentile 94% 94% 94% 94% 94% 93% 93% 93% 93% 93% 25th Percentile 98% 98% 98% 95% 95% 95% 95% 95% 95% 95% Average Annualized Excess Return - Median Manager: 2.12% Excess Return 17.0 14.0 11.0 8.0 5.0 2.0 (1.0) (4.0) (7.0) (10.0) (13.0) (16.0) (19.0) Rolling 12 Quarter Excess Return Relative To MSCI:EAFE US$ for 20 Years Ended December 31, 2008 CAI:Intl EQ Non-US Style MSCI:EAFE US$ 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 11
International Equity Structure Non-US Equity versus MSCI ACWI ex US Index Percent of Three-Year Periods where Manager Beat Benchmark by More than Hurdle - by Percentile Hurdle 0.20% 0.25% 0.30% 0.35% 0.40% 0.45% 0.50% 0.55% 0.60% 0.65% Median 57% 57% 57% 57% 57% 57% 57% 56% 56% 56% 45th Percentile 61% 61% 60% 60% 60% 60% 60% 60% 58% 58% 40th Percentile 69% 65% 65% 65% 65% 63% 63% 63% 63% 61% 35th Percentile 76% 76% 74% 74% 74% 72% 72% 72% 71% 68% 30th Percentile 79% 79% 79% 79% 79% 78% 78% 78% 78% 78% 25th Percentile 90% 90% 89% 89% 89% 89% 85% 83% 82% 81% Average Annualized Excess Return - Median Manager: 1.39% Excess Return 16.0 13.0 10.0 7.0 4.0 1.0 (2.0) (5.0) (8.0) Rolling 12 Quarter Excess Return Relative To MSCI:ACWI ex US for 18 Years Ended December 31, 2008 CAI:Intl EQ Non-US Style MSCI:ACWI ex US 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 12
Fixed-Income Structure Guiding Principles/Best Practices Role of Fixed Income: the portion of a fund s total portfolio that normally acts as a low risk anchor for the fund and should therefore be fairly conservative. broad, diversified exposure investment-grade quality bonds Primary determinants of fixed income performance: Duration Sector Quality Callan Premise: Neutral to the broad market, as represented by the Barclay s Aggregate Bond Index. Neutrality in this case is primarily defined as the duration range and secondarily as the credit quality. 13
Fixed-Income Structure Callan s General Philosophy/Best Practices The three main factors that define strategies active management versus passive broad market exposure versus one narrowed by sector or duration opportunistic core plus mandates versus dedicated allocations to securities outside of the benchmark, primarily high yield and non-u.s. bonds. The most commonly employed strategies include passive (benchmarked to the Aggregate), active core, and active core plus. Callan s overriding philosophy: keep the structure as simple as possible given the circumstances. 14
Fixed Income Structure Active Management Premiums: Core Bond Percent of Three-Year Periods where Manager Beat Benchmark by More than Hurdle - by Percentile Hurdle 0.20% 0.25% 0.30% 0.35% 0.40% 0.45% 0.50% 0.55% 0.60% 0.65% Median 36% 34% 24% 16% 15% 14% 13% 9% 8% 6% 45th Percentile 43% 36% 29% 29% 20% 15% 14% 13% 10% 8% 40th Percentile 55% 48% 36% 30% 26% 23% 15% 14% 14% 11% 35th Percentile 69% 55% 46% 35% 31% 28% 23% 18% 15% 14% 30th Percentile 78% 66% 58% 45% 38% 34% 30% 24% 21% 18% 25th Percentile 88% 78% 68% 56% 48% 41% 36% 31% 28% 24% Average Annualized Excess Return - Median Manager: 0.14% Rolling 12 Quarter Excess Return Relative To BC:Aggr Bond for 20 Years Ended December 31, 2008 Excess Return 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 (0.5) (1.0) (1.5) (2.0) (2.5) (3.0) (3.5) (4.0) CAI:Core Bond Style BC:Aggr Bond 89 90 91 92 93 94 95 96 97 98 99 00 01 02 Callan 03Associates 04 05 06 Knowledge 07 08 for Investors 15
Fixed Income Structure Active Management Premiums: Core Plus Bond Percent of Three-Year Periods where Manager Beat Benchmark by More than Hurdle - by Percentile Hurdle 0.20% 0.25% 0.30% 0.35% 0.40% 0.45% 0.50% 0.55% 0.60% 0.65% Median 64% 63% 61% 60% 58% 56% 54% 54% 53% 48% 45th Percentile 65% 65% 63% 63% 63% 59% 56% 55% 54% 54% 40th Percentile 71% 69% 66% 65% 64% 63% 61% 58% 55% 55% 35th Percentile 76% 74% 71% 66% 66% 65% 65% 64% 61% 59% 30th Percentile 85% 81% 78% 75% 73% 71% 68% 66% 66% 63% 25th Percentile 88% 86% 86% 84% 81% 79% 74% 71% 70% 66% Average Annualized Excess Return - Median Manager: 0.56% Rolling 12 Quarter Excess Return Relative To BC:Aggr Bond for 20 Years Ended December 31, 2008 Excess Return 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 (1.0) (2.0) (3.0) (4.0) (5.0) (6.0) (7.0) CAI:Core Plus Style BC:Aggr Bond 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 16
Fixed-Income Structure Fixed Income Structure choices depend on size and role of fixed income in the total portfolio. Four Basic Variations Core Core Plus Core/Satellite Liability Driven Investments (DB only) Usually a single manager who maintains risk close to the broad market investment grade bond market (Barclay s Aggregate). Value added by duration management, yield curve positioning, sector and security selection. One or more managers with the mandate to use high yield, non-u.s. bonds and other market segments opportunistically. Performance is typically compared to investment grade index (Barclay s Aggregate). Core manager plus specialty managers. Specialty assignments mix include high yield and non-u.s. Bank loans, convertibles may also play a role. One or more managers who run a portfolio whereby the duration is extended significantly. The purpose is to dampen the volatility of the plan s liabilities as opposed to a total rate of return focus. 17
Fixed Income Structure Fixed Income Structure Archetypes: Relative Return More COMPLEXITY Less Core Plus Barclay s Agg Or Universal Core Plus Barclay s Agg Or Universal Core Barclay s Agg Core Barclay s Agg Passive Or Enhanced Objective Focus on low tracking error and less interest on adding value over the benchmark. 18
Executive Summary Total Portfolio Callan is very comfortable with the number of managers represented in the portfolio and the balance between active and passive. Domestic Equity The current number managers used to gain exposure to the domestic equity market is reasonable relative to asset size. Callan concurs with the passive (& structured) implementation of the Large Cap Core portion of the portfolio. The portfolio has a good balance between its small cap growth and small cap value managers. Relative to an 80%/20% neutral split between large cap and small cap, the portfolio exhibits an overweight to small cap (75%/25%). International Equity The current International Structure is reasonable in terms of the number of managers. The current managers provide coverage of developed and developing markets. We don t believe that passive exposure is necessary. Fixed Income Setting aside manager specific issues, the portfolio has an appropriate number of managers and an appropriate allocation between active and passive mandates. 19