Asset Allocation Strategies for Police & Fire Benefit Plans Docs/Public Safety/2019/PP… · US...

National Conference on Public Employee Retirement SystemsNational Conference on Public Employee Retirement Systems

Asset Allocation Strategies for Police & Fire Benefit Plans

NCPERS 2019 Public Safety ConferenceNew Orleans, LA

Jennifer MinkSenior ConsultantInvestment Performance Services, LLC


Today’s Agenda

OpportunisticReview Capital Market Assumptions

and Asset Class Distinctions

Introduce Factors to Consider

Illustrate Sample Portfolios


Five Factors to Consider1.

2.

3.

4.

5.

Objective

Cash Flows

Fund Size

Expected Returns

Risk Tolerance


Factor #1 ‐ Objective

What is the objective of my Fund?

Target Return

Income Generation

Preservation of Capital


Factor #2 – Cash FlowsWhat are the cash flows of my Fund?

Contributions Expenses

Inflows

Pre‐negotiated amounts

Occur on a regular basis

Outflows

Benefit & expense payments

Occur on a regular basis


Types of Cash Flows

Positive/Stable Cash Flow

Contributions are equal to or greater than benefits/expenses

Negative Cash FlowContributions do not meet cash needs and investments must be sold in order to meet benefit/expense payments


Cash Flows

Depending on the level of negative cash flow, a Fund may need to limit its exposure to,

or be unable to invest in, less liquid (alternative) asset classes.


Factor #3 – Fund Size

Fund

Size Does Matter?


Fund SizeAccording to the SEC….. YES!

Accredited Investor

> $5 million

Qualified Purchaser

Qualified Institutional Buyer

> $25 million > $100 million

Rule 144ABank Loans

Real EstateHedge Funds

Hedge FundsOpportunistic


Factor #4 – Expected Returns

What is the market expected to do?


Wide variety of public sources provide guidance on capital market assumptions

Current market environment

Where the market is in the business cycle

Global interest rates

Expected Returns

Net of fee “market” (index) returns

Should be reasonable

Consider more than one set of assumptions


Capital Market AssumptionsEquity Return Risk

US Large Cap 6.0% 16.2%

Annualized (net of fee) index return

(Standard Deviation) –statistical measurement of volatility of returns

i.e. Expected range of Returns for US Large Cap: ‐17.8% to 22.2% (over 10 years or more)

The higher the standard deviation, the wider the range of returns…higher highs and lower lows


Horizon Actuarial Services

Survey of different investment advisors

2019 includes assumptions from 34 firms

Large and small firms

2019 Survey of Capital Market Assumptions

Publicly traded and independently owned firms

Firms servicing multi‐employer, public funds, corporates


Annualized 10‐Year Returns

Source: 2019 Horizon Survey; average expected return of all 34 respondents

Equity Return Risk

US Large Cap 6.0% 16.2%

US Small/Mid Cap 6.5% 20.2%

Non‐US Equity ‐Developed 6.8% 18.2%

Non‐US Equity ‐Emerging 7.8% 24.7%




Fixed Income Return Risk

US Treasuries 2.6% 2.3%

US Coporate Bonds ‐Inv Grade 3.5% 5.5%

US Corporate Bonds ‐High Yield 5.1% 10.1%

Non‐US Debt ‐Developed 2.6% 7.6%

Non‐US Debt ‐Emerging 5.6% 11.3%




Alternatives Return Risk

Real Estate 5.7% 15.0%

Hedge Funds 5.2% 8.4%

Commodities 3.9% 17.7%

Infrastructure 6.8% 14.4%

Private Equity 8.8% 22.0%

Private Debt 7.4% 11.6%



Equity Min Return Median Return Max Return RiskUS Large Cap 2.6% 6.0% 7.5% 16.2%

US Small/Mid Cap 3.5% 6.5% 8.4% 20.2%Non‐US Equity ‐Developed 4.2% 6.8% 8.8% 18.2%Non‐US Equity ‐Emerging 4.7% 7.8% 10.5% 24.7%

Fixed Income Min Return Median Return Max Return RiskUS Treasuries 2.0% 2.6% 3.4% 2.3%

US Coporate Bonds ‐Inv Grade 2.5% 3.5% 4.5% 5.5%US Corporate Bonds ‐High Yield 3.3% 5.1% 6.5% 10.1%

Non‐US Debt ‐Developed 0.0% 2.6% 6.0% 7.6%Non‐US Debt ‐Emerging 4.1% 5.6% 6.7% 11.3%

Alternatives Min Return Median Return Max Return RiskReal Estate 2.7% 5.7% 9.0% 15.0%Hedge Funds 3.0% 5.2% 7.3% 8.4%Commodities 1.4% 3.9% 6.8% 17.7%Infrastructure 5.1% 6.8% 7.9% 14.4%Private Equity 5.5% 8.8% 13.3% 22.0%Private Debt 5.5% 7.4% 9.1% 11.6%

Source: 2019 Horizon Survey


Factor #5 – Risk Tolerance

Market Risk

Interest Rate Risk

Liquidity Risk

Volatility of investment returns

In a rising interest rate environment, the return of bonds tends to be below the

long‐term average

Restrictions on withdrawals

Equities

FixedIncome

Alternatives


BONDS


Components of Bonds

Maturity Date

Face Value

Coupon Rate

The amount of money the bond will be worth at maturity; also called principal value or par value; typically $1,000

The rate of interest the bond issuer will pay on the face value of the bond

Date at which the term of the bond (loan) ends and issuer will pay the face value of the bond


Characteristics of Bonds

The lower the credit rating, the higher the interest demanded by investors

Bonds are rated based on the credit-worthiness of the issuing entity


Credit Ratings for BondsStandard & Poor’s Moody’s

AAA AaaAA AaA A

BBB BaaBB Ba

B BCCC Caa

CC Ca

C C

Investment Grade Bonds

High YieldBonds

High QualityHigh Yield

Low QualityHigh Yield;

Junk Bonds


Measuring Interest Rate Sensitivity

DurationTerm used to describe the

"average life" or maturity of the bonds in a portfolio

Expressed in years

A bond portfolio’s sensitivity to changes in interest rates can be measured mathematically by its “risk multiplier.”



A "duration of 5 years" means the risk multiplier is

5 times the change in interest rates

A 1% increase in interest rates means the portfolio price will

decline by 5%

1% x 5 = 5%

A 1% decrease in interest rates means the portfolio price will

increase by 5%

1% x 5 = 5%


Source: Federal Reserve

24 Years 30 Years

Interest Rate Cycle



Rates decrease

Rates increase

12 Month Holding Period ‐Annualized returns as of August 31, 2019

Yield Change Investment Grade Bonds High Yield Bonds

(basis points) 10 Yr Teasury Barclays Agg ML 1‐3 yr ML US HY ML Defensive US HY BB/B

ML Short Duration US HY BB/B

150 ‐12.24 ‐7.02 ‐1.05 1.05 ‐0.07 2.36

100 ‐7.66 ‐3.97 ‐0.12 2.66 1.54 3.08

50 ‐3.08 ‐0.92 0.82 4.26 3.15 3.80

25 ‐0.79 0.61 1.29 5.07 3.96 4.16

0 1.51 2.13 1.75 5.87 4.77 4.53

‐25 3.80 3.66 2.22 6.67 5.57 4.89

‐50 6.09 5.18 2.69 7.47 6.38 5.25

‐100 10.67 8.23 3.62 9.08 7.99 5.97

SDHYLess

sensitiveto rising rates

Provided by Penn Capital


Why High‐Quality High Yield?

6.967.21

7.05

8.20

6.526.39

6.28

6

7

8

9

AAA AA A BBB BB B CCC

%

Annualized Corporate Returns by Credit Rating1989 – 2018*

Credit Rating

Provided by: Chartwell Investment Partners

Investment Grade High Yield

Source: Bloomberg Barclay’s IndicesPast performance does not guarantee future results.

*Date range is the longest period that data is available for all categories listed

Investment Return


Why Short Duration High Yield Bonds?

Shorter duration protects capital in a rising interest rate environment

Reduced likelihood of bonds being recalled late in maturity

Reduced risk of default

Bonds are in the late stage of life cycle (1‐2 years)


Default RiskAverage High Yield Cumulative Default Rates By Year

Years

Def

ault

Rat

e

Provided by:Chartwell Investment Partners

Source: Moody’s

Short duration strategies focus on bonds in last 1-2 years of their life cycle.



How To Invest in Real Estate?Type Form Primary Drawback

Direct (buy a building) Private Not liquid

Limited Partnership Private Not liquid

REIT Publicly Traded

Volatility of returns(high correlation to public markets)

Institutional Fund Private Less liquid than stocks & bonds


Components of Real Estate Returns

Appreciation/Depreciation

IncomeTotal Return


REIT S&P 500 ODCE


Real Estate Diversification

Property Type Geographic Location

Office

Multi‐family apartments

Warehouse/Industrial

Retail

Hotel

Northeast

Southeast

Midwest

Southwest

Westcoast


Styles of Real Estate InvestmentsIRR 7.5 ‐10% IRR 10‐15% IRR 10‐15% IRR 13‐18% IRR 15‐20%


Provides stable income

Investor can elect to receive income distributions

Higher expected return than bonds

Why Invest in Institutional Real Estate?

Less volatile than stocks

Quarterly liquidity (restrictions may apply based on market conditions)



What are Opportunistic Investments?• Opportunistic investments are generally idiosyncratic or catalyst-driven

(unique, not repeatable, time-sensitive) investment opportunities thatseek to exploit a market or price dislocation

• They often involve the purchase of assets from owners that aremotivated to sell when there are few willing or able buyers

• Opportunities can occur in every asset class:

STOCKS BONDS REAL ESTATE COMMODITIES CURRENCIES


Characteristics of Opportunistic Investments

• Securities can be a mix of illiquid, private, some traded over-the-counter as well as public debt and equity

• Dominated by high yield and distressed debt, low levels of investment grade

• Often a contrarian investment strategy, as it may involve buying out-of-favor or minimally understood assets

• Astute and nimble investors can profit from buying assets at a substantial discount


Return objectives typically range 8‐10% (net of fees) for credit strategies; higher for equity strategies

Increased diversification of investment portfolio

Higher expected return than traditional bonds

Why Invest in Opportunistic?

Quarterly liquidity with notice (restrictions may apply)

Less volatile than stocks



What is Private Equity?

Asset class in which money is invested in privately‐held companies to fund growth or new technologies, make acquisitions, or

restructure inefficient companies.

42


Types of Private Equity InvestmentsVenture Capital Financing for early stage, emerging or start‐up companies

(often in technology and healthcare sectors)

Buyouts Acquisition of all or part of a company from its current shareholders; primarily mature businesses

Distressed Debt

Investments in the debt of companies undergoing financial distress (i.e. bankruptcy) to restructure/revive the company

Special Situations

Investments in a variety of event‐driven corporate activities –spinoffs, mergers, acquisitions


Typical Timeline for Private Equity Investment

44Note: For illustrative purposes only. Courtesy of Neuberger Berman


J‐Curve Effect

Drawdowns Distributions Cumulative Cash Flow

For illustrative purposes only. Not indicative of any particular investment. Source: http://blog.dealmarket.com/j‐curve‐analysis‐could‐impact‐pe‐industry/


Private Equity Allocation OptionsInvestment Type Description

Primary Fund Investment (Direct Investments)

Limited Partnership structures formed to make investments in private companies. Investor capital is called over time as the General Partner identifies investment opportunities within the stated mandate.

Secondary Fund Investment

Limited Partnership structures formed to purchase interests in existing Private Equity partnerships, often at a discount to the current Net Asset Value. Some Secondary Funds also participate in General Partner restructuring transactions.

Co-Investment Fund Investment

Investment funds structured to invest alongside General Partners of Primary Funds in transaction where the General Partner needs additional capital to complete the transaction.

Fund-of-Funds Investment funds structured to allocate to underlying primary funds. Can also include allocations to secondary investments and co-investments.


What is a Private Equity Secondary Investment?

47

Involves the purchase of an existing private equity fund interest from a limited partner (investor) that is seeking liquidity by selling

their position to another investor


Who is Selling?

Above charts provided by Glouston Capital Partners

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2015 2016 2017

Public Pension / SWF General Partner Fund‐of‐Fund

Endowment & Foundation Corporate Pension Financial Institution

Other

Source: Greenhill & Co. as of December 31, 2017

Active Portfolio

Management66%

GP Liquidity Solution24%

Regulatory Pressure

4%

Other3%

Distressed Seller3%

BROAD SELLER MOTIVATIONS

Source: Evercore Private Capital Advisory as of December 31, 2017

Secondary Activity by Sellers


Who is Buying?

49Source: Setter Capital Volume Report


Benefits of Secondaries

Mitigated ‘J’‐curve

Limited Blind Pool Risk

Broader Diversification in Portfolio Purchases

Seasoned Assets

Reduced Underlying Fees


What Are Private Equity Co‐Investments?

Co-investors are invited by lead Private Equity groups to directly invest alongside

of them in a single portfolio company


Why Private Equity GPs Offer Co‐Investments

To fund a new platform portfolio company

To fund add‐on acquisitions

To provide liquidity to an existing direct shareholder

Opportunity to deepen relationship


Benefits of Co‐Investment

Increased speed of capital deployment

Direct access to additional deals

Flexible, tacticalportfolio management

Tangible diligencetool for primaries Increased fee efficiency

Enhanced exposure to andrelationship with key managers



Annualized Returns 10‐Year Time HorizonEquity Return Risk

US Large Cap 6.0% 16.2%US Small/Mid Cap 6.5% 20.2%

Non‐US Equity ‐Developed 6.8% 18.2%Non‐US Equity ‐Emerging 7.8% 24.7%

Fixed Income Return RiskUS Coporate Bonds ‐Inv Grade 3.5% 5.5%US Corporate Bonds ‐High Yield 5.1% 10.1%

Short Duration High Yield 4.5% 6.5%High Quality High Yield 5.5% 8.5%Opportunistic High Yield 5.8% 8.8%Non‐US Debt ‐Emerging 5.6% 11.3%

Alternatives Return RiskReal Estate ‐Core 7.0% 10.0%

Real Estate ‐Value Add 8.0% 12.0%Real Estate ‐Opportunistic 10.0% 15.5%

Hedge Funds 5.2% 8.4%Commodities 3.9% 17.7%Infrastructure 6.8% 14.4%

Opportunistic Strategies 7.8% 11.0%Private Equity ‐Secondary 10.0% 18.0%Private Equity ‐Primary 10.0% 20.0%

Note: All asset classes highlighted in purple represent IPS risk/return assumptions. All others represent the median risk/return of 2019 Horizon Actuarial Survey respondents.


% Asset Class Target Asset Allocation

USLC Equity

SMID Cap Equity Int'l Equity Fixed

Income Core High Yield High Quality High Yield Opp HY Real Estate ‐

CoreReal Estate ‐Value Add

Real Estate Opp

HFoF Multi‐Strategy

Opp Strategies

Private Equity

Private Equity

Secondary

Expected Return Risk Stocks Bonds Alts

Scenario #1 30.0 20.0 15.0 15.0 5.0 0.0 0.0 5.0 0.0 0.0 5.0 0.0 5.0 0.0 6.37% 12.91 65.0 20.0 15.0

Scenario #2 25.0 15.0 12.5 10.0 0.0 10.0 0.0 10.0 0.0 0.0 0.0 10.0 7.5 0.0 6.89% 11.51 52.6 20.0 27.5

Scenario #3 20.0 15.0 10.0 7.5 0.0 10.0 0.0 5.0 10.0 0.0 0.0 12.5 5.0 5.0 7.27% 10.92 45.0 17.5 37.5

Scenario #4 20.0 15.0 10.0 5.0 0.0 5.0 5.0 0.0 10.0 5.0 0.0 15.0 5.0 5.0 7.47% 12.00 45.0 15.0 40.0

Sample Defined Benefit Plan Asset Allocation


% Asset Class Target Asset Allocation

US LC Equity Fixed Income Core SDHY High Quality High

Yield Real Estate ‐ Core Opp Strategies Cash Expected Return Risk Stocks Bonds Alts

Scenario #1 0.0 100.0 0.0 0.0 0.0 0.0 0.0 3.50% 5.50 0.0 100.0 0.0

Scenario #2 0.0 65.0 20.0 15.0 0.0 0.0 0.0 4.07% 4.89 0.0 100.0 0.0

Scenario #3 20.0 50.0 15.0 15.0 0.0 0.0 0.0 4.68% 5.96 20.0 80.0 0.0

Scenario #4 10.0 50.0 30.0 0.0 10.0 0.0 0.0 4.60% 4.48 10.0 80.0 10.0

Scenario #5 10.0 45.0 25.0 0.0 10.0 10.0 0.0 5.00% 4.92 10.0 70.0 20.0

Scenario #6 0.0 45.0 30.0 0.0 15.0 10.0 0.0 4.92% 4.18 0.0 75.0 25.0

Sample Health & Welfare Plan Asset Allocation

National Conference on Public Employee Retirement Systems

Key Takeaways

Define your investment objective Know your flows

Fund size may dictate what asset classes you can/cannot invest in

Your capital market assumptions should be reasonable

Revisit your asset allocation if you experience significant changes in your objective, fund size, or cash flows

Get educated about asset classes

Document your asset allocation decisions

Diversify!

Update your Investment Policy Rebalance!


Jennifer MinkSenior Consultant | Senior Partner

Investment Performance Services, LLCjmink@ips‐net.com

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