FY 2016 Annual Investment Plan - New Mexico State ... - Annual Investment... · Web...

State of New MexicoSTATE INVESTMENT COUNCIL

41 Plaza La PrensaSanta Fe, New Mexico 87507

Phone: (505) 476-9500Fax: (505) 424-2510

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July, 2015

Executive Summary

Fiscal 2016 will be a year of continuing to “fill in the blanks” – funding capital calls from the many new private market commitments made since 2011. This funding will come from publicly-traded asset classes as the Land Grant Permanent Fund and the Severance Tax Permanent Funds shift toward their long-term asset allocation targets.

Macroeconomic and Market Environment

The Council’s Strategy Group continues in the belief that the next 7-10 year investment period will be characterized by slower-than-average economic growth, rising interest rates and higher rates of inflation. Compared to the last ten years, growth should be somewhat better on average, but unlikely to consistently achieve longer-term averages of 3%-4% real annual increases. Higher interest rates, demographic trends, financial deleveraging and other factors and trends will likely conspire to keep GDP growth modest relative to history.

Correspondingly, returns from the large investment markets are expected to be subdued, perhaps in-line to slightly higher than experienced over the last ten years. High starting valuations for the stock market and low starting bond yields erode future potential, and rising interest rates will also hamper market returns.

Investment strategy in this environment is one of shifting from publicly-traded equity market risk premia to other sources of risk premia, and increasing the income-producing potential of the portfolios.

Implementation

In the publicly-traded portion of the portfolio, a small degree of structure work will be accomplished over the course of the fiscal year, but for the most part, these portfolios have been restructured and on-going monitoring and maintenance will be the main focus. More than $3 billion remains to be liquidated from these portfolios and moved to the private investment portfolios over the next 24-36 months. In the private investment side, our pacing models show that more than $1 billion in new commitments will need to be made in the fiscal year across the private equity, real estate and the real return portfolios to keep the investment program on track into the nearer-term future.

STEVEN K. MOISESTATE INVESTMENT OFFICER

ROBERT “VINCE” SMITH, CFADEPUTY STATE INVESTMENT OFFICER

SUSANA MARTINEZGOVERNOR

FY 2016 Annual Investment Plan

Market Study and Strategy

The Council’s Strategy Group will focus on projects related to the execution of the strategies incorporated herein, as well as developing further educational and informational presentations to help keep the Council current with longer-term economic and market themes and trends.

FY 2016 Annual Investment Plan Page 2


Part I: Expected Investment Environment, Portfolio Direction & Outlook

Macroeconomic Environment

The Council’s Investment Strategy Group continues in the belief that the forward 7-10 year period will be characterized by slower-than-average economic growth, rising interest rates and higher rates of inflation. Our view on rising rates and rising inflation has moderated to a degree for the nearer term due to a combination of continuing weak global economic growth and a deleveraging cycle that looks rather persistent.

Inflation--Historically in the U.S., liquidity provision by the Fed at levels below what has been injected has stoked price inflation in goods and services. So far, the demand for money has not responded, creating the proverbial “pushing on a string”.

Rates -- With short rates anchored at zero by the Fed and a combination of low demand and high supply of money, the yield curve has stayed low and steady. We continue to expect change, but catalysts and timing remain unsure.

As a result of this economic view coupled with current levels of interest rates and valuations in the major asset classes, we continue to expect a lower return environment. The table below summarizes historical data and forecasts for growth, inflation, interest rates, and returns.

Main Forecasts and Assumptions

Last 10 Years (12/31/2014)

Long Run Historical

Strategy Group Expectations (7-10

Years Fwd)

U.S. GDP (Real) 1.57% 2-5% 1.50-3.00%

U.S. Inflation (CPI) 2.11% 2-6% 2.00-5.00%

U.S. GDP (Nominal) 3.49% 5-9% 3.50-6.00%

Global Stocks ~6.00% 8-10% ~6.50%

U.S. Bonds ~4.70% 5-6% ~4.00%

60/40 Stocks/Bonds ~5.50% 7-9% ~5.50%

10 Yr U.S. Treasury (Yield)

~3.40% 5-6% ~4.00%



Considering asset allocation, the Strategy Group’s economic regimes research and analysis suggests the shift in the economic environment from that experienced over the last ten years—and relative to longer-term history—will result in a more “real return” investment-friendly environment than in recent history. Over the next 7-10 year investment horizon the economic environment should improve for global equities and weaken for fixed income investments compared to the last ten years, but relative to longer-term history, the environment is expected to be less-equity friendly and more supportive of real return and fixed income investments than usual.

Economic Regimes, 1948 - Present



To broadly summarize our observations, expectations and likely impacts:

Summary Horizon Analysis

7-10 Year Time Horizon

Financial Market Performance

• High equity market valuations forecast lower than average returns for the period.

• Low starting interest rates make the fixed income portion of the investable universe poor-returning.

• Portfolio-wide, low risk-free rates hold back return potential.

Economic and Political Influences

• Economic influences that exist are those that predominately work to slow GDP growth.

• Interest rates look to have bottomed and we expect them to begin to rise in a new cycle.

• Inflation is a bit of a wild card; central bank activity amounts to monetization of debt that could lead to an oversupply of money in the financial system relative to goods available. Or not.

“Big” Trends:• Demographics• LT Debt Cycle• Emerging

Economies• Technology Trends• Regulation• Central Bank• “Peer” Trends

• Demographics are beginning to weigh more heavily on global economic growth. The world’s population is getting older on average, and this applies downward pressure on economic growth. 25-65 year old people are the engine of economic growth. Younger people are a small drag on growth; older people are a big drag on GDP potential.

• The debt cycle is also a hindrance to growth. Non-financial debt in the global economy relative to global GDP is at very high levels relative to history.

• Globally, we are in a re-regulation cycle, particularly in the financial sector. This drags on GDP growth.

• Global central banks are in full liquidity mode, which is supportive of economic expansion.

• Peers are selling publicly-traded equity and bonds and moving toward the private asset classes.



Portfolio Direction and Outlook

Against the backdrop of the expected economic and financial market environment, portfolio orientation and direction for the 7-10 year investment horizon is summarized below.

Land Grant Permanent Fund – The LGPF underwent a triennial asset allocation study that concluded last August, resulting in shifting the Fund’s exposure toward private market assets and away from publicly-traded U.S. equity. This was a continuation of the restructuring of 2011, and was aimed at the following enhancements:

Greater diversification of the asset mix and risk exposures, in particular less reliance on the publicly-traded U.S. equity risk premium for return;

Greater non-U.S. exposure across most asset classes for further diversification and access to economic growth (post constitutional amendment);

The further addition of illiquidity premia to the return stream – selling public equity market risk to own more liquidity risk;

The further addition of active management through greater exposure to the private investment asset classes in light of concerns about how strong “market” returns can be from the publicly-traded asset classes in our longer-term economic outlook and investment market environment;

Reduction in active management in the publicly-traded asset classes and new end-goals for active management; and

Greater income generation in exchange for a lower reliance on capital gain, consistent with our long-term thinking of subdued economic growth and in defense against the current very low interest rate environment.

The new asset allocation for the LGPF is in the table below:

Land Grant Permanent Fund Asset Allocation Current Current Previous New Interim Allocation LT Target LT Target Target (03.31.2015)Domestic Equity 31.0% 22.0% 35.0% 36.9%International Equity 15.0% 18.0% 15.0% 12.5%Fixed Income 16.0% 19.0% 20.0% 22.4%Absolute Return 8.0% 7.0% 7.0% 7.1%Real Estate 10.0% 10.0% 8.0% 7.3%Real Return 10.0% 12.0% 5.0% 5.1%Private Equity 10.0% 12.0% 10.0% 7.7%Cash/Liquidity 0.0% 0.0% 0.0% 1.0% 100% 100% 100% 100%

Likely, it will take another three to four years to fully implement the new mix, by pacing the capital over time into the private market portfolios. Making the change to greater exposure to international equity and reducing domestic equity is expected to be accomplished this fall, following the international equity structure study completed this spring and the conclusion of manager searches expected this summer.

Over the 7-10 year investment horizon we expect the following range of portfolio values and range of distributions from the LGPF:

LGPF – Potential Range of Fund Values, Next Seven to Ten Years



Land Grant Permanent Fund Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

10th Percentile NAV 13,645,535,881$ 13,559,551,838$ 13,570,919,230$ 13,728,110,069$ 13,784,837,868$ 14,070,985,975$ 14,355,559,995$ 14,758,729,398$ 15,050,011,285$ 15,369,877,104$ 25th Percentile NAV 14,578,530,471$ 14,975,854,841$ 15,353,468,644$ 15,793,283,845$ 16,283,251,887$ 16,783,632,908$ 17,464,752,723$ 18,080,560,111$ 18,736,483,874$ 19,480,591,114$ 50th Percentile NAV 15,607,481,782$ 16,563,924,985$ 17,456,591,714$ 18,354,497,680$ 19,224,408,025$ 20,156,172,138$ 21,212,964,477$ 22,333,383,728$ 23,261,384,297$ 24,427,085,667$ 75th Percentile NAV 16,691,054,612$ 18,205,030,442$ 19,507,782,527$ 20,985,447,681$ 22,583,618,866$ 24,078,161,563$ 25,607,251,875$ 27,185,866,547$ 28,732,929,886$ 30,434,061,428$ 90th Percentile NAV 17,762,965,010$ 19,888,377,728$ 21,812,728,797$ 23,731,910,280$ 25,796,073,969$ 27,913,581,817$ 30,043,491,566$ 32,199,626,428$ 34,243,651,514$ 36,602,966,246$

1Monte Carlo Simulations assume Land Grant Permanent Fund is invested at the Long-Term Target Allocation.

Projected Fund Market Value by Percentile for Next Ten (10) Years

$-

$5,000,000,000

$10,000,000,000

$15,000,000,000

$20,000,000,000

$25,000,000,000

$30,000,000,000

$35,000,000,000

$40,000,000,000

$45,000,000,000

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Land Grant Permanent Fund - Nominal Basis

10th Percentile NAV 50th Percentile 90th Percentile NAV

Beginning Value ($ Mil)1 = $14,763 (as of 3/31/2015)Contributions ($ Mil) = $461m (10-year historical average) in Year 1 and increased by inflation each subsequent yearDistributions = 5.5% until FY16, then 5.0% of trailing 5-year average market value

LGPF – Range of Potential Fund Distributions, Next Seven to Ten Years

Land Grant Permanent Fund Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

10th Percentile 687,663,607$ 695,891,853$ 783,362,977$ 875,520,555$ 963,794,327$ 1,064,171,324$ 1,164,923,705$ 1,266,999,112$ 1,375,635,922$ 1,482,977,876$ 25th Percentile 687,663,607$ 685,176,440$ 758,426,378$ 829,877,345$ 894,002,100$ 968,629,791$ 1,040,933,567$ 1,115,158,789$ 1,194,830,333$ 1,274,358,734$ 50th Percentile 687,663,607$ 674,344,402$ 732,897,459$ 786,232,008$ 828,807,317$ 872,803,597$ 917,295,602$ 965,445,772$ 1,014,641,261$ 1,062,128,458$ 75th Percentile 687,663,607$ 664,054,889$ 708,819,095$ 743,409,361$ 762,346,778$ 780,380,280$ 805,960,190$ 829,505,379$ 858,783,714$ 889,148,827$ 90th Percentile 687,663,607$ 654,717,562$ 686,515,071$ 705,135,941$ 707,271,721$ 706,540,118$ 709,189,807$ 713,812,968$ 722,997,190$ 740,867,018$

1Monte Carlo Simulations assume Land Grant Permanent Fund is invested at the Long-Term Target Allocation.

Projected Fund Distributions by Percentile for Next Ten (10) Years

$-

$200,000,000

$400,000,000

$600,000,000

$800,000,000

$1,000,000,000

$1,200,000,000

$1,400,000,000

$1,600,000,000


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Land Grant Permanent Fund - Nominal Basis

10th Percentile Distribution 50th Percentile Distribution 90th Percentile Distribution

Beginning Value ($ Mil)1 = $14,763 (as of 3/31/2015)Contributions ($ Mil) = $461m (10-year historical average) in Year 1 and increased by inflation each subsequent yearDistributions = 5.5% until FY16, then 5.0% of trailing 5-year average market value


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Severance Tax Permanent Fund – The STPF also underwent an asset allocation study at the same time as the LGPF, which resulted in an allocation move in the same direction as the LGPF, and for the same reasons. Specific to the STPF study, the New Mexico in-state private equity investments were formally included in the asset mix for the first time. Earlier in the year the Council had formally adopted a specific allocation of 5%, and this action in turn was incorporated via the study. STPF’s mix is now targeted as follows:

Severance Tax Permanent Fund Asset Allocation Current Current Previous New Interim Allocation LT Target LT Target Target (03.31.2015)Domestic Equity 31.0% 22.0% 35.0% 35.8%International Equity 15.0% 18.0% 15.0% 13.6%Fixed Income 16.0% 18.0% 20.0% 22.6%Absolute Return 8.0% 7.0% 7.0% 6.8%Real Estate 10.0% 10.0% 8.0% 5.1%Real Return 10.0% 12.0% 5.0% 3.0%Private Equity 10.0% 8.0% 10.0% 6.7%NM Private Equity 0.0% 5.0% 0.0% 5.2%ETIs 0.0% 0.0% 0.0% 0.6%Cash/Liquidity 0.0% 0.0% 0.0% 0.6% 100% 100% 100% 100%

As with the LGPF’s asset mix, the STPF’s mix will be paced over three to four years to arrive at the longer-term targets set by the study.

The expected range of portfolio values for the STPF over the 7-10 year investment horizon appear on the next page:



STPF – Potential Range of Fund Values, Next Seven to Ten Years

Severance Tax Permanent Fund Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

10th Percentile NAV 4,261,955,583$ 4,101,136,548$ 4,011,336,120$ 3,955,776,552$ 3,863,146,230$ 3,836,649,386$ 3,821,716,653$ 3,830,430,126$ 3,804,289,938$ 3,778,897,183$ 25th Percentile NAV 4,566,173,989$ 4,554,724,614$ 4,576,204,975$ 4,606,345,467$ 4,644,761,329$ 4,672,637,577$ 4,778,050,763$ 4,834,211,067$ 4,910,135,916$ 5,000,165,861$ 50th Percentile NAV 4,903,112,733$ 5,070,559,093$ 5,246,394,624$ 5,412,044,989$ 5,556,756,599$ 5,709,062,398$ 5,917,091,948$ 6,126,019,521$ 6,261,826,932$ 6,456,801,262$ 75th Percentile NAV 5,255,723,047$ 5,602,437,917$ 5,912,823,416$ 6,243,244,103$ 6,602,600,440$ 6,933,861,404$ 7,276,426,678$ 7,589,574,273$ 7,930,904,117$ 8,265,477,086$ 90th Percentile NAV 5,605,246,536$ 6,143,446,456$ 6,641,891,540$ 7,118,783,980$ 7,622,562,462$ 8,125,620,210$ 8,648,465,246$ 9,155,754,133$ 9,592,312,034$ 10,162,354,238$

1Monte Carlo Simulations assume Severance Tax Permanent Fund is invested at the Long-Term Target Allocation.Contribution schedule: Year 1 - $4.8m; Year 2 - $8.7m; Year 3 - $52.2m; Year 4 - $38.9m; Year 5 - $33.5m; Year 6 - $40.6m; Year 7 - $51.1m; Year 8 - $36.4m; Year 9 - $36.5m; Year 10 - $57.7m.

Projected Fund Market Value by Percentile for Next Ten (10) Years

$-

$2,000,000,000

$4,000,000,000

$6,000,000,000

$8,000,000,000

$10,000,000,000

$12,000,000,000


Severance Tax Permanent Fund - Nominal Basis

10th Percentile NAV 50th Percentile 90th Percentile NAV

Beginning Value ($ Mil)1 = $4,749 (as of 3/31/2015)Contributions ($ Mil) = see contribution scheduleDistributions = 4.7% of trailing 5-year average market value

STPF – Range of Potential Fund Distributions, Next Seven to Ten Years


10th Percentile 199,736,310$ 215,381,724$ 236,521,006$ 258,568,618$ 279,661,253$ 304,129,031$ 327,963,143$ 350,880,783$ 376,919,452$ 399,854,181$ 25th Percentile 199,736,310$ 212,098,435$ 228,888,697$ 244,485,186$ 258,760,653$ 275,507,233$ 290,754,437$ 306,421,316$ 323,213,402$ 340,174,299$ 50th Percentile 199,736,310$ 208,781,666$ 221,050,112$ 231,349,129$ 239,004,460$ 246,311,899$ 253,805,617$ 262,432,831$ 270,559,063$ 278,088,726$ 75th Percentile 199,736,310$ 205,615,558$ 213,723,201$ 218,299,455$ 219,013,857$ 218,795,271$ 220,699,932$ 222,648,110$ 225,116,170$ 228,402,042$ 90th Percentile 199,736,310$ 202,754,789$ 206,875,034$ 206,691,003$ 202,194,841$ 196,378,142$ 192,071,866$ 188,409,712$ 186,098,614$ 185,954,791$

1Monte Carlo Simulations assume Severance Tax Permanent Fund is invested at the Long-Term Target Allocation.Contribution schedule: Year 1 - $4.8m; Year 2 - $8.7m; Year 3 - $52.2m; Year 4 - $38.9m; Year 5 - $33.5m; Year 6 - $40.6m; Year 7 - $51.1m; Year 8 - $36.4m; Year 9 - $36.5m; Year 10 - $57.7m.

Projected Fund Distributions by Percentile for Next Ten (10) Years

$-

$50,000,000

$100,000,000

$150,000,000

$200,000,000

$250,000,000

$300,000,000

$350,000,000

$400,000,000

$450,000,000


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Severance Tax Permanent Fund - Nominal Basis

10th Percentile Distribution 50th Percentile Distribution 90th Percentile Distribution

Beginning Value ($ Mil)1 = $4,749 (as of 3/31/2015)Contributions ($ Mil) = see contribution scheduleDistributions = 4.7% of trailing 5-year average market value


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Tobacco Settlement Permanent Fund – The TSPF continues to be a source of concern structurally; a recent court decision regarding the reverting of a portion of payments received in 2004 back to the tobacco companies casts additional doubts on the health of this fund. Asset allocation work done in 2013 concluded that while it was still prudent to be invested for growth, the fund would have to stick with the publicly-traded markets for liquidity reasons, and forego the better returns at lower volatility that greater exposure to private/less liquid assets can provide.

Water Trust Permanent Fund – The WTPF, too, remains in jeopardy. Asset allocation work in 2013 concluded that the fund had a significant probability of running out of money in as early as the next decade. The strong returns of the past five years have improved things for this fund, but in reality, have only pushed the inevitable out into the future a little farther.



Financial Models

The highest-order goal of the permanent funds is to take in contributions that are finite in duration and create an endowment that can make distributions to New Mexicans in perpetuity. This goal in turn invokes the concept of intergenerational equity, the idea that future generations should benefit from permanent fund distributions pari passu with the current generation. This defines an objective of maintaining the economic value, or the inflation-adjusted value, of the fund over time.

The Council’s Strategy Group and general investment consultant have developed financial models for the LGFP and STPF to project future possibilities and probabilities of success in maintaining the economic value of the funds. Assumptions were made regarding future contributions, investment rates of return and volatility the associated of those returns, inflation rates, distribution policy and other variables, resulting in a statistical analysis developed for a forward 50-year time horizon.

Since the future is uncertain, the model produces a range of possible outcomes over the 50 year period. The ideal outcome is that the model predicts a 50% chance that the fund will maintain its economic value over the 50-year period. This spreads the risk, or the uncertainty regarding the future, evenly between the current generation and future generations. If the model predicts a materially higher than 50% chance of maintaining the economic value, then the odds are tilted toward the fund becoming larger in economic value than it is today, with the future generation benefitting to a greater degree than the current generation. If the model predicts a substantially lower than 50% chance of maintaining the economic value of the fund, then the odds are that the fund will shrink in economic value from today’s value and the current generation would benefit more than future generations. At the 50% chance level, the risk of the funds changing in economic value (whether larger or smaller) is evenly borne by current and future generations. The models for LGPF and STPF appear on the next two pages.



Land Grant Permanent Fund Year 5 Year 10 Year 15 Year 20 Year 25 Year 30 Year 35 Year 40 Year 45 Year 50

10th Percentile 11,580,637,081$ 11,104,063,645$ 10,932,066,794$ 10,896,495,339$ 11,046,536,584$ 11,261,452,041$ 11,618,791,006$ 11,723,695,469$ 11,793,417,538$ 12,002,240,437$ 25th Percentile 13,886,545,372$ 14,019,378,720$ 14,290,796,595$ 14,720,101,971$ 14,858,192,731$ 15,318,136,338$ 15,960,003,827$ 16,208,463,400$ 16,334,733,663$ 16,615,468,657$ 50th Percentile 16,466,625,713$ 17,775,369,934$ 18,760,301,586$ 19,574,078,274$ 20,709,980,786$ 21,522,947,178$ 22,752,564,344$ 23,448,798,480$ 23,913,690,468$ 24,775,314,429$ 75th Percentile 19,441,993,500$ 22,181,194,762$ 24,607,116,877$ 26,811,195,086$ 28,943,547,761$ 30,815,854,890$ 32,594,235,598$ 34,311,613,958$ 35,622,719,423$ 37,072,179,304$ 90th Percentile 22,433,170,473$ 27,243,826,676$ 31,547,850,175$ 35,736,058,660$ 39,988,593,535$ 43,094,863,581$ 46,993,152,347$ 49,002,191,380$ 52,563,885,863$ 55,858,455,109$

1Monte Carlo Simulations assume Land Grant Permanent Fund is invested at the Long-Term Target Allocation.2Year 50 Full Objective is estimated as the current Fund market value increased by 1% real growth each year.

Projected Fund Market Value by Percentile for Next Fifty (50) Years

$-

$10,000,000,000

$20,000,000,000

$30,000,000,000

$40,000,000,000

$50,000,000,000

$60,000,000,000

$70,000,000,000

Land Grant Permanent Fund - Real Basis

10th Percentile 50th Percentile 90th Percentile

Beginning Value ($ Mil)1 = $14,763 (as of 3/31/2015)Inflation Assumption = 3%/yearReal Growth = 1%/yearContributions ($ Mil) = $461m (10-year historical average)Distributions = 5.5% until FY16, then 5.0% of trailing 5-year average market valueFull Objective ($ Mil)2 = $24,279Probability of Attaining Full Objective in Year 50 = 51.2%

The LGPF model continues to predict near-50% likelihood of maintaining economic value (51.2% probability) – a very good and balanced result. Based on this modeling, the LGPF is in good condition relative to the intergenerational equity objective, subject to the underlying assumptions as a whole panning out.


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10th Percentile 3,234,057,163$ 2,737,742,713$ 2,489,661,773$ 2,322,508,444$ 2,222,878,078$ 2,127,319,580$ 2,116,666,010$ 2,084,647,611$ 2,044,873,951$ 2,018,792,059$ 25th Percentile 3,942,847,005$ 3,599,456,459$ 3,434,175,434$ 3,336,505,530$ 3,181,971,011$ 3,126,227,713$ 3,140,191,429$ 3,088,798,409$ 3,002,154,297$ 2,983,640,947$ 50th Percentile 4,751,290,501$ 4,726,732,675$ 4,702,686,264$ 4,693,393,725$ 4,748,422,007$ 4,716,479,831$ 4,804,976,688$ 4,819,891,982$ 4,815,337,983$ 4,859,123,318$ 75th Percentile 5,689,747,439$ 6,052,089,535$ 6,395,931,726$ 6,682,179,942$ 6,921,254,364$ 7,204,430,184$ 7,395,252,829$ 7,627,021,292$ 7,785,425,910$ 7,893,140,554$ 90th Percentile 6,620,539,458$ 7,563,241,492$ 8,434,931,304$ 9,285,243,579$ 10,004,719,181$ 10,673,659,872$ 11,272,980,238$ 11,749,448,572$ 12,175,408,911$ 12,730,798,919$

1Monte Carlo Simulations assume Severance Tax Permanent Fund is invested at the Long-Term Target Allocation.2Year 50 Full Objective is estimated as the current Fund market value increased by 1% real growth each year. Contribution schedule: Year 1, 4.8m; Year 2, 8.7m; Year 3, 52.2m; Year 4, 38.9m; Year 5, 33.5m; Year 6, 40.6m; Year 7, 51.1m; Year 8, 36.4m; Year 9, 36.5m; Years 10-50, 57.7m.

Projected Fund Market Value by Percentile for Next Fifty (50) Years

$-

$2,000,000,000

$4,000,000,000

$6,000,000,000

$8,000,000,000

$10,000,000,000

$12,000,000,000

$14,000,000,000

$16,000,000,000

Severance Tax Permanent Fund - Real Basis

10th Percentile 50th Percentile 90th Percentile

Beginning Value ($ Mil)1 = $4,749 (as of 3/31/2015)Inflation Assumption = 3%/yearReal Growth = 1%/yearContributions ($ Mil) = see contribution scheduleDistributions = 4.7% of trailing 5-year average market valueFull Objective ($ Mil)2 = $7,810Probability of Attaining Full Objective in Year 50 = 25.5%

Despite recent positive changes to future contributions for the STPF, this fund continues in quite poor condition, and the model predicts that the current generation is spending far more today than future generations will be able to spend, in inflation-adjusted terms. The two factors that can most improve the condition of the STFP are higher than targeted investment returns, and/or increased inflows. Given the low investment return environment forecasted for the next 7-10 year investment horizon, that option looks bare.


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Part II: Fiscal Year 2016 Implementation

Asset Class Plans

The Council, the Investment Office and consultants have been deeply engaged in building out the new asset class portfolios since 2011, with extensive work to be continued in fiscal 2016.

Publicly-Traded Equity -- As detailed in the investment environment section, lower long-term equity returns are expected due to slower global economic growth, rising interest rates, rising inflation, and higher than average current market valuations. In the nearer-term, cyclically positive economic growth combined with low unemployment, low interest rates, low inflation, reduction in consumer debt, and strong corporate balance sheets could work to uphold equity values, depending on investor attitudes toward these factors.

International economies are also expected to have slower economic growth, driving lower long-term equity market returns. However, newly-implemented central bank quantitative easing designed to combat weak economies in Europe and Japan could translate into continued gains from foreign stocks in the shorter-run.

Across the globe, economic growth among countries is diverging and expected to continue. This divergence is primarily due to varying debt levels, disinflationary drags from deleveraging, monetary policy, regulatory environments, and reform. The divergence is wider in emerging markets because of differences in debt, reform, export dependence, and the waning positive effects of globalization. Divergence benefits active management and therefore, going forward, active management in emerging markets seems more timely than usual.

In preparation for an economic and market environment that is expected to be less supportive of equities over the next 7-10 years than on longer-term average, the public equity portfolio is being positioned to better withstand increased market volatility and drawdowns. Significant repositioning was accomplished this last winter in the domestic equity portfolio with the addition of three smart beta strategies (Low Volatility, Large-cap Fundamental Value, and Russell 1000 Equal Weight), modest active manager reallocations, and addition of two passive strategies to better manage portfolio exposure. As a result, the portfolio is expected to have better performance in down markets, improved diversification, and lower fees. A review is planned this fall to get a ‘first read’ on whether the changes appear to be effective. Otherwise, in the coming year, no other changes are expected for this portfolio.

Summary of Restructuring12/31/2014

Before2/1/2015

After DifferenceImproved down market capture 95.7 94.5 1.2%Increased value allocation 16.4% 26.5% 10.1%Increased growth allocation 16.6% 18.5% 1.9%Increased large-cap (decreased smid-cap) 84.0% 90.1% 6.1%Decreased fees (approximate, varies w/ assets) 24 bps 20.25 bps -3.75 bps

In addition to manager reallocations, other changes that contributed to improved portfolio. Decreased active management 15.4% Added low volatility allocation (4.5%), 7-year UMC/DMC 79.7 / 66.6 Added fundamental value allocation (12.0%) to increase value allocation



As a result of the removal of the 15% international cap and the February 2015 structure study, a Developed All-cap RFP, an Emerging Market RFP, and a Developed Smart Beta ITB are in process with manager selection recommendations planned for early FY 2016. Pending approval, the international portfolio is expected to be restructured by late fall 2015. Following the restructuring, for the first time, the international portfolio will be in-line with the MSCI ACWI ex-US Index. Market, geographic, and country risk that currently exist in the portfolio will be removed. As with the domestic equity portfolio, the changes are expected to result in improved diversification, better down-market protection, and lower fees.

3/31/2015MSCI ACWI ex-US IMI Index

Developed Market %

Developed Market ($M)

Emerging Market %

Emerging Market ($M)

Current International Equity 58.2% $1,541 41.8% $1,104Expected International Equity 78.5% $2,800 21.5% $800

Performance of the total equity portfolio relative to peers has been solid. The March 2015 TUCS report, for funds greater than $10 billion, shows the Council’s total equity portfolio performing in the second quartile for the 1-, and 2-year periods (ranked 38th and 33rd percentiles, respectively) and just below median in the 3-year period, ranked 53rd. While active manager performance relative to benchmarks has been challenging, the weak showing is something that has also been widely suffered by peers.

Over the next year, relative performance of active managers is expected to improve due to increased volatility and increased dispersion of stock returns, which generally provide a better environment for stock picking. The VIX, which averaged about 14 in 2014, is averaging slight less than 16 YTD and is expected to remain at this level or slightly higher over the next year. Increased dispersion of stock returns provides improved alpha opportunities for active management but is not expected to be equal across the market. Therefore, the equity portfolio’s multi-layered approach across active, passive, and style investing (smart beta) is expected to provide the most potential for stable equity portfolio returns and protection in declining markets.

Domestic Equity 12/31/2014 Allocation %

12/31/2014 Allocation ($M)

3/31/2015 Allocation %

3/31/2015 Allocation ($M)

Active 55.8% $4,183 38.2% $2,913Smart Beta 0% $0 14.3% $1,091Passive 44.2% $3,317 47.4% $3,612

Fixed Income – Volatility in the credit markets continues to increase as the timing for expected rate increases by the Federal Reserve continues to be delayed on economic news releases that have been running below market expectations. Earlier in the year, most forecasters were expecting the Fed to start raising rates in June, but that has since been pushed out until at least September, with some forecasters not expecting a rate increase until 2016.

Another factor creating volatility in the credit markets is the lack of liquidity across many sectors in fixed income. Dealer risk-taking is lower due to regulatory pressures and capital constraints which have resulted in reduced daily trading volumes and smaller dealer inventories in treasuries, mortgages, and credit products. Lower liquidity will magnify spread moves in the event of a market disruption.

As sovereign rates trade at or below zero interest rate levels and real interest rates here in the U.S. hover around zero, the continuing search for yield is driving many investors into sectors in which they’ve not



invested before. Institutional investors are increasing their allocations to the high yield market and to alternative asset classes such as distressed debt. This increased demand has fueled a heavy new issue supply, with many issuers refinancing existing debt or using the proceeds to repurchase equity. Exchange Traded Funds (ETFs) have entered the high yield market as buyers in order to provide access to this market to non-institutional investors. So far in 2015, about $9 billion has flowed into high yield bond ETFs, a significant increase to the $44 billion market. New entrants into what has historically been a volatile asset class combined with greatly reduced liquidity in the markets could spell trouble in the future.

NMSIC Total Fund Fixed Income Allocation as of March 31, 2015:

Sub-Sector Current Allocation 3.31.2015

Net Asset Value 3.31.2015

Expected Allocation 2016

Core Plus Bonds Pool 49.3% 2,328.0 45%Core Bonds Pool 15.0% 707.6 25%Unconstrained Fixed Income Pool 16.2% 765.4 15%Credit & Structured Finance Pool 19.5% 924.8 15%

Fixed Income Composite 4,725.8 100%

Changes to the fixed income portfolio structure that were approved by the Council last August continue to be implemented. The emphasis is to slowly reduce credit risk and to reduce overall portfolio duration in response to expected lower-returning and more-volatile fixed income markets in the coming years. Reducing fees wherever possible is also vitally important to generating as much return on a net basis as possible in the expected low-return environment.

The new, passive Barclays Aggregate bond index account managed by BlackRock, was initially funded in November 2014 and is currently 70% funded. Most of this was funded by reducing positions in the Core Plus strategies and this account should be fully funded in the coming fiscal year as funds are redeemed from the Credit & Structured portfolio. The defensive shift to higher quality assets is evidenced below as the portfolio’s exposure to U.S. Government and Agency debt increased by 12% from March 2014, while exposure to non-investment grade bonds (“high-yield”) was reduced by almost 4%. This trend will continue as assets are moved during the fiscal year to the passive BlackRock allocation up to its target level of 25% of the Fixed Income Composite.



U.S. Core Bonds Passive, U.S. Core Bonds Plus and Unconstrained by Sector:Sector Distribution Net Asset

Value 3.31.2014

3.31.2014 Net Asset Value

3.31.2015

3.31.2015

U.S. Government and U.S. Agency Debt

856.6 25.2% 1,412.3 37.2%

Non-U.S. Government and Agency Debt

92.3 2.7% 207.2 5.4%

Municipal Bonds 79.4 2.3% 74.0 2.0%Securitized Debt 538.8 15.8% 526.6 13.9%Investment Grade Corporates 916.7 26.9% 890.0 23.4%Non-Investment Grade Corporates 537.8 15.8% 457.0 12.0%Other Debt 43.7 1.3% 60.6 1.6%Equity 20.1 0.6% 20.2 0.5%ETFs / Funds 0.0 0.0% 20.0 0.5%Cash / Derivatives 320.2 9.4% 133.0 3.5%

3,405.6 100.0% 3,800.9 100.0%

This defensive shift in the portfolio can also be observed by examining the quality distribution of the portfolio on a year-over-year basis. AAA-rated assets increased by 10% while the amount of BBB-rated assets in the portfolio decreased by 8%.

U.S. Core Bonds Passive and U.S. Core Bonds Plus Quality Distribution:Ratings Net Asset

Value 3.31.2014

% Net Asset Value

3.31.2015

% % Change

AAA 1,058.6 35.9% 1,389.0 45.8% +9.9%AA 211.3 7.2% 184.2 6.1% -1.1%A 455.3 15.4% 534.3 17.6% +2.2%BBB 690.8 23.4% 463.3 15.3% -8.1%BB 309.6 10.5% 262.7 8.7% -1.8%B 98.1 3.3% 89.2 2.9% -0.4%CCC or Lower 126.4 4.2% 103.6 3.4% -0.8%Not Rated 1.4 0.1% 9.2 0.2% +0.1%

2,951.5 100.0% 3,035.5 100.0%

A third unconstrained fixed income manager, GAM, was hired and the account was funded in March 2015. GAM, along with the other unconstrained managers, will utilize a flexible investment mandate to make opportunistic investments in what is expected to be a volatile market going forward. The shorter (and sometimes negative) duration of these investment vehicles will bring the overall duration of the aggregate fixed income portfolio below that of the major bond indices. As seen below, overall portfolio duration has been reduced by 4.6 years to 3.9 years as of March 31.

U.S. Core Bonds Passive, U.S. Core Bonds Plus and Unconstrained:



Asset Manager Net Asset Value

3.31.2014

Duration Net Asset Value

3.31.2015

Duration

BlackRock Core Passive n/a n/a 707.6 5.04PIMCO Core Plus 1,249.5 4.56 1,130.5 3.95Loomis Core Plus 851.7 5.57 595.6 6.05Prudential Core Plus 850.1 5.54 601.7 5.37PIMCO Unconstrained 252.0 1.20 256.3 -1.04Loomis Unconstrained 202.2 1.70 211.2 2.18GAM Unconstrained n/a n/a 298.0 -0.67

3,405.5 4.64 3,800.9 3.91

The consolidation continues in the Credit & Structured portfolio, reducing the number of underlying managers and reducing the overall size of the portfolio. With the termination of KKR Prisma last summer, the number of underlying funds in the Credit & Structured Portfolio has been reduced from 27 last year, to 19 currently, with the expectation of a total of 12 underlying funds in the future as redemptions are processed. By 2016, the Credit & Structured portfolio should be at its target of 15% of the Fixed Income Composite.

Absolute Return - Much like the credit markets, institutional investors continue to allocate to absolute return strategies despite the exit from several large investors such as CALPERS last year. Overall, the hedge fund industry now boasts almost $3 trillion in assets. This might explain the rather tepid results that most hedge fund managers experienced in 2014. Managers continue to blame the Fed’s quantitative easing policies for dampening volatility and creating one-way (up) markets in equities and distressed asset classes, but maybe it’s just a case of too much money chasing too few good investment ideas at this point. Either way, as market volatility increases in 2015 or the Fed ends it QE policy, absolute return managers will be out of excuses for weak performance.

The allocation to this asset class was reduced to 7% last year and it is within target. Consolidation of underlying funds continues and the number of underlying managers has been reduced from 61 funds as of September 2014 to 52 underlying funds presently.

Fund of Fund Manager # of Funds 9.30.2014

# of Funds 3.31.2015

Expected # of Funds 2016

Net Asset Value

3.31.2015

Aetos Capital 21 18 13 451.8Crestline Investors 22 19 18 385.1Mariner Investment Group 18 17 15 520.0

61 52 43 1,356.9

This year, a structure study is planned for the portfolio, including a review of options for the appropriate number of underlying funds in the Absolute Return portfolio.



Private Equity – Due to secondary sales from the portfolio, faster than expected distributions, slower than expected capital calls and strong publicly-traded markets, the private equity portfolio actually shrank in percentage allocation in the LGPF and STPF portfolios. These trends have begun to reverse, but still have had an impact on forward-looking pacing:

Private Equity Commitments and Allocation Forecast($ in millions)

Each year's private equity commitments are based on a predetermined amount. Model assumes overall portfolio returns of 3.5% (net of all contributions and distributions)and private equity returns of 13%. Different return assumptions may result in a different pacing target. Pacing targets should be evaluated on a regular basis.Aggregate vintage year performance can differ by year and increasing commitments during a lower performing vintage year could lead to lower portfolio performance.* Note: Vintage year is defined by the calendar year capital is called. 2015 includes $450 million of commitments approved in 2014 and 2015 that are expected to call capital in 2015 and $150 million of additional commitments yet to be approved that are expected to have a vintage year of 2015.Private equity allocations for 2014 and before reflect as of December 31 whereas 2015 and after reflect as of June 30 (fiscal year-end).

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Private Equity Commmitments Private Equity Allocation

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Investment pacing looks set to increase modestly to a $550-$650 millionannual range for the foreseeable future, up from the $500-$600 million range of the last two years. This should be comprised of 5-8 investments in 2016 and annually thereafter, with an increasing shift toward re-ups with existing managers as the portfolio restructuring begun in 2011 has made excellent progress in consolidating investments with a core group of managers.

The table on the next page summarizes the direction of the private equity portfolio for 2016:



NM SIC National Private Equity Strategy Strategy Current State

PE Allocation

12% Target (increased from 10% in August 2014)

Current allocation of National Private Equity Program is 7.2% as of December 31, 2014

Vintage Year

$750 million through end of fiscal 2015 ($500 million annual pace) – Assumed 10% Target

$550 million to $650 million annual pace (Oct 2014 Structure Study assuming 12% Target)

Six to eight managers per year

2014: Committed $550 million to seven managers

YTD 2015: Committed $300 million to four managers

Includes amounts by year approved, vintage years may be different depending on when capital is drawn

Managers At least 25 core managers; less

than 50 total < 100 funds

As of March 31, 2015: 85 Managers in 124 funds (22 core

managers) Target expected to be reached over time

as funds are liquidated or opportunistically sold

Strategy

Strategic Exposures Venture Capital: 0%-10% Growth: 10%-20% Buyout: 50%-70% Special Sits: 10% - 25%

Exposure as of December 31, 20141: Venture Capital: 2.7% Growth: 18.1% Buyout: 57.3% Special Situations: 21.9%

Geography North America: 60% - 70% Europe: 15% - 25% Asia and EM: 10% - 20%

Remaining value as of December 31, 2014 North America: Europe:

Asia and Emerging Markets:

Unclassified:



Real Estate – Both the core and tactical real estate portfolios continued to perform well and ahead of their benchmark over the last 12 months. Fund commitments made since 2011 have made a measurable positive contribution to outperformance over this period.

Recent activity has focused on US core through an additional commitment to an existing industrial position and also a number of commitments in the tactical portion of the portfolio in both the US and international markets.

The current allocation as of the end of December, 2014 is presented below. The market value of the portfolio is $1.28 billion (6.7%) and the exposure, including unfunded commitments represents 9.6% of the SIC’s total assets.

Target RangeCurrent Position

Net Asset Value($bn)

Unfunded($bn)

NAV+ Unfunded($bn)

Core 40% - 70% 59% $0.76 $0.10 $0.86Tactical 30% - 60% 41% $0.52 $0.52 $1.04Total 100% 100% $1.28 $0.62 $1.90

Given that real estate markets are becoming more divergent, sector and geographic diversification are becoming increasingly important. We expect continued strength in US core real estate for the near term; however, with a well established US core portfolio, we are currently seeking to broaden the geographic diversification of the core portfolio. In general, the following markets and sectors appear attractive in the current environment:

Industrial – US, Mexico, Europe and China; Office – US, Europe; Residential – China and India; and Retail – US, China.

The following opportunities and markets are less likely to provide attractive new opportunities in the near term:

Office – China; Multifamily – US , Europe; and Retail – Japan, select pockets within developed markets.

The Real Estate Structure study presented to the Council in April 2015 maintains the structure put in place in 2011 and builds on the strategic direction established at that time for the Real Estate allocation. The next phase of portfolio development will focus on further development of the international exposure, streamlining the core portfolio, and a focus on alpha generation through manager and strategy selection in the tactical portfolio. Market access will be primarily through co-mingled funds.



The current position and targets for the fund in terms of number of funds and commitment size, are set out below:

ItemCurrent Real

Estate Portfolio Target

Number of Funds 42 15-20

Number of Managers 32 12-15 Managers

Average Commitment Size (Per Fund)

Core - $105mTactical - $56m

Core - $150m-$250mTactical - $50m-$150m

The pacing assumptions assume the core portfolio is fully established by 2016. Additional commitments to the tactical portfolio of between $170 million to $200 million per year are planned in the near to medium term. NMSIC is on target to achieve its 10% exposure in two years (June 2017).

NMSIC is considering open ended structures for the lower risk portion of the tactical portfolio which would reduce the annual pacing requirement, if implemented.

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Real Return – The real return program was very active over the last fiscal year with commitments across all four areas including infrastructure, energy, timberland and farmland. While the portfolio is still early in its development, returns have been meeting expectations. Over the next 3-5 years, as the portfolio matures, the assets will provide considerable current yield, a key objective of the allocation.

The financial assets component of the portfolio has continued to deliver returns consistent with expectations and ahead of the long term benchmark. The Master Limited Partnership (MLP) asset type was added recently with a $300 million investment. Additionally, steps were taken to reduce some of our floating rate structured credit exposure. The Real Return portfolio is currently structured as follows:

Target Range

Current Position

(NAV basis)

Net Asset Value (NAV)

($bn)

NAV+ Unfunded

($bn)Financial Assets 20% - 40% 20% $0.481 $0.481

Real Assets 60% - 80% 12% $0.292 $1.432

Total 100% 32% $0.77 $1.911. As at 3/31/15, prior to the MLP commitment2. As at 12/31/14

The MLP commitment of $300 million, plus expected additional capital calls in the next month should raise the total capital invested to $1.46 billion by the start of fiscal year 2016.

The chart below shows the historical growth and forecast plan (incorporating pacing for Real Assets) for Real Return. Financial assets are considered to be fully invested post June 2015 and are grown at a combined annual rate of seven percent. The Real Return portfolio is expected to reach its target allocation within 3 years. In later years, some financial assets are assumed to be sold to return to the long-term financial assets target.

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Real Return Allocation - Projected Growth



Generally, the following markets and sectors appear attractive in the current environment: Timberland – pre-merchantable timber, US South; Farmland - Brazil, U.S. permanent props, Australian row crops; and Energy – energy infrastructure, exploration and production.

The following opportunities and markets are less likely to provide attractive new opportunities in the near term:

Infrastructure – assets driven through auctions, U.S transportation; Timberland – mature U.S. timber, and; Farmland – U.S. row crops.

Activity in fiscal year 2016 will be focused on monitoring the financial asset markets for entry points in TIPS and other assets which have been excessively priced over the past several years, discouraging entry; and in the real asset space, selective additions to the infrastructure portfolio, the timberland sub-allocation and a continuation of the build-out of the energy sub-portfolio.



Special Topic: Demographics

Earlier in this report, it was noted that the current economic recovery has been slower than the typical turnaround from a recession. Many factors have been blamed for this situation, such as government regulation, political inactivity, income inequality, debt deleveraging, and other short-term influences. While some combination of the above has surely had an effect, there are also longer-term trends that are dampening growth. Perhaps the most significant underlying factor is the demographic change taking place in society, and its influence on GDP growth.The long-term productive capacity of an economy is the sum of population growth, employment growth (the change in the labor participation rate of the population), and productivity growth. In the U.S., we have come to think of 3-3.5% GDP growth as our birthright, and as seen in the table below that has historically been the case. The average annual growth rate of GDP from 1951-2000 was 3.3%.

Real GDP Growth: 1951-2000Population Growth 1.4%Employment Growth 0.3Productivity Growth 1.6

Annual Real GDP Growth 3.3%

In the last decade, GDP growth in the U.S. has slowed significantly, as shown in the following Table. In fact, only in 2005 did we reach the previous 50 year average growth level of 3.3%, and the average real GDP growth for the last decade was only 1.6%.

Real GDP Growth: 2005-20142005 2006 2007 2008 2009 2010 2011 2012 2013 2014 3.3 2.7 1.8 -0.3 -2.8 2.5 1.6 2.3 2.2 2.4

Thus something has changed from the “old normal” expectations to our “new normal” current and future prospects for growth in the U.S. economy. To gain a better appreciation for the changes that are taking place, let’s take a look at the aforementioned components of productive capacity. Population growth will be restrained relative to historical rates, as the fertility rate in the U.S. has fallen below replacement level of 2.1 births per woman to the current level of 1.86 (see graph below). At this level, any growth in the population will be the result of immigration. Employment growth benefitted from women entering the workforce in greater numbers from 1951-2000, which pushed the labor force participation rate from 58% to a high of 67% of the population. This trend has since reversed, and with the aging of the workforce, the participation rate has recently fallen below 63%. That leaves productivity growth as the wild card in forecasting future growth prospects. Unfortunately, the work of Arnott & Chavez in their paper, “Demographic Changes, Financial Markets, and the Economy” (2012) provides convincing evidence to suggest that productivity growth declines as well, as a society ages.



Total Fertility Rate

To summarize, and to take a stab at a forecast, please refer to the Table below to see how the components of the long-term productive capacity of the economy may look going forward based on the discussion above. Population growth of 0.7% is roughly the rate at which the U.S. has been growing recently, and thus assumes no changes to immigration policy or the fertility rate. The -0.2% rate for employment growth assumes that as the population ages, the labor force participation rate will continue to decline. The 0.5% productivity growth rate is perhaps the most controversial forecast, and is based on the work of Arnott & Chavez (2012).

Real GDP Growth: 2015 - Population Growth 0.7%Employment Growth -0.2Productivity Growth 0.5

Annual Real GDP Growth 1.0%

The headwind to economic growth as a result of the changing demographic landscape will have considerable effects for the portfolio which will require further study. On a surface level, lower GDP growth will lead to lower company revenue and earnings prospects. Many have also argued that this environment will put pressure on the real rate of interest, as well. Together this would imply a “low return environment” similar to that described in the December 2014 Update to the Annual Investment Plan.



Special Topic: Return Target: Can We Make 7.50%?

For a number of years now, investors have been debating the probability of a “low return environment” on the horizon. It is widely speculated that with financial markets now mostly-to-more-than (depending on the individual asset type) recovered from the financial crisis of 2008-2009, a period of sub-par returns, relative to history, is about to commence, if not underway already. Forecasted long-term returns by the major investment consultants and other forecasters for the various asset classes are generally below historic long term returns, and the more intermediate (7-10 year) term numbers are even lower. But why?

One way to think about it is to use basic financial theory. Theory holds that longer-term returns generated by well-diversified portfolios can be disaggregated into two components: a “risk-free” rate of return, and a “risk premium”. The risk free rate is generally associated with U.S. Treasury rates. The most risk-free of “risk-free rates” is the yield on treasury bills. Often, in the context of long-term institutional investment portfolios, the yield on the ten-year treasury is used as the “risk-free rate”. A “risk premium” can be earned, above and beyond the risk-free rate, by holding a diversified portfolio of riskier assets than treasury bonds that yield the risk-free rate (such as stocks, bond, real estate, and so forth).

To visualize this, observe the chart to the right. Historically, the 10 year Treasury has traded at an average yield of about 6.00% (5.00% if one excludes the anomalous 1970s). Well diversified institutional investment portfolios have generally earned 2.50%-3.00% above that risk-free rate in “risk premium” for owning riskier assets than U.S. Treasury bonds.

For specific example, consider an investment board that has two choices when investing their fund for the next ten years. Option “A” is to invest in 10 year Treasury bonds at the prevailing interest rate. Historically, on average, such an investment provided a rate of return a couple of percentage points above the rate of inflation, and delivered back all principal at maturity. This portfolio held such little risk as to be considered “risk-free” – the principal was protected against the corrosive effects of inflation, the portfolio generally experienced limited volatility along the way and produced significant income, and all principal was returned at maturity. Option “B” is to invest in a diversified mix of assets such as stocks, bonds, real estate and other assets. Historically, this option provided a rate of return about 2.50%-3.00% higher than Option “A” – a premium earned over the “risk-free” portfolio in compensation for enduring more volatility, less income production and uncertainty as to full return of principle at the end of the period.

Boards that oversee the investment of public funds like the Land Grant Permanent Fund always choose Option B (with no exceptions that we’re aware of). The graph on the next page shows the returns of the LGPF displayed in this manner:



Land Grant Permanent Fund10 Year Annually-Compounded Rates of Return, Periods Ending 1998-2014

The line on the chart displays the annually compounded rate of return for the LGPF for ten year periods ending with the year listed on the x-axis. The bar associated with each year breaks down that return into the components shown in the chart on the previous page: the risk-free rate and the risk premium (it also adds a component – the purple portion – to account for the actual portfolio outperforming or underperforming its benchmark).

So for example, observe the bar farthest to the left, marked 1998. The LGPF earned an annually-compounded rate of return for the ten year period ended in fiscal year 1998 (the period July 1, 1988 – June 30, 1998) of 13.40% (author comment…wow!). That 13.40% breaks down as follows:

1. the risk-free rate of 8.80% -- which was the yield on a ten year Treasury bond on July 1, 1988 -- represented by the red portion of the bar;

2. a risk premium of 5.35%, represented by the green portion of the bar, 3. excess return of negative 0.75% (the portfolio underperformed its benchmark by 0.75% annually

on average in the period).

Moving forward to 2008 (2.40% compounded annually over the ten year period ended June 2008) for another example:

1. risk-free rate of 4.75%2. a risk premium of negative 2.30%3. negative excess return of 0.05%

Now, observe the green portion of the bars. You can guesstimate that they average between 2.50%-3.00%, with strong periods of 4.75% and tough periods of -3.00%. This corresponds to the green area in the generic chart on the previous page. The red portions of the bars average roughly 5.00%, corresponding to the blue bar on the in the chart on the previous page.

Once you grasp the idea of the chart on the previous page, and understand how that translates in the real world returns depicted in the chart above on this page, you’re ready for the bar at the far right of the chart



above -- and a theoretical understanding of why we’re very likely facing a low-return world until things change (like interest rates going up!).

The red portion of the bar to the right depicts a recent observation of the current yield of the ten-year Treasury bond (the risk-free rate). It’s about 2.20%. The 7.50% at the top of the bar is the target rate of return for the LGPF. There is a small amount of positive excess return built in (the purple portion, about 0.35%). This leaves the green bar, or the risk premium needed to get to the 7.50% target, at 4.95% (2.20% + 4.95% + 0.35% = 7.50%). A risk premium of 4.95% is very high and, in our view, unrealistic to expect over the next ten years. The only time we’ve seen annually-compounded 10-year risk premiums of near that size in the last 50 years was in the ten year periods ending 1998, 1999 and 2000 – the culmination of the biggest bull market in equities since the late-1920s. It is much more realistic to assume average risk premiums, which would theoretically leave returns for a well-diversified portfolio of risk assets at about 5.55% (2.20% risk-free rate + 3.00% risk premium + 0.35% positive excess return = 5.55%).

Now there’s a case to be made that risk premiums might have a bias to the higher side in the next ten years (more financial theory for another time). And indeed, the Council’s forecast for the long-run rate of return of the LGPF is 6.85% compounded annually (exclusive of any excess return that can be generated). The Strategy Group expects that number could be lower over the next ten years, but improve thereafter as interest rates rise -- and correspondingly -- the risk-free rate rises. But for now, it looks quite likely that we are stuck in an environment that will generate low returns – low returns versus history and low returns relative to our long term target return of 7.50%.



Special Topic: Economic Regimes: Some Empirical Data

The Strategy Group’s economic regimes work is a meaningful component of the Council’s investment program. The broad state of the U.S. and global economy – GDP growth, level and direction of inflation, level and direction of interest rates – has significant impact on financial market returns in intermediate-term and longer time horizons. ‘Regimes’ work is incorporated into investment strategy in a number of ways: in the asset allocation process as a component of the asset class selection decision; and in the efficient frontier modeling process for asset allocation as one of the tools used in setting minimum/maximum weights of asset classes. Regimes serves a role in asset class portfolio structure and construction, and it is helpful in investment pipeline development in the private asset classes. A table familiar to the Council and followers of our investment program appears below:

Economic Regimes: Historical Distribution of Asset Class-Supportive

Since 1948 (which presently is as far back as the Strategy Group’s data goes), and excluding the period of the early 1970s to the early 1980s (an anomaly of inflation that we believe skews the data unnecessarily), the economy provided a supportive environment for equity investing about 62% of the time. In other words, it pays to be an “owner” much of the time, making it no wonder that institutional investment portfolios, historically and now, rely extensively on equity investments to generate returns.

Economic regimes divides economic conditions into three categories: economic conditions which support equity investments, conditions which are more supportive of fixed income investments, and conditions that are more favorable to “real return” investments.

Equity-supportive environments are defined as environments where nominal GDP exceeds 5.00% annually, and the real GDP component of nominal GDP exceeds the GDP deflator component. If interest rates are falling from higher levels or steady/falling at average or low levels, all the better. Economic conditions like this are supportive of corporations growing their revenues and keeping their costs down, in turn translating the additional revenue into a growing profits stream. Equity investors capitalize these greater profits, causing stock prices (and company values, in the private equity area) to rise and good returns to be generated.

Fixed income-supportive environments are weaker-growth and recessionary environments (nominal GDP below 5.00% and real GDP below 2.50%). These environments tend to also feature falling interest rates and falling inflation, both favorable factors to fixed income investments.

Real return-supportive environments feature positive real GDP growth but have an inflationary leaning – periods where the GDP deflator exceeds real GDP. Real return assets generally benefit from some inflation in the environment -- certainly more than equity or fixed income investments do.



The last ten years (40 quarters) have predominantly been spent in fixed income regimes. Referring back to the table on the previous page, it can be seen that less than 20% of the time over the last ten years did the economy qualify as supportive of equities, and more than half of the time the environment was in a state that was more friendly to bonds—quite a wide swing from the longer-term norms. This bears out in the performance numbers: despite quite low interest rates, fixed income investments were able to produce returns near historical averages over the last ten years, but stocks produced returns that were at quite a discount from historic norms (see the table on page 3 for a review of returns).

The Strategy Group has done a broader analysis of empirical data related to the association of actual asset class returns with the corresponding economic regime. The analysis is presented below.

Equity -- The median and average annualized performance of the S&P500 stock index, back to 1948 and categorized by regime, appears in the table to the right. The influence of regimes is quite apparent in this asset class.

In equity-supportive environments, stocks produced annualized returns north of 15% on average. When the economic regime changed to a fixed-income supportive one, however, equity returns dropped by almost two-thirds on average. In real return environments, equities did better than in the fixed-income environments, but only about half as well as when the economic environment was more supportive of equity investments.

Real return assets (proxied here by real estate, a quite close cousin), had a similar, though less dramatic pattern. Real estate performed fairly well in equity environments as this asset type (as well as the more purely real return assets) have a positive return correlation with growth, but because they are also driven by inflation (and/or rising interest rates) these investments performed better (at the median) in the real

return environments. This data only goes back to 1978, which is the initiation of the NCREIF real estate indicies. The real return class of investments perform reasonably well in fixed income environments as some of these assets ARE bonds (albeit floating rate or inflation-linked) and the “real” assets often have very high income streams which get more valuable as interest rates fall, similar to the income stream from a bond.

The fixed income asset class poses a special situation when it comes to regimes. Fixed income assets are certainly impacted by the various states of growth and inflation, but perhaps more important is the level and direction of interest rates. If interest rates are high, fixed income investments can produce good rates of return (relative to longer-run fixed income return averages) in any regime. Fixed income investments are more impacted by changing regimes when interest rates are lower and the bonds’ current income stream is less overwhelming as a component of the total rate of return of the asset.


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