Asset Allocation Strategies for Police & Fire Benefit Plans Docs/Public Safety/2019/PP… · US...
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Asset Allocation Strategies for Police & Fire Benefit Plans
NCPERS 2019 Public Safety ConferenceNew Orleans, LA
Jennifer MinkSenior ConsultantInvestment Performance Services, LLC
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Today’s Agenda
OpportunisticReview Capital Market Assumptions
and Asset Class Distinctions
Introduce Factors to Consider
Illustrate Sample Portfolios
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Five Factors to Consider1.
2.
3.
4.
5.
Objective
Cash Flows
Fund Size
Expected Returns
Risk Tolerance
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Factor #1 ‐ Objective
What is the objective of my Fund?
Target Return
Income Generation
Preservation of Capital
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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
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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
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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.
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Factor #3 – Fund Size
Fund
Size Does Matter?
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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
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Factor #4 – Expected Returns
What is the market expected to do?
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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
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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
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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
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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%
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Annualized 10‐Year Returns
Source: 2019 Horizon Survey; average expected return of all 34 respondents
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%
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Annualized 10‐Year Returns
Source: 2019 Horizon Survey; average expected return of all 34 respondents
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%
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Annualized 10‐Year Returns
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
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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
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BONDS
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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
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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
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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
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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.”
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Measuring Interest Rate Sensitivity
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%
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Source: Federal Reserve
24 Years 30 Years
Interest Rate Cycle
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Measuring Interest Rate Sensitivity
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
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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
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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)
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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.
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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
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Components of Real Estate Returns
Appreciation/Depreciation
IncomeTotal Return
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REIT S&P 500 ODCE
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Real Estate Diversification
Property Type Geographic Location
Office
Multi‐family apartments
Warehouse/Industrial
Retail
Hotel
Northeast
Southeast
Midwest
Southwest
Westcoast
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Styles of Real Estate InvestmentsIRR 7.5 ‐10% IRR 10‐15% IRR 10‐15% IRR 13‐18% IRR 15‐20%
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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)
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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
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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
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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
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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.
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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
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Typical Timeline for Private Equity Investment
44Note: For illustrative purposes only. Courtesy of Neuberger Berman
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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/
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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.
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What is a Private Equity Secondary Investment?
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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
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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
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Who is Buying?
49Source: Setter Capital Volume Report
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Benefits of Secondaries
Mitigated ‘J’‐curve
Limited Blind Pool Risk
Broader Diversification in Portfolio Purchases
Seasoned Assets
Reduced Underlying Fees
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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
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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
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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
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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.
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% 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
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% 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
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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!
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Jennifer MinkSenior Consultant | Senior Partner
Investment Performance Services, LLCjmink@ips‐net.com