Equity Allocation:

We began the year with a 45% allocation to equities, split roughly 50/50 between domestic and international equities. Throughout most of the year we maintained this allocation to equities, but we began to favor international markets towards the end of the year based on concerns over the U.S. Dollar. The massive amounts of U.S. Government debt issued to finance the various stimulus programs are a significant threat to the value of U.S. dollar relative to foreign currencies. This makes international holding more attractive relative to U.S. equities. Furthermore, the outlook for economic growth is more favorable in developing countries such as China, India, and Brazil, as the U.S. consumer continues to clean up their balance sheet and reduce spending.

Going forward, as part of the asset allocation study, the Board approved a single allocation to global equities in lieu of separate allocations to domestic and international equities. The new global equity benchmark has a 44% weighting to domestic equity and a 56% weighting to international and emerging market equities.

Fixed Income Allocation:

We began fiscal year 2010 with a slight underweight to overall fixed income assets, and remained heavily weighted to hedge fund strategies within the overall allocation. The total fixed income portfolio, which underperformed drastically in fiscal year 2009, rebounded strongly in fiscal year 2010 generating a 22.9% return. This type of return from a fixed income allocation shows just how dislocated the market was in fiscal year 2009. While MPERS was rewarded for staying the course with these strategies over the past year, it raises the question as to whether this kind of volatility is desirable in a fixed income portfolio. That was an important element of the asset allocation review completed during the year, and going forward the Board of Trustees approved separate allocations to traditional fixed income and hedge fund strategies.

Real Estate Allocation:

MPERS' commercial real estate portfolio continued to drag down overall returns in fiscal year 2010. It was the only asset class to deliver negative returns for the year. Overall, the real estate portfolio fell by 12.8% in fiscal year 2010, but performance varied across the various real estate sectors. Private real estate strategies suffered write-downs in appraisals ranging from 15-19%, the timber portfolio dropped in value by 12%, while publicly traded real estate investment trusts (REITs) actually rose by 23% during the year.  The rise in REIT shares during the year is encouraging, as they are often a leading indicator for private real estate values. Private real estate values, while negative for the year, were positive during the last quarter of the fiscal year and have rallied considerably since July 1, 2010. We are optimistic about the return prospects in this sector going forward.

Private Equity Allocation:

MPERS' private equity allocation rose from 9.3% of assets to 12.1% of assets during the course of fiscal year 2010. Overall the portfolio generated a 7.6% return in fiscal year 2010. While very respectable given the relative immaturity of the portfolio (we only started committing to private equity in 2005), the portfolio drastically trailed the benchmark return due to some unfortunate timing. MPERS' private equity benchmark converted to a "public equity plus" benchmark (S&P 500 + 4%) on April 1, 2009 - almost the exact time when public equity markets bottomed during the last downturn. The subsequent rally in public equity markets caused MPERS' private equity portfolio to underperform the benchmark by over 48% in fiscal year 2010, as private markets are much slower to adjust the pricing of the underlying holdings. The change in the private equity benchmark contributed 4.3% of underperformance at the total fund level. Said another way, without the change, MPERS would have outperformed the total fund benchmark by 2.6% instead of trailing it by 1.65%.

Looking Forward:

As we move to fiscal year 2011 the primary focus will be the re-positioning of the portfolio towards the new asset allocation targets approved by the Board of Trustees. The new targets are listed on the chart below. The biggest focus will be to gradually shift assets away from publicly traded stocks, offset by increased exposures to traditional fixed income, real estate, and private equity structures.

Changes to the hedge fund portfolio seem to be a never-ending process, and going forward will be no exception. As part of the asset allocation study, we will look to offset the reduced global equity exposure by increasing the expected return in the hedge fund portfolio. To accomplish this, we are transitioning away from market neutral oriented strategies and migrating towards more event-driven and long/short equity strategies. MPERS' hedge fund portfolio, all things considered, held up very well during the last downturn. We remain convinced it is well positioned to deliver strong returns going forward.

The last major restructuring will take place within the traditional fixed income portfolio, as we look to reduce the risk that led to such wide swings in performance. We intend to gradually allocate funds away from the existing manager base towards passive investment strategies in long duration fixed income, Treasury Inflation Protected Securities (TIPS), and a core allocation to the Barclay's Capital Government/Credit Index.

The chart below lists the target and actual allocations to the various sub-asset classes within the overall portfolio (as of June 30, 2010).