Letter From CIO

October 5, 2016

 

To the Board of Trustees and System Members:

It is my pleasure to provide you with the investment section of this year’s Comprehensive Annual Financial Report (CAFR). My letter provides an overview of the investment portfolio’s performance over the past year and our view of the investment market in the years to come.

Fiscal year 2016 was a challenging year for MPERS’ investment portfolio, as a slowing global economy sent oil and gas markets down over 40% and global equity markets down 3.7% for the year. It was another year where MPERS’ efforts to diversify the portfolio paid off, as the investment portfolio was able to navigate the difficult market and generate a positive 1.01% return for the year, net of all management fees and based on time-weighted rates of return and market valuations. Despite underperforming the policy index return of 1.85%, MPERS’ performance ranked in top 34% of the public fund peer universe and longer term performance remains very strong. MPERS’ three, five, and ten year returns rank in the 1st, 2nd and 27th percentile, respectively. The ten year return is even more impressive given the fact that MPERS’ portfolio has a lower risk profile than 74% of the peer group (with risk measured by standard deviation of returns).

The individual asset classes delivered a wide range of returns for the year, led by the real estate portfolio with a 10.62% return and the fixed income portfolio with a 7.55% return. The private equity portfolio also continued to mature and delivered a positive return of 4.86%. The global equity, hedge fund, and real assets portfolios all generated negative returns, with real assets representing the worst asset class with a -8.69% return. The performance of the real assets portfolio was the primary source of underperformance to MPERS’ policy index, as the sector contributed over 1% of underperformance at the total fund level (while the total fund underperformed the policy index by 0.84%). Overall, we were actually pleased with how well the real assets portfolio held up in such a difficult environment, and we believe the sector is positioned for better performance going forward.

Hedge funds were another asset class that didn’t perform up to expectations over the past year, as the industry struggles to adapt to the changing regulatory and political environment. Unlike real assets, we believe the weakness in hedge funds is more structural in nature and better risk-adjusted investments exist elsewhere in the portfolio. Recognizing the difficult market environment for hedge funds, in June of 2016 the Board approved a recommendation to reduce the targeted asset allocation from 15% to 10% of assets. The reduction in hedge funds will be offset by increasing the targeted allocation to real assets and opportunistic debt to 7.5% each (both currently have 5% targets). As part of the change, the opportunistic debt allocation will be carved out and reported as a separate asset class rather than a subset of the broader fixed income allocation. The changes will become effective January 1, 2017.

While MPERS’ fiscal year return fell short of the actuarial target of 7.75%, MPERS’ longer-term performance was strong enough to allow an additional $47 million investment into the recently established contribution stabilization fund. The reserve fund now has a balance of $188 million, which will be used to offset years when experience falls short of our actuarial goals. I commend the Board for their foresight in creating this fund, as it demonstrates a true alignment of interest with our members and will provide stability to our employers’ contribution rates as we navigate this difficult investment climate.

As we look ahead to fiscal year 2017, financial markets seem eerily similar to the start of last year. Equity valuations remain near the high end of historical ranges, and the global economy has yet to demonstrate the ability to grow without the constant support of government stimulus. The global economy will have to find new sources of growth to send equity markets higher from current levels. To make matters worse, the one place to hide in recent years, namely government bonds, is looking risky as well. With government bonds yielding between 1 ½ and 2 ½ percent, and the Federal Reserve debating how much – not whether or not – to raise interest rates, long-term government bonds can no longer be viewed as a safe haven (albeit with a different set of risks relative to equity markets). Balancing the need to diversify the portfolio, along with the need to generate consistent positive returns, is going to be a very difficult task in the years ahead. The restructuring efforts of years past should help the portfolio produce consistent returns across a wide range of economic scenarios – not just when the stock market is rising – but the markets seem destined to deliver modest returns in the years ahead. All of this reinforces the need to be realistic about our return prospects, protect the corpus of the fund, and do everything under our control to deliver solid risk-adjusted returns for our members.

Thank you for the opportunity to serve as your Chief Investment Officer, and I hope you enjoy this year’s annual report.

 

Sincerely,

Larry Krummen, CFA