There was one significant revision to MPERS’ asset allocation targets in fiscal year 2017. Effective January 1, 2017, the Board approved a reduction to the target allocation to hedge funds (formerly 15%) to 10%. The change was offset by increasing the targeted allocation of real assets and opportunistic debt to 7.5% each (previously both had 5% targets). Additionally, the opportunistic debt portfolio was carved out of the broader fixed income allocation and is now reported as a separate asset class.
As of June 30, 2017, all of the sub-asset class allocations were within the acceptable ranges established by MPERS’ investment policy. Any deviance relative to the target allocation represents a conscious decision based on the investment staff’s view of the market. The chart below lists the target and actual asset allocation as of June 30, 2017, followed by commentary on each of the underlying asset classes.
MPERS began the year with a 28.9% allocation to global equities, representing a slight underweight versus the targeted allocation of 30%. Given the fear and uncertainty in the markets at the start of the fiscal year, we maintained a slight underweight position throughout the first half of fiscal year 2017. We moved back to a neutral position in January of 2017, based on the falling market volatility and the improved regulatory and taxation outlook. We maintained a neutral to slight overweight position through the end of the fiscal year, finishing with a 30.7% allocation to global equities.
In terms of performance, global equity markets traded steadily higher over the course of fiscal year 2017, despite stretched valuations and threats of geopolitical issues. Active management (where utilized) added value throughout the entire equity portfolio as MPERS consistently outperformed the broader market indexes. MPERS’ U.S. small-cap portfolio led the way, producing a 30.93% return for the year. U.S. large cap trailed the small-cap portfolio, but still generated a healthy 20.45% return. International markets fared well this year with our portfolio producing a 24.41%. Emerging markets also had a nice year, after being hit hard by commodity and oil prices in 2016. MLPs continue to be a strong yielding asset, yielding about 6%, but also continues to underperform the broader equity indexes as investors are allowing oil prices to affect MLP prices.
The strong performance in global equities provided an excellent opportunity to take some gains and redeploy that capital into other areas of the portfolio where we found better opportunities. Most of that activity involved reducing active management risk throughout the equity portfolio and shifting towards an internally-managed strategy utilizing derivatives. Publicly traded equity markets are very efficient, and the passive benchmarks are often difficult to outperform on a net of fees basis. For this reason, we believe MPERS is better served by taking active management risk in other areas of the portfolio where managers have demonstrated a better ability to outperform their passive benchmarks, such as the alternative asset classes. We will continue to use active equity management strategies where a manager has a certain niche or in markets that are less efficient. For example, in March of 2017, we provided the seed capital for an existing manager to start an international micro-cap strategy. That particular manager has an excellent track record of outperforming the passive benchmark in smaller markets, which we expect will continue with the new micro-cap strategy.
Effective January 1, 2017, the opportunistic debt portfolio was carved out of the broader fixed income allocation and is now reported as a separate asset class. Fixed income performance for fiscal year 2017 includes the first 6 months where opportunistic debt was rolled into the broader fixed income allocation, and the back half of the year where returns were exclusively from traditional fixed income strategies. Regardless of whether you include opportunistic debt or not, MPERS’ was consistently underweight the targeted fixed income allocation of 20% throughout the entire year, ending the year just above the minimum permissible range with a 15.17% allocation.
Maintaining the appropriate allocation to fixed income in the current interest rate environment continues to be a balancing act. While fixed income strategies (particularly long duration Treasuries) offer the best diversification against equity market risk and other various strategies dependent on economic growth, we are also mindful of the difficulty of meeting MPERS’ long term actuarial return target of 7.75%. At the start of the fiscal year, the 30 year Treasury had a yield of 2.25%. Simple mathematics will tell you that for every dollar you invest that earns 2.25%, you need to invest another dollar in “something” that earns 13.25% to generate an average return of 7.75%. While equity markets delivered returns exceeding 13.25% this year, nobody believes that can be sustained over longer periods of time. That leaves pension funds with a dilemma; while U.S. Treasuries provide excellent diversification, investing any considerable amount of funds in them virtually guarantees you won’t meet your actuarial return hurdle. MPERS tries to balance this risk by mixing a blend of fixed income strategies, including core fixed income strategies that offer a modest coupon with limited exposure to rising interest rate risk, inflation protected securities that will perform better in rising inflation periods, long duration securities, and opportunistic credit strategies (which will be broken out into a separate asset class going forward).
It was a challenging year for core fixed income investors, as investors sold their less risky fixed income securities to buy into the strong equity markets (sending bond prices lower and yields higher). Long duration fixed income fared the worst, as the 30 year U.S. Treasury yield rose from 2.25% to 2.84% over the year. Opportunistic credit strategies fared much better, as the “risk on” rally led to tighter credit spreads which more than offset the rise in interest rates (an improving economy reduces the default risk of the underlying borrowers). While the overall fixed income portfolio generated a positive 3.73% return for the year, the gains were almost exclusively from opportunistic credit strategies. MPERS’ long duration portfolio lost 2.16% for the year, while the core portfolio lost 0.7% and the inflation sensitive portfolio generated a modest 0.34% return. The divergence of goals, objectives, and ultimately the returns between opportunistic and traditional fixed income securities is the primary reason we opted to carve out the opportunistic debt portfolio into a stand-alone asset going forward.
Looking ahead, we intend to maintain the underweight position to traditional fixed income securities. While the 30 year Treasury yield rose to 2.84% over the course of fiscal year 2017, using the same math as before you still need to find an offsetting investment that returns 12.66% to generate an average return of 7.75% (MPERS’ actuarial hurdle). While the U.S. Treasury bonds are certainly free of default risk, they are not risk free as all fixed income securities (especially long duration) have a considerable amount of interest rate risk (market pricing risk). Given the Federal Reserve is still on a path to raise short term rates further (which can add volatility to fixed income assets), we continue to believe that better risk-adjusted investments are available elsewhere in the investment portfolio.
Performance in the hedge fund portfolio rebounded in fiscal year 2017 to generate a return of 10.21%, which outperformed the benchmark return of 6.41%. Most of the outperformance can be attributed to a higher equity exposure through our equity-oriented strategies, which ironically were the drivers of the underperformance in fiscal year 2016. While we are happy to see the improved performance, we are also mindful that equity valuations are considerably higher today which makes it harder to generate those same returns going forward. The changing regulatory and political environment has proven to be quite a challenge for most hedge fund strategies, and many are struggling to adapt and navigate their approach. We believe that paying the high fees associated with hedge funds in this difficult return environment is not prudent, and have maintained a considerable underweight to the new 10% allocation target throughout the year. We ended with a 6.90% allocation, continuing to favor opportunities in real estate, real assets, and private equity relative to the hedge funds sector.
The real assets portfolio rebounded from poor performance in the previous year to generate a return of 13.59% in fiscal year 2017, versus a policy benchmark of 5.62%. Performance was strong across the board, as the aviation, energy, mining, and shipping strategies all performed well. Timber also contributed positively to absolute performance in the first full year of MPERS’ revised Timber and Natural Resources’ policy. The new authority has generated a tremendous amount of deal flow, and we closed several attractive throughout fiscal year 2017. We are very pleased with the early success of the new program, and continue to source additional investments to complement the existing asset base.
We ended the year with a 10.25% allocation to real assets, with roughly 3% of the portfolio in timber. We continue to see a number of attractive investments throughout the asset class, particularly in timber and in the energy sector, and expect the allocation to increase towards the high end of the permissible range of 12.5% throughout the coming year(s).
MPERS’ real estate portfolio has a target allocation of 10% of assets, and includes a mix of public and private equity strategies, along with tactical exposures to public and private debt strategies. We continue to favor a mix of real estate debt and equity strategies over the core private equity real estate benchmark, as it offers a comparable dividend yield relative to the index but provides additional downside protection from our debt allocations. The benchmark has proven difficult to keep up to however, as our blended portfolio generated a 6.72% return for the year but marginally underperformed the policy benchmark return of 7.23%.
We started the fiscal year with 11.69% allocation to real estate, a moderate overweight position, on the view that our diversified portfolio would outperform traditional fixed income markets. As the year progressed, capitalization rates (the equivalent of dividend yields) in real estate continued to fall and we gradually reduced our overweight by redeeming from our core real estate portfolio, ending fiscal year 2017 with a 10.43% allocation. We are mindful of the strong correlation between core real estate and interest rates, and believe that capitalization rates on core real estate have hit their lows for the current cycle. Net operating income for real estate properties has been excellent (driven by higher rental rates), but the market is also pricing in very aggressive rental rate growth going forward. So while we continue to believe real estate is attractive relative to traditional fixed income, the overall risk profile of core real estate has also increased. Looking forward, we are looking to reduce our core real estate exposure in favor of other strategies that offer a better forward-looking return profile.
MPERS was consistently overweight the targeted allocation of 15% to private equity throughout fiscal year 2017, although that allocation dropped from 17.57% to 16.13% over the course of the year. The portfolio generated a 9.86% return for the year, underperforming the “public equity plus” benchmark (S&P 500 + 3%) which generated a 20.64% return. This benchmark has been difficult to outperform in recent years given the strength of public equity markets and the relative immaturity of MPERS’ private equity portfolio. The portfolio is maturing, as fiscal year 2017 was the third consecutive year where distributions (from portfolio company sales) outpaced new capital calls. We remain optimistic that relative performance will improve as the underlying companies advance toward their ultimate exit strategy.
While we are comfortable with the progress of the private equity portfolio, keeping up with the “public equity plus” benchmark has been a difficult task. Some of that is clearly a matter of bad timing, as the benchmark converted to the current hurdle just as equity markets started to recover from the financial crisis. MPERS is a long term investor, and trends like this have a way of reversing over time. The private equity portfolio remains our best performing strategy over the trailing ten year period, but has simply struggled with the benchmarking issue. While we don’t ever want to wish for bad performance in the public equity markets, we fully expect the private equity portfolio will outperform policy benchmarks when public equity markets are having difficulties. Mindful of all these issues, we continue to cautiously, but actively, commit to new managers and strategies – favoring smaller, niche managers who are not “fishing in a crowded pond.” These managers have a more repeatable strategy that is compelling even in the low return environment that we face today.