There were no revisions to MPERS’ asset allocation targets in fiscal year 2018. As of June 30, 2018, 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, 2018, followed by commentary on each of the underlying asset classes.
MPERS began the year with a 30.70% allocation to global equities, representing a slight overweight versus the targeted allocation of 30%. The combination of record low volatility and an improving economic outlook continued to push equity markets higher throughout the remainder of calendar year 2018, which drove our allocation above 31% at the end of the calendar year. After nearly a decade of relatively calm equity markets, volatility returned to the equity markets in the first quarter of 2018 driven by rising interest rates, the fear of inflation, and rising geopolitical tensions. Given the increased market volatility and relatively high valuations, we moved back to a neutral position towards the end of fiscal year 2018.
Overall, it was another excellent year for the global equity markets in terms of performance, despite the stretched valuations and continued threats of geopolitical issues. MPERS’ global equity portfolio generated a 9.9% return for the fiscal year, but there was widespread dispersion across the various underlying markets and strategies. MPERS’ domestic equity portfolio led the way with a 12.6% return, while international markets lagged U.S. markets due to a stronger U.S. Dollar and weakness in the emerging markets. We continue to overweight master limited partnerships (MLPs) within the equity portfolio, based on their strong dividend yields of roughly 6.5% and relatively low exposure to underlying commodities. Unfortunately, MLPs continue to underperform the broader equity indexes as investors are concerned over the MLP structural changes and new FERC rulings. MLPs were down nearly 2% for the fiscal year, but performance has stabilized and the strategy was up over 11% in the second quarter of 2018. We continue to favor the strategy over the long term.
MPERS’ remained consistently underweight the targeted fixed income allocation of 20% throughout the entire year, starting the year just above the minimum permissible range with a 15.2% allocation and ending the year with a 16.3% allocation. Managing the 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 2.84%. For every dollar you invest that earns 2.84%, you need to find another investment that earns 12.66% to generate an average return of 7.75%. With the economy entering a record tenth year of expansion and equities at/near all-time highs, finding 12+% returns is an extremely difficult task. That leaves pension funds with a recurring dilemma; while U.S. Treasuries provide excellent diversification, investing any considerable amount of funds in them virtually guarantees you will not 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, and long duration securities that offer diversification in times of falling economic growth.
From a performance perspective, it was another challenging year for fixed income investors. The lack of volatility in the equity markets continued to push investors towards stocks versus bonds (sending bond prices lower and yields higher). The Federal Reserve also raised the overnight Federal Funds Rate three times during the fiscal year, creating a flatter yield curve making longer-term bonds less attractive (investors typically favor shorter-term bonds if there is not an incremental pickup in yield by extending maturities). Overall, MPERS’ fixed income portfolio did very well relative to the benchmark, earning a 2.0% return versus the benchmark which lost 0.6% of value throughout the year. The absolute return nature (and short duration) of MPERS’ internally managed portfolios, along with strong performance from our active fixed income managers were the primary drivers of the relative performance during the year.
Given the Federal Reserve is still on a path to raise short term rates and the U.S. economy continues to grow, we continue to favor growth investments in the portfolio versus traditional fixed income securities. We are watching interest rates closely, however, and intend to gradually reduce the underweight position to traditional fixed income securities if rates continue their grind higher. The Federal Reserve is expected to raise rates another two times in calendar year 2018, which could potentially lead to a flat (and possibly inverted) yield curve all the way from 2-year Treasuries out to 30-year Treasuries. While not 100% accurate, this is typically a leading indicator of a future recession. Should the yield curve approach zero and economic conditions deteriorate for any reason, we will likely move to a more defensive posture in the overall portfolio and increase MPERS’ fixed income exposure.
Fiscal Year 2018 marks the first full year of separate performance for the opportunistic debt portfolio, as it was previously a sub-sector of the broader fixed income portfolio. The benchmark for the portfolio is the Barclays US Corporate High Yield Index. The decision to carve out the portfolio was driven by the constant flow of opportunities that have evolved in the sector over the recent years, which warranted a separate mandate and a benchmark that more accurately reflected the sector’s risk profile. The portfolio is comprised of a mix of direct lending portfolios that throw off capital quickly and some more esoteric strategies to boost returns.
MPERS started the fiscal year with a 9.2% allocation to opportunistic debt, relative to a 7.5% policy target. It was another strong year of performance in the sector, as the 11.96% return for the year outperformed the benchmark return of 2.62%. The strong performance, along with our additional commitments, drove our ending allocation up to 10.25%. While the portfolio is broadly built out, we continue to find interesting investments in more sector-focused funds that are complementary to the current portfolio. We will likely maintain an overweight to the asset class for the foreseeable future.
MPERS’ remained consistently underweight the targeted hedge fund allocation of 10% throughout the entire year, starting the year with a 6.9% allocation and ending the year with a 6.4% allocation. On a relative basis, performance across the hedge fund portfolio was strong in fiscal year 2018, as the portfolio generated a return of 7.78% versus the benchmark return of 5.50%. Equity-oriented strategies (such as long/short equity and activist equity) fared very well during the year, consistent with the overall upward trend in equities. The performance was also strong with our global macro managers and event-driven strategies (such as merger arbitrage). While we are happy with the relative performance, the changing regulatory and political environment continues to be quite a challenge for the hedge fund industry, as market movements have been dominated by macro events (outside of a manager’s control) instead of bottom-up fundamentals. The trend towards passive management in the equity markets has also been a challenge for many equity-oriented strategies. Ultimately, we believe this represents an opportunity for the industry over the long term but remains a short-term hurdle for many managers. Together with the fees associated with hedge funds, we expect to remain underweight the 10% allocation target over the coming year.
We continued to build out and grow the real assets’ portfolio throughout fiscal year 2018, ending the year with an 11.1% allocation versus the policy target of 7.5%. The portfolio now has a balanced mix of timber & natural resources (35% of total), energy (34%), power & infrastructure (18%), and metals & mining strategies (13%). The recent focus on timber & natural resources was an effort to diversify the portfolio and provide a core strategy to offset the volatility embedded in the energy sector. Overall the real assets’ portfolio generated a return of 6.12% in fiscal year 2018, versus a policy benchmark of 6.89%. MPERS’ energy-related strategies performed very well, as oil prices trended up towards $70/barrel throughout the year. The timber & natural resources portfolio also contributed positively to absolute performance during the year, albeit underperforming the overall asset by generating a 2.5% return. We are pleased with the overall construction of the timber portfolio but expect returns to be somewhat lumpy over the coming years and dependent on our ability to execute the operating strategy and subsequently liquidate the portfolio.
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. MPERS started the year with a 10.4% allocation and marginally reduced the allocation over the course of the year, ending with a 9.7% allocation. The portfolio generated a 10.57% return for the year, outperforming the policy benchmark return of 7.68%. The core real estate portfolio (primarily stabilized and fully leased properties) generated an 8.3% return, while the non-core portfolio (value-added or opportunistic real estate strategies) returned an impressive 15.7% return. The publicly traded REIT (real estate investment trust) portfolio also contributed positive performance, returning 5.8% for the year.
We continue to monitor the rising interest rate environment and are mindful of the strong correlation between core real estate and interest rates. We believe that capitalization (cap) rates on core real estate have hit their lows for the current cycle, and further increases in interest rates will likely coincide with increased cap rates for real estate (sending core real estate pricing lower). Net operating income growth within the underlying properties can offset the increased cap rates, as many properties are roller over rental agreements put in place shortly after the financial crisis (when rental rates were much lower), but investors are definitely lowering their return expectations going forward. Given that backdrop, we will likely maintain neutral or slight underweight to the asset class over the intermediate term.
MPERS maintained a modest overweight to the targeted allocation of 15% to private equity throughout fiscal year 2018, starting the year at 16.13% and ending the year at a 15.99% allocation. Private equity was our best performing asset class for the year, generating a 17.15% return. While still underperforming the benchmark (S&P 500 + 3%), which generated a 17.37% return, the portfolio is maturing nicely as fiscal year 2018 was the fourth consecutive year where distributions (from portfolio company sales) outpaced new capital calls. The “public equity plus” 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. It is important to note that relative performance is only a portion of the overall strategy. From a total return perspective, private equity remains our best performing strategy over the trailing one, three, five, and ten year periods. It has simply struggled to keep up with a very challenging benchmark, which is not an investable index (you cannot passively invest into an S&P 500 + 3% benchmark). We are optimistic that relative performance will improve as the portfolio continues to mature and more underlying companies advance toward their ultimate exit strategy, and when/if the returns in the public equity markets start to moderate.