Letter From CIO

September 5, 2017

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.

The theme of this year’s CAFR is the “road to retirement”, with the investment section being responsible for “maintaining momentum on the hills”. As I look back over the past 12 months, these were very appropriate themes for the investment markets. At the onset of the year, global equity markets were facing an uphill battle. Global economic growth was extremely weak, investors were still trying to determine the long-term implications of Britain’s vote to exit the European Union, and the U.S. was in the midst of a hotly contested Presidential race. Fear and uncertainty were the primary emotions on the minds of investors. We fully anticipated a rocky, uphill road for the financial markets.

Surprisingly, over the coming months, Central Banks around the world pledged additional stimulus to support their respective economies, the dust settled rather quietly from the “Brexit” vote, and Donald Trump was elected the 45th President of the United States. The equity markets quickly embraced the idea of an improved regulatory and business tax environment and shifted from a sense of fear and uncertainty to one of cautious optimism. Equities rallied sharply after the U.S. election and “maintained their momentum” throughout the remainder of the fiscal year, closing up 18.8% for the year. Market volatility (sometimes referred to as the “fear index”) ended the year at the lowest levels in over a decade, leading to a “risk on” rally across all major asset classes.

While the rally in the equity markets was admittedly unexpected, we’re happy to take the results. MPERS’ return of 11.22% (net of all management fees and based on time-weighted rates of return and market valuations) easily outpaced the actuarial return target of 7.75% and also outperformed the policy index return of 10.95%. We did fall short of the median public fund return of 11.9%, but that is somewhat expected in a year when the global equity market generated such strong results. MPERS’ relatively low exposure to public equities typically results in lagging the broader public fund universe when equity markets are strong, but we also expect to outperform the average public fund in years where equity markets are flat or negative. Longer term, our diversified approach has served the system well, as MPERS’ three, five, and ten year returns rank in the 5th, 6th, and 43rd percentile of the public fund peer universe. We also take comfort in knowing MPERS’ portfolio has a lower risk profile than 75% of our peer group (with risk measured by standard deviation of returns over the past ten year period).

Each individual asset class delivered a positive return for the year, led by the global equity portfolio with a 20.89% return. The real assets portfolio, “fueled” by the recovery in the oil and gas markets, rebounded nicely from the losses in fiscal year 2016 to produce a 13.4% return for the year. The hedge fund portfolio also rebounded to generate a double digit return of 10.18%, followed by private equity at 9.92%, real estate at 6.74% and the fixed income portfolio at 3.69%. Relative performance (actual performance relative to the respective policy benchmark) was solid across most asset classes, with the exception of the private equity portfolio which struggled to keep up with the rally in public equity markets.

There was one significant change to MPERS’ asset allocation during the year. Effective January 1, 2017, the Board approved a change to reduce the targeted allocation to hedge funds from 15% to 10% of assets. The reduction in hedge funds was offset by increasing the targeted allocation to real assets and opportunistic debt to 7.5% each (both previously had 5% targets). As part of the change, the opportunistic debt allocation was carved out and is now reported as a separate asset class rather than a subset of the broader fixed income allocation.

While MPERS’ fiscal year return exceeded the actuarial target of 7.75% and MPERS’ longer-term performance was strong enough to allow an additional $31 million investment into the recently established contribution stabilization fund. The reserve fund now has a balance of $220 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 2018, financial markets seem to be facing the same uphill battle they faced at the start of last year – arguably an even steeper hill after the strong performance of last year. While President Trump and a Republican Congress certainly has the prospect of a more business-friendly environment, they have yet to pass any meaningful reforms and are at risk of losing momentum on many of their initiatives. The market rally over the past year clearly “pulled forward” the earnings growth that is expected from these initiatives, stretching equity valuations even further and increasing the risk of a pullback should the regulatory and tax reforms not materialize. We’re now in the ninth year of the economic expansion since the financial crisis, and while I personally believe that expansions don’t die simply from old age, you have to be mindful that a slowdown or correction is coming. Government bonds, normally a safe haven and source of diversification, offer very little in terms of yield and the Federal Reserve continues on a path to raise rates (which would send current bond prices lower).

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 “maintain momentum in the hills” that inevitably lie ahead. Doing so will require a balanced portfolio and the use of unique structures that can extract value from markets that otherwise appear fully valued.

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