PERAC Memo #16 - 2006: Various Investment Issues

Memorandum # 16/2006
M E M O R A N D U M TO: All Retirement Boards FROM: Joseph E. Connarton, Executive Director RE: Various Investment Issues DATE: February 15, 2006

First of all, we wish to remind all boards of the necessity to comply with the regulations (840 CMR 16.07 (1)(2)(3)) that require periodic performance and strategy review meetings with all investment managers. Once again, we would appreciate written confirmation at some point during the year that all such reviews are either scheduled or have been completed.

As you know, periodic review meetings are a fundamental aspect of the relationship between investment managers and their public pension plan clients. When logistic or other circumstances prevent a manager from attending a board meeting, conference calls are a viable and acceptable alternative, but they should be the exception rather than the rule.

In the most basic aspect of these reviews, boards should use the meetings to ascertain that managers are doing what they said they would do and to determine how well they are doing it. At these reviews, board members should not hesitate to ask even the most basic of questions. Board members and/or their consultants should examine periodic portfolio listings and transaction journals and should freely question whether certain held securities are consistent with the portfolio guidelines and whether certain trading patterns or turnover rates seem unusual.

In making its annual determination whether a manager is satisfactorily fulfilling its mandate, a board should question the retention of any manager who has failed to outperform its benchmark over a reasonable period such as three years. In such instances, boards may decide to search for a more successful active manager or they may choose to achieve benchmark performance at a fraction of the cost of active management by hiring an index manager. Particularly in asset classes like large cap equity that are seen as very efficient, index funds are widely used by public pension plans of all sizes.

Systems that hired investment consultants in 2001 are reminded of Regulation 26.04(3) which requires re-certification of consultants every five years. As explained in PERAC Memo #9/2004, re- certification does not require a new search process but simply a determination by the board and the subsequent submission of updated regulatory forms.

PERAC has frequently and consistently advised systems about the importance of achieving as much diversification as possible both within and among asset classes. The superlative performance of the

PRIT Fund over the past three years is a testament to the benefits of diversification. Because of its size and its clout, the PRIT Fund can invest in certain asset classes and gain access to top-tier managers that are beyond the scope and reach of most small to medium-sized plans. It’s impossible to predict whether some of the alternative asset classes that have worked so well for PRIT in recent years --- such as emerging markets, real estate, timber, and private equity--- will continue to shine, and some of these asset classes are clearly less liquid and/or more volatile than traditional stocks and bonds. Nevertheless, diversification has proven to be successful over time and boards should at least examine whether their current portfolios are as diversified as possible. Thirty nine systems have successfully enhanced their diversification by investing in one or more of the PRIT Fund’s investment segments or by having a partial investment in the PRIT Core (general) Fund. As always, the PERAC Investment Unit is pleased to offer assistance or advice to any system that may have questions about asset allocation.

In today’s challenging investment environment, where expected returns from the traditional asset classes may be insufficient for a retirement board to achieve its actuarial rate of return, institutional investors have begun to consider new products and strategies in their search for elusive “alpha” (i.e., returns in excess of a particular market benchmark, or the value added by a manager). Many of these new strategies involve short-selling and/or use of derivatives, both of which could be at odds with PERAC Investment Regulations. Nevertheless, if after a search process for one of these type of products, the retirement board and its consultant are satisfied with the investment manager’s organizational strength and track record and are comfortable with the risk controls inherent in the product, boards may use the supplementary regulation process to request PERAC authorization. Boards are encouraged to request feedback from PERAC prior to commencing searches on such “new age” products.

Investment Regulations 19.01 (4) and (8) contain limits on the percentages of total portfolio assets that can be allocated to real estate and alternative investments. If, as the result of an asset allocation study, retirement boards wish to exceed either or both of the limitations contained in those regulations, they may request exemptions from these regulations through the supplementary regulation process.

As we’ve previously stated, investment managers frequently call PERAC to seek clarification on confusing questions that appear on systems’ RFPs, such as those that ask whether prospective managers are “PERAC-approved” for the particular asset class. Once again, it must be emphasized that there is no separate process for managers to obtain “PERAC approval”. The list of managers distributed quarterly by PERAC simply lists those managers in certain asset classes that have been hired by one or more systems (and granted exemptions by PERAC) and whose products remain open to new investment. The exemption process does not apply to all domestic equity and fixed income. As is stated in the memorandum that accompanies the quarterly manager listings, boards are free to consider managers not on these lists in their search processes. If boards are simply trying to ascertain whether prospective managers have existing Massachusetts public fund accounts, please ask the question in a more concise manner.

The PERAC Investment Unit is pleased to offer assistance to systems in the preparation of their RFPs.
For further assistance on these or any other investment matters, retirement boards are encouraged to call Investment Director, Robert Dennis at 617-4446 ext 922.