EFTA02691355.pdf

NYC Mayor's Office of Pensions & Investments Assessing and Mitigating Risks in Today's Market Environment Impact on Institutional Investors June 7, 2011 Ran,ii H. Nagaswomi Chief Investment Advisor Mayor's Office of Pensions and Investments New York City 6/28/2011 4.21 PM 1 EFTA_R1_02033246 EFTA02691355  NYC Mayor's Office of Pensions & Assessing and Mitigating Risks Inyestmenfs Agenda: Current Policy Portfolio Shaped by History Living with Lower Returns Identifying Risks that Matter Redrawing the Policy Roadmap 6/28/2011 4.21 PM 2 EFTA_R1_02033247 EFTA02691356  NYC Mayor's Office of Pensions & Current Policy Portfolio Shaped by History Investments Over the past several decades pension systems have targeted absolute returns at +/- 8% Given declining bond yields, this led to an overweighting of equities... ...steadily increasing the absolute risk levels of pension assets... ...resulting in policy portfolios that perform well primarily in high growth/low inflation environments [e.g. the 1990s] 6/28/2011 4.21 PM 3 EFTA_R1_02033248 EFTA02691357  NYC Mayor's Office of Pensions Declining Bond Yields Challenge Overall Plan Returns Investments 20% 18% —6 year Forward Return 16% —Beginning 10 year Treasury Yield 14% r 12% Jun '00 10 yr Treasury Yield 6.0% 10% Jun '00 - Dec '10 Return* 5.9% 8% 6% 4% Correlation of starting yield to forward return: 0.88 2% Dec 31 '10 10 yr Tsy Yield 3.3% 0% Next-5-10 yr Return Est. 3.4% 1969 1974 1979 1984 1989 1994 1999 2004 2009 Source: St. Louis Fed, Ibbotson, Research Affiliates, NEPC, NYC MOPI 6/28/2011 4.21 PM 'Merrill Lynch US Treasury Master Annualized Total Return 4 EFTA_R1_02033249 EFTA02691358 Progressively More Equity Needed to Achieve NYC Mayor's Office of Pensions 8% return Investments All U.S. Pension Plans Historical Fixed Income Allocations for 8% Mixes 100% 90% EO 80% o c 70% o c P 60% Cl LL 50% O 40% <7 cn 30% co 20% 10% 0% N c,c,t„cp („6\cob cob N N N N N N ,,,b eee95'6\95' 95' (15' rt, rt, Ocb Cf Source: Callan 6/28/2011 4.21 PM 5 EFTA_R1_02033250 EFTA02691359  NYC Mayor s Office of Penstons Equity Concentration Sharply Increased Total Risk Investments All U.S. Pension Plans Historical Projected Standard Deviations for 8% Mixes 13% Standard Deviation 8% 6% 4% 2% 0% 45 4° .,44` 00 O1' 4) „44) 4\ 41) 45 ,1,4cP 19.ci` (1941'ZOo'b LOOt' 20 •,4 (ISO ) C3 ,45)0 \ Oq5 NO 6/28/2011 4.21 Source: Callan PM 6 EFTA_R1_02033251 EFTA02691360  Equity Concentration Means Plan Returns Track NYC Mayor's Office of Pensions Equities Investments Rolling Annual Returns —New York Oty Pensions Beta Fbrttotio — awry Component 70% 50% 30% 10% -10% -30% Correlation: 98% 50" 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Correlation of U.S. Public and Private Pension Funds to the S&P 500 98% 100% ll Percentage of Portfolios 90% 80% - 70% • 60% • 50% • 40% 30% • 20% 10% • 0% 0% • 0-.25 .25-.5 .5-.75 .75.1.0 Correlation to S&P 500 Seurat POISPCM 6 Invosttrans and Bncloawatol warn WHERE SHOWN. HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIISTATIONS UNLIKE AN ACTUAL PERFORMANCE RECORD. SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING OR THE COSTS OF MANAGING THE PORTFOLIO. ALSO. SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER OR OVER COMPENSATED FOR THE IMP ACeMTAIN MARKET FACTORS, SUCH AS LACK OF LIOUIDITY. SIMULATED TRADING PROGRAMS W GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDS7 HT. NO RE ISBEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. Source: Bridgewater EFTA_R1_02033252 EFTA02691361  NYC Mayor'S Office of Pensions 6 Redrawing the Policy Roadmap Investments Agenda: Current Policy Portfolio Shaped by History Living with Lower Returns 6/38/2011 4.21 PM 8 EFTA_R1_02033253 EFTA02691362  NYC Mayor's Office of Pensions & Living with Lower Returns Investments Significant downward revisions to next 5-10 year return assumptions* Cash 2.5% Inflation Forecast 2.5% Growth Diversifying Inflation Hedging Assets Assets Assets US Large/Small Cap Eq. 7.7% US Fixed Inc TIPS 3.2% Non US Developed Eq. 7.7% International Fixed Inc Core Real Estate 6.4% Emerging Markets Eq. 8.7% High Yield 6.17. Commodities 4.3% Private Eq. 9.6% Opportunistic Fixed Inc [Bank Loans, Distressed] 7.3% Convertibles 7.1% EM Debt 5.5% Non Core Real Estate 7.9% Absolute Return 6.6% REITs 7.6% 6/28/20114:21 * Average Forecast of Several Major Pension Consulting Firms PM 9 EFTA_R1_02033254 EFTA02691363  NYC Mayor's Office of Pensions & Living with Lower Returns Investments Actuarial investment rates of 8% unachievable with current policy portfolio, atleast for next 5+ year period We must also understand 'normal' portfolio returns in 30 year period [long term] independent of cyclical valuation anomalies Long term balanced policy portfolio should be built using normal returns Short term policy portfolio must begin transition towards long term portfolio, adjusted for cyclical- valuation opportunities 6/28/2011 4.21 PM 10 EFTA R1 02033255 EFTA02691364  NYC Mayor's Office of Pensions & Redrawing the Policy Roadmap Investments Agenda: Current Policy Portfolio Shaped by History Living with Lower Returns Identifying Risks that Matter 6/28/2011 4.21 PM 11 EFTA_R1_02033256 EFTA02691365  NYC Mayor's Office of Pensions & Identifying Risks that Matter Investments In the last decade, asset diversification tailed just when it was most needed Failure of markets or ailure of assumptions? •Model risk: Over-reliance on mean-variance analysis as the primary tool to model potential outcomes: Volatility higher than forecasted ,Downside risk in 'tail' events underestimated Markets failed to realize 'mean return expectations' Amid stress, 'normal' correlations among assets soared 6/28/2011 4.21 PM 12 EFTA_R1_02033257 EFTA02691366  NYC Mayor's Office of Pensions Limits to the Use of Mean-Variance Analysis Investments Mean Returns May Not be Realized For Long Periods of Time US Stocks (2000 - 2009) Japan Stocks (1990 - 2010) US Stocks (cumulative excess returns. In) Japan Stocks 1990 • 2010 (cumulative omen returns. In) — Aces limns —E thosRon (Apr o0) —.M 2 Sanderd larelaiths —sass Awn —11xpocied Rakoes (Jan Sek — 2 Simko Orono* 12 Probability 1 / 120 years 2.0 0.8 • 1.5 0.4 • 1.0 0.0 0.5 0.0 -0.4 -0.5 -1.0 •1.2 1.5 2000 2002 2004 2006 2008 1990 1995 2000 2010 US Bonds (1965 - 1981) US Bonds (1981 - 1987) to Bonds(cumulative moss tokens, In) US Bonds (cumulative excess ielurns In) — Las nosana —spaded fluent (Oa au —.I. 2 S.wd Drain Aetna —limbo"Returns (S 56) — il• 2 Slavard WEI= .6 0.6 0.4 0.5 ProbabilityJut/ 150 years 0.9 0.4 02 0.3 0.1 02 0.0 0.I -0.1 0.0 -0.2 -0.3 -02 -0.4 -0.3 -0.5 -0.4 -0.6 1980 1981 1982 1983 1985 1986 1965 1970 1975 1980 6/28/20114:21 Return exp0piab0nS are balled On OsernOuS 10 year volablily mulUpte00y a 025 Sharpe relict Expectations we Cased on Backteether Associates under stanOng al csowit markets. Source: Bridgewater 13 There a rkietiarantee lhal the MAAS Sown Can O. will be °thieved Saga: Global Financial Data ma and 8/162eanuet Analysis EFTA_R1_02033258 EFTA02691367  NYC Mayor's Office of Pensions Limits to the Use of Mean-Variance Analysis Investments Correlations: Unstable and Environmentally Dependent Rolling 3-yr Correlation of Monthly Excess Returns —Global Stenos and Global Nominal Bonds — Global Stocks and Global I. Bonds 80% 60% 60% 40% 40% 20% 20% 0% 0% -20% .20% 40% 40% .60% Avg Corset a 0.18 40% GO% 75 80 85 90 95 00 05 10 75 80 85 90 95 00 05 10 H Global Nominal Bonds and Cornmatinee —Global Stocks and COMMOCISS 80 60 40% 20 0 20% 40 -60 75 80 85 90 95 00 05 to 6/28/2011 4.21 14 PM Source: Bridgewater EFTA_R1_02033259 EFTA02691368  NYC Mayor's Office of Pensions 8, Identifying Risks that Matter [continued] Investments • Model Risk - failure of mean-variance assumptions • Environmental risk concentration in high growth/low inflation sensitive asset classes ■ Risk Budgetinc a necessary complement to Capital Budgeting 6/28/2011 4.21 PM 15 EFTA_R1_02033260 EFTA02691369  NYC Mayor's Office of Pensions & Economic Environments Change... Investments Environment* Eco Growth Inflation [Real GDP] [CPI] 1930-2009 3.3% 3.2% 1950s 1960s 1970s 1980s 1990s 20O0s ki Positive Economic Indicator 6/28/20114:21 PM Negative Economic Indicator 16 *Source: Bureau of Economic Analysis, Federal Reserve Bank of Minneapolis, Ibbotson SBBI, Deutsche Bonk EFTA_R1_02033261 EFTA02691370  NYC Mayor's Office of Pensions & ... Driving Asset Returns Investments Environment* Capital Markets Returns* Eco Growth Inflation Long Crude [Real GDP] [CPI] Equity Treasury Oil 1930-2009 3.3% 3.2% 9.6% 5.7% n/a 1950s 4.1 2.2 19.3 0.4 1.5 1960s 4.4 2.5 7.8 2.8 0.8 1970s 3.2 7.4 5.9 6.1 28.0 1980s 3.0 5.1 17.6 12.8 -5.4 1990s 3.2 2.9 18.2 8.0 1.7 2000s 1.8 2.6 -0.95 6.6 11.9 Positive Economic Indicator Highest Return Asset Class in decode 6/28/20114:21 PM Negative Economic Indicator Lowest Return Asset Class in decade 17 •Source: Bureau of Economic Analysis, Federal Reserve Bank of Minneapolis, Ibbotson SBIII, Deutsche Bank EFTA_R1_02033262 EFTA02691371 Environmental Risk: NYC Mayor's Office of Pensions Asset Allocation Viewed Through Another Lens Investments 60/40 Equity/Fixed Income Balanced Policy Portfolio Portfolio Asset Allocation Growth Inflation Growth Inflation Mr- Rising Rising Falling Falling 6/28/20114:21 PM Source: Bridgewater 18 ,olor 10 NUO 4 IU relOvang 05..0,05 EFTA_R1_02033263 EFTA02691372 Environmental Risk: NYC Mayor's Office of Pensions Asset Allocation Viewed Through Another Lens Investments i .s High High Growth, Low Non-U.S. Equity Emerging Equity Growth, Inflation High 1.00 "Goldilocks" CI Inflation U.S. Equity Venture Capital Buyouts S ci 0.50 Emerging Debt it I Commodities 1 Convertible o High Yield a p.00 B .?: REITs :E Absolute Return ii, -0.50 Inflation-Linked Bonds a Core U.S. Fixed rX Income L II l Asset classes with Low useful environmental Low Growth, risk diversifying Growth, Low characteristics High Inflation Inflation -1.50 -1 50 -1.00 -0.50 0.00 0.50 I i ii I.50 Sensitivity to Inflation Expectations Note: bubble size represents relative assets allocation weights for alternative #2 (with Absolute Return) and should be used for illustrative 6/28/igpia PM only. 19 Source: Rocaton EFTA_R1_02033264 EFTA02691373 Risk Budgeting a Necessary Complement to Capital NYC Mayor's Office of Pensions & Budgeting Investments Risk Budgeting Consider the portfolio from a total risk perspective rather than total return An attempt to determine the contribution to risk by each asset class in the portfolio, based on • Asset class volatility assumptions • Correlations between asset classes Shows the benefit of diversification • But also the risk exposures in relation to allocation size Especially useful if asset classes are bucketed by • Role they play in total portfolio • Risk similarity 6/28/2011 4.21 PM 20 EFTA_R 1_02033265 EFTA02691374 Risk Budgeting a Necessary Complement to Capital NYC Mayor's Office of Pensions Budgeting Investments Capital [$] Weights Weights . Equities - Large Cap . 41% • ligh Viet, - 6% . Equities - Large Cap - 510:.. tigh Yield - 4% . Equities - hll. - 15% • Beal Estate - 6% In Equities • htl. • 17% . noel Estate • 6% I Equines - Ftivate Eq. - 5% Ill Nominal Govt Bonds - 4% Equities - EM - 3% El Mortgages - 9% MI L Bonds - 3% ❑ Convert. Bonds - 1% I Equities - Pnvate Eq. - 9% El Noninal Govt Bonds - 1% Equities - EM - 7% . Mongages - 2% • IL Bonds - 0% ❑ Convert. Bonds - 1% . Noninal Bond Agg - 7% . Nonital Bond Agg - 2% . Currency - 0% Equities: 64% Equities: 84% Source: Bridgewater 6/28/2011 4.21 PM 21 EFTA_R1_02033266 EFTA02691375 Risk Budgeting: NYC Mayor's Office of Pensions & Specifies the True Role/Risk of Asset Classes Investments Alternative Buckets * Traditional Classification Risk Budgeting Classification [Based on Volatility, Correlations and Environmental Risk]** ■Growth Assets • Equities Public Equities Private Equity - Non Core Real Estate • Fixed Income REITs? Aggregate - Combine Equities and Credit as Company - High Yield Risk? • Alternatives •Diversifying Assets Private Equity Treasuries [Interest Rates] Real Estate Credit Hedge Funds •I6 Corp • HY + Distressed • EM Debt Hedge Funds - REITs? •Inflation Hedging Assets - Inflation Linked Bonds - Core Real Estate - Commodities/Energy - Timber/Farmland 6/28/20114:21 PM *Many variations possible. All subjective! 22 ** Risk Buckets as defined by 5I5, MOPI estimate of asset class membership within buckets EFTA_R1_02033267 EFTA02691376 Risk Budgeting: NYC Mayor's Office of Pensions Risk Allocation, Not $ Allocation Matters Investments Capital [$] Risk Weights Weights Classifying Asset Classes by Risk Characteristics/Role in Asset Allocation 100% 100% % Growth Risk % Diversifying Risk 26% 5% % Inflation Risk 8% 5% Long term balancedpolicy portfolio should be designed to optimize risk weights 6/28/20114:21 PM 23 EFTA_R1_02033268 EFTA02691377  NYC Mayor's Office of Pensions 6 Identifying Risks That Matter Investments Accidents happen! Speed limits, road signs and seat belts don't prevent them.. .. but they foster discipline, reducing the instances of a really bad outcome! 6/28/20114:21 PM 24 EFTA_R1_02033289 EFTA02691378  NYC Mayor's Office of Pensions & Redrawing the Policy Roadmap Investments Agenda: Current Policy Portfolio Shaped by History Living with Lower Returns Identifying Risks that Matter Redrawing the Policy Roadmap 6/28/2011 4.21 PM 25 EFTA_R1_02033270 EFTA02691379  NYC Mayor's Office of Pensions & Redrawing the Policy Roadmap Investments Significant downward revisions to next 5-10 year return assumptions Risk/decision making tools must be broadened ...But... Near term, de-risking not possible/advisable Equity markets not recovered to pre-credit crisis levels Bonds unattractive Sponsor contributions already pressured 6/28/2011 4.21 PM 26 EFTA_R1_02033271 EFTA02691380  NYC Mayor's Office of Pensions 8, Redrawing the Policy Roadmap Investments ...Hence... Explicitly distinguish between short term and long term policy portfolios Long term policy portfolio must be designed to achieved the desired risk profile and balance across environments Short term policy portfolio managed for valuation opportunities and cash flow needs - always with a strong directional view to long term policy goals We have our current location, we need a roadmap and a destination! 6/28/2011 4.21 PM 27 EFTA_R1_02033272 EFTA02691381  NYC Mayor's Office of Pensions Asset Allocation Policy Roadmap Investments Long Term Current Balanced Portfolio Policy Portfolio Next 5-10 years • Achieves the desired risk profile [broadly defined] • Achieves balance across economic environments • Maximizes the return/ risk opportunity set • Designed today [and