State Universities Retirement System of Illinois

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1 State Universities Retirement System of Illinois Serving Illinois Community Colleges and Universities 1901 Fox Drive Champaign, IL (217) (217) (FAX) To: Investment Committee From: Daniel L. Allen and Tony J. Lee Date: May 27, 2011 Re: June 2011 Investment Manager Watch List Investment Department Summary The Investment Manager Watch List for June 2011 reflects investment performance for the period ending March 31, As stated in the Investment Policy, the Watch List is provided to the Board at the June and December Investment Committee meetings. The following firms/mandates qualify for inclusion on the Watch List: June 2011 Watch List SURS Investment Manager Watch List June 2011 U.S. Equity Managers on Watch List for Performance Investment Manager On Watch Since Benchmark Buford Dickson Harper and Sparrow Jun-11 Custom Benchmark Non-U.S. Equity Managers on Watch List for Performance Investment Manager On Watch Since Benchmark GlobeFlex Capital, L.P. Jun-09 S&P BMI Developed x-us Martin Currie Inc. Jun-10 MSCI ACWI x-us Mondrian Investment Partners Jun-11 MSCI ACWI x-us Managers on Watch List for Organizational Concerns Investment Manager On Watch Since Concern Piedmont Investment Advisors Jun-11 Ownership change Taplin Canida & Habacht Jun-11 Sale of firm's parent company ING Clarion Jun-11 Sale of company Buford Dickson Harper and Sparrow Jun-11 Loss of assets under management. Evaluation Process For reference, Section IX - Investment Manager Watch List of the approved Investment Policy is found at the end of this document. Per the Investment Policy, the following criteria are used to determine watch list status for performance:

2 1) Investment Performance Consistent shortfalls versus an agreed upon benchmark. Also considered would be measurement against a relative peer group of investment managers with similar investment styles a) Over two consecutive quarters on a rolling 3 year period basis, manager performance, net of fees, must be within 100 basis points of the stated benchmark or capture more than 90% of the stated benchmark performance. Performance for the watch list managers is displayed on the table that follows, along with a complete explanation of performance. Watch List Managers - Investment Performance As of March 31, 2011 Manager Incep $ millions 3 YR Mgr 3 YR Bmark Under Perform Prior 3 Yr Mgr Prior 3 Yr Bmark Under Perform Martin Currie Jul % -0.8% -2.2% -8.7% -5.0% -3.7% Mondrian Investment Partners Feb % -0.8% -2.0% -6.4% -5.0% -1.3% Globeflex Capital Apr % -0.8% -5.7% -10.9% -5.0% -5.9% Buford, Dickson, Harper & Sparrow Jun % 10.2% -7.7% -4.3% 2.2% -6.5% Martin Currie has been on the watch list since June 2010 due to below benchmark performance in the Non-U.S. Equity mandate. Underperformance over the past three years has been primarily due to market conditions that were not favorable to their investment style. Martin Currie utilizes a fundamental bottom up stock selection process that focuses on quality, value, growth, and change. During the market collapse of 2008 and early 2009, macro events generated considerable market volatility resulting in negative relative performance in the portfolio. During the market recovery of 2009 and early 2010, the portfolio continued to underperform as lower quality stocks rallied. Portfolio performance has begun to improve. The portfolio returned 1.30% versus the benchmark return of -0.23% for the month of March The Board of Trustees approved a $200 million reduction to Martin Currie s funding at their October 2010 meeting. Staff met with representatives from Martin Currie on September 24, 2010 and again on January 25, 2011, in Champaign. In addition, a conference call was conducted on April 22, 2011, to discuss the portfolio. Staff will continue to monitor performance. GlobeFlex Capital has been on the watch list since June 2009 due to below benchmark performance in the Non-U.S. Equity mandate. The global financial crisis has had a material impact on GlobeFlex s performance. During the second half of 2008 the portfolio underperformed by 783 basis points, after exceeding the benchmark return by 169 basis points in the first half of the year. The significant underperformance continued into calendar year 2009 when the portfolio trailed the benchmark by 1,280 basis points. This represents the first period of underperformance for the portfolio. GlobeFlex has exceeded the benchmark return in four of the last five quarters, returning 16.1% versus a benchmark return of 13.0%. GlobeFlex has not experienced any significant organizational changes during the past three years. Assets under management in the International All-Cap portfolio have remained steady despite the performance shortfall. During the past 18 months, GlobeFlex has experienced a net

3 loss of 3 accounts in the portfolio. Staff most recently met GlobeFlex representatives in March 2011, and also conducted a conference call with the firm in May Staff will continue to closely monitor GlobeFlex. New Additions to Watch List Buford Dickson Harper and Sparrow (BDHS) was added to the watch list in June 2011 due to both below benchmark performance in the U.S. Equity mandate as well as organizational concerns. BDHS utilizes a concentrated portfolio approach in the small cap growth product utilized by SURS purchasing approximately 30 stocks focused on momentum and characterized by high volatility. Although the portfolio exceeded its benchmark in 2007 by 3,103 basis points, it had difficulty navigating the tumultuous markets of For the year, the portfolio trailed the benchmark by 439 basis points, suffering from weak stock selection in the information technology and consumer discretionary sectors. The portfolio continued to struggle in 2009, lagging the benchmark return by 1,951 basis points. High quality, low risk stocks detracted from performance for the year. Despite slight outperformance of 26 basis points in 2010, the portfolio has trailed the benchmark by 647 basis points annually for the three years ended December 31, 2010 (-4.29% versus 2.18%). BDHS has experienced disappointing results in 2011, trailing the benchmark by 154 basis points but performance in the second quarter has shown improvement. SURS is one of three clients invested in the $55 million small cap product which has had no client gains or losses over the past four years. As of March 31, 2011, BDHS had 13 clients and assets under management of approximately $90 million after losing the Illinois State Board of Investment as a large cap client during March Mr. Reginald Dickson, Chairman of the Board and Chief Executive Officer, is a founding member and 63% owner of BDHS. He is one of the firm s five employees and serves on the three-member investment committee. Mr. Dickson currently is phasing out of the firm. Despite Mr. Dickson s scheduled departure from the firm, BDHS has not instituted a succession plan. These organizational developments are cause for concern regarding the viability of the firm. SURS staff and Callan most recently expressed concerns to BDHS during an on-site due diligence visit to the firm s office in St. Louis, Missouri, on May 9, Staff will continue to closely monitor performance and organizational developments. Mondrian Investment Partners was added to the watch list in June 2011 due to below benchmark performance in the Non-U.S. Equity mandate. Mondrian is a value investor, focusing on those stocks with high dividend yields and attractive valuations. Mondrian significantly exceeded the benchmark in 2008 but lagged in both 2009 and The primary reason for the underperformance of the portfolio is the underweight to economically sensitive sectors in the past two years. The long-term focus of Mondrian s investment process resulted in a defensive posture to the portfolio. Because economic growth has been much stronger than expected during the last two years, performance of defensive stocks has significantly lagged that of cyclical stocks. In fact, the underperformance of defensive stocks over the last two years has only been exceeded by that experienced in 2000 during the dot com bubble. Despite this higherthan-expected economic growth, Mondrian believes that inevitable headwinds of deleveraging and higher taxes exist longer term in global economies. As a result, the portfolio remains defensively positioned. Mondrian s focus on large cap, high dividend-yielding stocks also

4 detracted from performance in 2010 as those stocks with the largest market capitalizations and highest dividend yields materially underperformed smaller cap and lower yielding stocks. Calendar year 2011 appears to be off to a better start, with Mondrian exceeding the benchmark by 29 basis points for the first four months of the year (8.75% vs. 8.46%). It should also be noted that the Sudan restrictions resulted in a -124 basis point impact to the portfolio over the past year. Staff conducted a meeting with Mondrian in March 2011 to review the portfolio and discuss the performance issues. In addition, staff conducted a conference call with Mondrian on May 17, 2011, to discuss the watch list status. Staff will continue to monitor performance of the portfolio and is scheduled to conduct an on-site due diligence visit to Mondrian s Philadelphia office in July Organizational Concerns ING Clarion currently manages U.S. and global Real Estate Investment Trust (REIT) accounts for SURS. On February 15, 2011, ING Group announced its plans to sell a portion of its real estate businesses, including ING Clarion Real Estate Securities, to CB Richard Ellis Group (CBRE). CBRE is focused on commercial real estate services and has over 31,000 employees in both developed and emerging markets. The transaction is expected to close in July ING Group Real Estate Securities will merge with CBRE Investors, a business unit of CBRE. All staff and functions within Clarion Real Estate Securities will remain the same. Portfolio management, client service, marketing, and all operational staff will continue in their current roles in the firm s offices globally. As a result of this pending acquisition, ING Clarion Real Estate Securities has been added to the watch list. Staff and Callan Associates will monitor the development of the transaction and provide updates to the Board as appropriate. Taplin, Canida & Habacht was added to the watch list in June 2011 due to organizational concerns regarding the sale of the firm s parent company, Marshall and Ilsley, to Bank of Montreal that was announced on December 17, The transaction is expected to close in mid Bank of Montreal is a financial institution with global assets under management in excess of $58 billion. TCH indicates it will continue to conduct business autonomously in its Miami, Florida offices. The current portfolio management team, Tere Alvarez Canida, Alan M. Habacht, and William J. Canida, will continue to be responsible for managing and servicing the firm s accounts. TCH believes the acquisition is a positive for the firm as BMO has a stronger financial position than M&I. SURS Board of Trustees provided consent to the assignment of the investment management agreement for approval of the transaction at the April 2011 Board meeting. Piedmont Investment Advisors is being added to the watch list due to a recent ownership change. On April 1, 2011, Piedmont entered into an agreement whereby Rosemont Partners II, L.P., a private equity fund of Rosemont Investment Partners (Rosemont), LLC, will acquire a 30% ownership interest in Piedmont. In connection with this transaction, Piedmont will exercise its right to redeem the membership interest of Legato in accordance with Piedmont s operating

5 agreement. Proceeds from the sale of ownership to Rosemont will also be used to repay a loan obtained in connection with the redemption of NCM s approximately 10.5% ownership interests that occurred on November 10, Upon completion of the Rosemont transaction, Piedmont will be 70% employee owned. SURS Board of Trustees provided consent to the assignment of the investment management agreement for approval of the transaction at the April 2011 Board meeting. Additionally, staff met with Piedmont in Durham, NC on May 20, At the meeting, Piedmont announced that Dawn Alston Paige, one of the firm s founding partners, would be retiring for personal reasons effective July 31, Ms. Alston Paige s ownership stake will be purchased by Piedmont and redistributed on a pro rata basis to the remaining active employee owners. Staff will carefully monitor both ownership changes and their potential impact on Piedmont. Removal from the Watch List The following managers are being removed from watch list status: Managers Removed from Watch List June 2011 Investment Manager Investment Mandate Reasons for Removal NCM Capital U.S. Equity Performance improvement

6 IX. Investment Manager Watch List Factors for Consideration The watch list is intended to address investment managers in the SURS investment program with actively managed, public securities mandates that are not achieving desired results. The following factor(s) could warrant an investment manager being placed on watch. Items that are sub bulleted in lower case letters are the practical criteria used to define these factors: 1) Investment Performance Consistent shortfalls versus an agreed upon benchmark. Also considered would be measurement against a relative peer group of investment managers with similar investment styles. a) Over two consecutive quarters on a rolling 3 year period basis, investment manager performance, net of fees, must be within 100 basis points of the stated benchmark or capture more than 90% of the stated benchmark performance. 2) Change in Organizational Structure or Personnel Significant change in personnel or firm infrastructure a) Key individual(s) of an organizational depart. b) Organizational ownership changes materially and negatively impacts firm. 3) Clients/Assets under management - Significant loss of clients and/or assets under management a) Number of clients decreases so significantly as to increase firm viability concerns. b) Assets under management decrease significantly. 4) Changes in Investment Strategy or Process If an investment manager diverges from the strategy and/or style originally hired to implement. a) Investment process or strategy changes materially without the consent of SURS. b) Changes to Investment Strategy result in investment manager investment style as unacceptable, redundant, or inappropriate to SURS program by staff and/or Consultant. 5) Compliance Failure to comply with written instructions or requests related to communications requested by the Board or staff. a) Pre arranged policies in the investment management agreement are not implemented by investment manager. b) Direct, written instructions by Board or staff are not executed in timely manner. 6) Significant change in the active risk profile of the investment manager - This includes factors such as changes in asset allocation and/or risk profile. a) Risk profile/ asset allocation significantly changes as a result of investment manager s investment philosophy, style, or strategy. 7) Brokerage Guidelines Investment managers that do not comply with SURS s brokerage policy for four consecutive quarters will be considered for placement on watch status. 8) Other SURS staff has the ability to include the investment manager on the watch list should other significant circumstances arise that are not currently contemplated. a) Operations Firm level issues involving regulatory violations. Monitoring of Investment Managers A review of investment managers on watch will be conducted on a regular basis. At least quarterly, status calls and/or visits will be conducted with the investment manager.

7 Circumstances under which the Investment Committee may elect to terminate an investment manager not on a watch list may also arise. The watch list will be presented to the Investment Committee twice a year, at the June and December meetings, reflecting investment performance for the periods ending in March and September, respectively. Investment managers may qualify for immediate inclusion on the watch list as a result of the occurrence of any of the previously mentioned organizational factors. When presenting firms on the watch list, the investment staff will identify factors causing investment managers to be placed on watch. If the investment manager does not remedy the concerns of SURS, the following actions may occur: Immediate termination of the investment manager. Any investment manager termination will follow the guidelines set forth in Section X of the SURS Investment Policy, entitled, Investment Manager Termination Guidelines. Initiate a plan for replacement of the investment manager. Reduce allocation of funds to the investment manager by an amount to be determined by the Board with the recommendation of Staff and the Consultant. Conduct an interview with the investment manager to determine whether investment performance is explainable or if an upward trend in relative performance has developed. Investment managers placed on the watch list will receive written notification from SURS, informing the investment manager of the issue and requesting a written explanation. The written response from the investment manager should include an assessment of the alleged event, an explanation of the cause of the event and what changes will or should be expected to assure that the event will be resolved and/or not reoccur. Removal from Watch list An investment manager may be removed from the watch list at any time if staff becomes satisfied that the concerns no longer apply and if confidence in future ability to deliver investment performance is restored. Factors warranting removal from watch list: Performance has materially improved to above benchmark and/or above investment manager median over a market cycle (defined as either 3 or 5 year period). Organizational issues of concern have been resolved completely or significant progress has been made to address SURS concerns. Concerns with investment strategy, philosophy or active risk profile have been resolved or significant progress has been made to address SURS concerns. Assets under management stabilize or significantly increase to strengthen viability of firm on an ongoing basis. Firm complies or is pending compliance with SURS policies.