SONOMA COUNTY EMPLOYEES RETIREMENT ASSOCIATION INVESTMENT COMMITTEE MEETING MINUTES

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1 Tuesday, 8:35 a.m. SCERA Board Room 433 Aviation Boulevard, Suite 100 Santa Rosa, CA INVESTMENT COMMITTEE MEETING MINUTES Presiding: Present: Also present: Absent: Chair Greg Jahn presided. Trustees Neil Baker, Michael Gossman, John Pels, Christel Querijero, Joe Tambe, Brian Williams and Bob Williamson, Administrator Julie Wyne, Assistant Administrator Kelly Jenkins, Senior Investment Officer Jim Failor, Investment Analyst Steve Marsh and Administrative Aide Phyllis Reason. Managing Director Justin Henne of Parametric Clifton, Managing Director Todd Macy of Credit Suisse, Senior Consultant Shane Schurter, Associate Partner Dan Kim and Consultant Chris Behrns of Aon Hewitt, member of the public Jim Scriven. Trustees David Rabbitt and David Sundstrom. I. MINUTES APPROVAL Approval of September 16, 2015 Minutes. Trustee Williamson noted on page 3 paragraph 2 of the September minutes read 1,219 bps should read bps. Motion was made by Trustee Williams, seconded by Trustee Williamson to approve the September 16, 2015 minutes with corrections. The motion carried With voting as follows: AYES NAYS ABSTAIN ABSENT Mr. Gossman Mr. Rabbitt Mr. Jahn Mr. Sundstrom Mr. Pels Ms. Querijero Mr. Tambe Mr. Williams Mr. Williamson Page 1 of 8

2 II. PRESENTATIONS A. Parametric Clifton Managing Director Justin Henne presented an update on the organization and reviewed the firm s overlay and rebalancing services. Mr. Henne provided an outline of the history of the Clifton Group noting that it was founded in 1972 in Minneapolis and that it has been a pioneer in overlay strategies. In 2012, the firm was acquired by Parametric Portfolio Associates LLC which is a majority owned subsidiary of Eaton Vance Corp. Parametric is a Quant Shop with offices in Seattle WA and Westport CT. The Seattle office focuses on rules-based portfolio strategies while Westport focuses on option portfolio management and Minneapolis (Clifton) focuses on overlay and risk management solutions. Parametric equity that is not owned by Eaton Vance is broadly distributed among senior management and investment professionals. There is a profit-sharing element to staff remuneration with a P&L calculated for each of the local businesses that drives bonuses. Mr. Henne gave a broad description of Parametric s mission and product set noting that funded and overlay assets now total just over $90 billion and that the business is well diversified by client type and asset class. The service used by SCERA falls within the client rules/overlay business. Initially, SCERA used Parametric to securitize cash balances and then extended the service in March 2014 to include portfolio rebalancing using derivatives controlled by a set of rules contained within the Investment Policy Statement. In response to questions as to how the overlay service performed in the 2008/09 Global Credit Crisis Mr. Henne noted that Parametric uses exchange traded instruments and that the futures markets remained liquid throughout the Crisis. (Mr. Failor noted that SCERA accessed the futures markets in the downturn to reduce the fixed income exposure and rebalance towards equities.) Some of Parametric s clients during the Crisis did not hold a cash buffer to back the overlay and were perturbed by the realization of equity derivative losses and the pain of maintaining equity exposure in the downturn. Those who discontinued the overlay strategy did not invest into the falling market and reap the rewards of the subsequent recovery. Mr. Henne pointed out that SCERA actively maintains a cash buffer to cover short-term market gyrations. Mr. Henne went on to describe in detail the philosophy and workings of the policy implementation overlay service. The primary object is one of risk control by keeping as close as possible to the target policy mix and so minimizing any potential policy shortfall. The securitization of cash through the use of derivatives reduces the expected long-term performance drag from maintaining economic exposure to cash. The overlaying of cash at the plan level and for specific portfolio managers has added about 9 basis points to total plan performance since account inception. Parametric s studies would indicate that disciplined rebalancing may add around basis points of annualized return over the long term. Parametric has authority to rebalance plan assets through the use of derivatives when the plan s asset allocation exposures deviate from target by a predetermined threshold. This happened twice in 2014 and twice in 2015 year-to-date. Since turning on the rebalance function in March 2014, rebalancing has added approximately $1.36 million to plan total assets. Page 2 of 8

3 Senior Investment Officer Jim Failor concluded by stating that the partnership with Parametric was working well, that the staff found the reporting to be very useful and that they were appreciative of Parametric s report enhancements which were added at SCERA s suggestion. B. Credit Suisse Managing Director Todd Macy presented an update on the organization and the prime brokerage services they provide for the Jacobs Levy 130/30 strategy. Staff asked Mr. Todd to comment on the impact that legislation such as Basel III and Dodd Frank is having on the prime brokerage business. Mr. Macy emphasized that the aim of Credit Suisse is to be one of the best capitalized banks in the world. They have a new Chief Executive Officer who has made the raising of fresh capital a strategic priority. He also noted that the banking standards set by the Swiss Financial Markets Supervisory Authority (FINMA), which they adhere to, are even tougher than those established by Basel III. Mr. Macy noted that Credit Suisse has been Basel III compliant since January 2013 and ahead of schedule. Increasing regulation and capital adequacy is forcing all banks to look at the profitability of their business lines and make decisions about where they want to commit limited capital. Prime brokerage is a balance sheet consumptive business but Credit Suisse has determined that it is a high return business and a good use of the bank s balance sheet so they remain committed to that business. That said, they have streamlined the business by shifting focus to key clients and moving smaller less profitable clients to a platform they refer to as mini prime. As a stand-alone account, Sonoma would not qualify as a key client, but they consider it to be part of the Jacobs Levy relationship and Jacobs Levy is considered a key client. Because the prime brokerage business is largely uncorrelated with traditional equity brokerage, it is seen within the bank as a revenue diversifier. They remain committed to the business and are among the top three prime brokers based on volumes. Break: 9:32 to 9:44 a.m. C. Third Quarter 2015 Investment Performance Report Senior Consultant Shane Schurter of Aon Hewitt presented selected pages from the Quarterly Investment Review Executive Summary. Covering the market highlights Mr. Schurter noted that the third quarter was a difficult one for equity markets globally with equity markets in aggregate down 9.6% as measured by the MSCI ACWI IMI Index and no major market posting a positive return in US dollars. Emerging markets suffered more than the developed markets with the aggregate index return declining by 17.7%. This was a reflection of their sensitivity to China where devaluation and slowing growth dominated the economic headlines and the degree of Dollar-linkage which ties them to US Federal Reserve policy decisions. Domestically, the Russell 3000 Index returned -7.25% over the quarter. The Utility sector was the strongest sector producing a return of 4.2% while the Energy and Materials sectors were the weakest performers producing returns of % and Page 3 of 8

4 -17.26%, respectively. With regard to style, large cap stocks outperformed small cap and large cap growth outperformed large cap value. Non-US equity returns were weaker than domestic returns, modestly so for Europe but more pronounced in Japan, Canada and the Emerging markets. The third quarter saw a flight to quality and credit spreads widening. US Government bonds returned 1.71% and the broader Barclays Aggregate Bond Index returned 1.23%. The Treasury yield curve flattened during the third quarter driven by falling long bond yields with the 10-year Treasury bond ending the quarter yielding 2.06%, 29 basis points lower than the beginning of the quarter. In consequence, longer-dated issues outperformed shorter maturities and high yield bonds represented by the Barclays Aggregate Index declined nearly five percent in value significantly underperforming investment grade bonds. In private real estate Mr. Schurter noted that the third quarter NCREIF ODCE return was 3.7%, in-line with the second quarter return of 3.8% and still lingering well above historical averages. Favorable demand trends along with lagging new supply continues to drive positive trends in the commercial real estate sector, but non-core investments are now past their cyclical sweet spot. In commenting on the Plan s performance overall, it was highlighted that a significant proportion of the Plan s assets are actively managed and while this has not been a source of added value in 2015, it has been a significant source of value-added over the trailing one, three- and five-year periods. The Plan s equity orientation has captured the buoyant equity markets over recent years and the move to diversify into real estate after the 2008/09 downturn captured the recovery in the property market. This asset allocation benefit, coupled with the gains from active implementation, has resulted in strong relative performance over the last three and five years which is reflected in peer group comparisons where SCERA is compared to a universe of public funds with over $1 billion in assets. In this universe, SCERA placed in the top ten percent over the three-year period and in the top eight percent for the five-year period. Focusing on the US equity portion of the Plan, Mr. Schurter noted that the Plan was inline with its asset class benchmark in the third quarter and that the trailing one, three-, five- and ten-year periods were all characterized by outperformance to the benchmark, with the since-inception return being in-line with the benchmark. For the third quarter, outperformance by Jacobs Levy and Systematic was offset by underperformance from Dodge & Cox and small cap equities. It was also noted that over all trailing periods the Plan s US equity portfolio has benefited from active management and ranked in the top 5% of peer group funds. Over the third quarter, the Plan s non-u.s equity portfolio matched the benchmark, but over the longer trailing one-, three-, five- and ten-year periods active management has delivered extra value over the benchmark. The Plan s total global equity portfolio underperformed its benchmark over the quarter and was behind over the one- and three- Page 4 of 8

5 year periods. Longer term, it has matched the benchmark over the five-year period and is marginally ahead since-inception. In core fixed income, active management detracted slightly from benchmark performance during the third quarter but over the longer periods it has been a source of value-add which is reflected in the portfolio ranking in the top quartile over the ten-year period. More recently, the 30% allocation to alternative fixed income (unconstrained bonds and bank loans) has muted portfolio performance. Comment was also made that the Plan s real estate portfolio has exhibited strong absolute performance over the last one-, three- and five-years but the longer term still contains the adverse impact of the value-added real estate exposure that underperformed during the real estate downturn. III. INVESTMENT CONSULTANT & STAFF A. Infrastructure Manager Search. Staff reported the progress made in the infrastructure manager search that culminated in a finals day held in SCERA s offices on November 9, A synopsis of the characteristics and qualifications of the three finalists was presented and discussed. The Board asked questions and there was a thorough deliberation regarding the candidates. Ultimately, the recommendation from Staff and Consultant was to engage IFM for the allocation. Motion was made by Trustee Tambe, seconded by Trustee Gossman to approve staff/consultant recommendation to engage IFM to manage the Plan s infrastructure allocation contingent upon the Plan s consultant confirming certain valuations in the GIF, staff s negotiation of acceptable legal terms, staff s evaluation and comfort with the diversification within the fund(s) and staff/consultant determination of an appropriate split in the allocation between the GIF, which is ex- Australia, and the firm s Australian Infrastructure Fund. The motion carried with voting as follows: AYES NAYS ABSTAIN ABSENT Mr. Gossman Mr. Rabbitt Mr. Jahn Mr. Sundstrom Mr. Pels Ms. Querijero Mr. Tambe Mr. Williams Mr. Williamson Page 5 of 8

6 B. Tactical Currency Management. Mr. Failor recapped the highlights from the presentation earlier in the year reviewing strategic or semi-permanent hedging of foreign currency exposure which concluded that SCERA s current practice of maintaining an unhedged stance remains an appropriate policy. The purpose of the latest presentation is to explore/review currency hedging from a tactical or short-term view. Adding to Mr. Failor s summary, Mr. Schurter informed the Committee that Aon will publish an updated research piece on currency hedging in the first quarter of 2016 but he did not expect any major changes in the views expressed in the previous discussion on strategic hedging. Mr. Schurter described the role of Aon s Medium Term Views (MTV) team which gives advice on asset allocation, including currency, with a one to three year view. The currency market periodically exhibits trending behavior which Aon believes can be exploited. Aon s current tactical (MTV) view points towards hedging some portion of foreign currency exposure back to the US dollar although much of the perceived rise in the US dollar has already occurred. Mr. Schurter then covered the practical aspects of currency hedging focusing, in particular, on costs and the impact on cash management. While they believe there remains some value in hedging back to the dollar Aon is not currently recommending SCERA tactically hedge its foreign currency exposure. Most plans do not have the time/resources to run a currency overlay program but there are firms, such as Parametric, who offer currency overlay services. Aon raised the topic because they do believe there is remaining value in hedging back to the dollar, though not the fat pitch that existed a couple of years ago, and because they wanted to vet the idea conceptually of taking-on tactical currency positions. Trustees expressed concern at being involved in selecting specific currency positions and any possible future solution should maintain the arms-length nature that is currently in place with existing portfolio managers. Staff and consultant agreed and confirmed that practical considerations would need to be addressed before SCERA would be in a position to capitalize if and when another fat pitch currency opportunity presents itself. C. RREEF America REIT III highlights of the wind-down process. Staff presented a summary of the progress made in winding-down the RREEF III fund. As of the third quarter of 2015, the Fund had twenty four investments left spread across eight metropolitan areas. The 2015 Strategic Plan called for $430 million of distributions in aggregate to shareholders and the first three quarters have yielded $340 million. The projections are to distribute another $140 million in the fourth quarter leaving a balance of $35 million. For SCERA, this remaining balance is a little over $1 million. The October 28, 2015 RREEF III Board meeting approved estimates of the final distribution and a cash reserve. On December 17, 2015 there is to be an Annual Shareholder meeting where the equity investors will have the opportunity to approve the plan of liquidation and dissolution. The final distribution payment and entity dissolution Page 6 of 8

7 will occur in December The Plan s investment consultant and staff were comfortable with and supportive of the plan to dissolve the fund and distribute funds. D. State Street Enhanced Custody Service update. This topic was moved to follow the break as it dovetailed with the Credit Suisse presentation. Mr. Failor updated the Board on the enhanced custody service offered by State Street which competes with prime brokerage and the feedback received from Jacobs Levy concerning past and future use of the service. Jacobs Levy is continuing its evaluation of the service and early next year should be able to share their view of the service based upon hard operating metrics. E. December Cash Raise. Staff notified the Board that they wished to raise cash in December to cover potential draw-downs for the Davidson & Kempner opportunistic investment, six months of expected retiree payroll and estimated operating expenses for the period. The cash raise was endorsed by the Board with the mechanics of the actual raise delegated to Staff. IV. COMMUNICATIONS A. Investment Benchmark Summary October It was noted that the total plan policy return for the month of October was a robust 5.2%. B. Staff Letter Reviewing the July 29, 2015 Due Diligence Meeting with IFM. C. Staff Letter Reviewing the July 29, 2015 Due Diligence Meeting with Credit Suisse. D. Financial Times, China s Great Game: Road to a new empire, October 13, E. The Economist, The Trust Machine, October 31, F. Business Insider, 20 Cognitive Biases..., September 22, V. GENERAL DISCUSSION MATTERS Opportunity to advise the Investment Committee of new matters and for Committee members to ask questions for clarification, provide information to staff, request staff to report back on a matter, or to direct staff to place a matter on a subsequent agenda. Page 7 of 8

8 VI. PUBLIC COMMENT Opportunity for public comment on non-agenda items within the jurisdiction of the Retirement Board. VII. NEXT MEETING Currently scheduled for Wednesday, December 16, 2015 at 8:30 a.m. in the SCERA Board Room located at 433 Aviation Boulevard, Suite 100, Santa Rosa, CA. Planned presentations for this meeting include a review by Reams. VIII. ADJOURNMENT The meeting was adjourned at 11:30 a.m. GREG JAHN, CHAIR Page 8 of 8