SONOMA COUNTY EMPLOYEES RETIREMENT ASSOCIATION INVESTMENT COMMITTEE MEETING MINUTES

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1 Wednesday, 8:31 a.m. INVESTMENT COMMITTEE MEETING MINUTES Presiding: Present: Also present: Absent: Vice Chair David Sundstrom presided. Trustees Neil Baker, Michael Gossman, John Pels, Christel Querijero, Joe Tambe, Brian Williams and Bob Williamson, Administrator Julie Wyne, Senior Investment Officer Jim Failor, Assistant Retirement Administrator Kelly Jenkins and Investment Analyst II Stephen Marsh. Executive Vice President Tony Docal and Vice President Bill Deakyne of Templeton, Partner John Lee and Senior Consultant Shane Schurter of Aon Hewitt Investment Consulting (Aon) and retirees Jim Scriven and David Wallace. Trustees Greg Jahn and David Rabbitt I. ELECTION OF OFFICERS The committee will select a Chair and Vice Chair by majority vote of the members. Motion was made by Trustee Gossman, seconded by Trustee Williamson to select Greg Jahn as Committee Chair and David Sundstrom as Committee Vice Chair. The motion carried With voting as follows: AYES NAYS ABSTAIN ABSENT Mr. Gossman Mr. Jahn Mr. Pels Mr. Rabbitt Ms. Querijero Mr. Sundstrom Mr. Tambe Mr. Williams Mr. Williamson II. MINUTES APPROVAL Approval of December 10, 2014 Minutes. Motion was made by Trustee Gossman, seconded by Trustee Williamson to approve the December 10, 2014 minutes. The motion carried With voting as follows: Page 1 of 8

2 AYES NAYS ABSTAIN ABSENT Mr. Gossman Mr. Tambe Mr. Jahn Mr. Pels Mr. Rabbitt Ms. Querijero Mr. Sundstrom Mr. Williams Mr. Williamson III. PRESENTATIONS A. Ceremonial Swearing-in of Appointed and Elected Trustees - Assistant Registrar of Voters Gloria Colter conducted a swearing-in for Trustee John Pels (elected to the term of the 8 th position by retired members) and a ceremonial swearing-in for Trustees Christel Querijero (elected to the term of the 3 rd position by active general members), Neil Baker (elected to the term of the 8 th Alt position by retired members) and Joe Tambe (appointed to the term of the 9 th position by the Board of Supervisors). The terms for these Trustees are from 01/01/15 to 12/31/17. B. Templeton Executive Vice President Tony Docal and Vice President Bill Deakyne presented an update on the organization as well as the positioning and performance of the non-us and global equity portfolios the firm manages for SCERA. Mr. Deakyne prefaced the investment section by providing an organizational update noting that the global equity group at Franklin Templeton Investments consists of thirty eight people located in seven offices that are based in financial centers around the world. The average tenure in finance is eighteen years with the average tenure at Templeton being thirteen years. The global equity group comprises one investment sleeve of Franklin Templeton which is divided into groups based on the investment specialty. Staffing within the global equity group has been stable with only one senior departure. That person was a portfolio manager who at the time of his departure had no specific sector coverage, and hence, no direct impact on Sonoma s portfolios or the investment process. Introducing Mr. Tony Docal, Mr. Deakyne noted that Tony had joined Templeton in 2001 and that he had recently given up his specific analyst work in the chemical sector to assume the role of deputy director of research assisting director of research Heather Arnold in her duties. Switching to portfolio performance and positioning, Mr. Docal commented that 2014 was a year of two halves. The first half displayed early optimism that economic fundamentals were returning while the second half saw retrenchment as the focus shifted to macro events and global instability. The two main macro drivers of performance were the decline in the price of oil and uncertainty in Europe. The latter driver was especially important for the benchmark-relative performance of the Page 2 of 8

3 Templeton portfolios due to their overweight exposure to Europe. In Mr. Docal s view, Europe has come a very long way in the last two years with the key question still being has systemic risk been reduced? The European Central Bank (ECB) in its latest review of the banking system reported that most European banks were well capitalized. Effectively, Europe has been in a recession for six years and not all the restructuring that needs to be done has been done, notably in the two large economies of France and Italy. Valuation measures remain attractive in Europe which compares well to the United States where valuations are back to 2007 levels. The dramatic fall in energy prices is having a major impact and, as a result, Templeton began taking a hard look at their energy and bank holdings in November. There is an old adage that says the cure for a low oil price is a low oil price. In Templeton s view, production volumes will decline in the second half of 2016 and oil prices should settle somewhere in the range of $90. These kinds of economic dislocations can provide opportunities and Templeton has been selectively adding to their energy holdings. Mr. Docal went on to recount the Templeton investment philosophy highlighting the three principles of value, patience and bottom-up stock picking. Templeton uses a fiveyear horizon for estimating and analyzing future earnings, seeking to uncover companies that are trading at a discount to their business value. Bottom-up stock picking means that the portfolios are built from the bottom-up and that any resulting aggregated exposure to currency, country, industry or sector is a residual of the stock selection process as opposed to a reflection of a particular top-down view. This means that the portfolios are agnostic to the benchmark. The portfolios are not completely untrammeled as there is a risk framework applied which sets limits on sector exposures and ensures that client guidelines are adhered to. The bottom-up process starts with each analyst maintaining a list of stocks they have modeled and are on their radar screen. The analysts are organized globally by sector with each sector having a team lead. The sector teams meet monthly to review and debate the stocks on their radar screen. Although the decision to put a stock in the portfolio rests with the portfolio manager, the analysts have a major role at Templeton. They provide indications when a position should be added to or trimmed and are the stock advocates who promote the stocks to membership of the Bargain list which drives a Templeton portfolio. To obtain small cap exposure, SCERA has authorized the manager to allocate funds to the Templeton International Smaller Companies Fund (a commingled fund). The allocation to the Fund is somewhat static and will generally move only following periods of extreme price movements. The Smaller Companies Fund is currently subject to a soft close which means it is only open to existing investors. Shifting to investment performance, Mr. Docal noted that 2014 was disappointing relative to its benchmark but that over the longer three, five and since inception periods Page 3 of 8

4 performance has been well ahead of benchmark. Key drivers behind the 2014 relative performance for the global portfolio was the heavier than benchmark commitment to Europe (a low return area) and the converse lighter commitment to the US (an area of stronger performance). Returns outside the US were adversely impacted by the strengthening US Dollar. In addition, stock selection within the Energy and Consumer Staple sectors also detracted from performance. Finance is the largest sector within the Index and the portfolio has a slightly higher than index weighting. The return in Finance was below the index sector return due mainly to the emphasis on European financials. The influences impacting the relative performance of the non-us equity portfolio were similar but without the large Europe vs US factor. Commenting on current portfolio positioning, Mr. Docal noted that the light US & heavy in Europe theme is still in play. In addition, two of the ten largest individual holdings are Chinese companies resulting in the portfolios having more than twice the index exposure to China (5.6% versus 2.3%). Within Europe, the ECB has joined the race to the bottom and weakened the Euro. However, the Templeton portfolios tend to hold European companies whose revenue stream is globally diversified and should benefit from both the weaker Euro and lower energy prices. C. Mr. Docal presented a review of the auto sector from the Templeton perspective. He began by commenting that he used to cover the auto sector and that when Gary Motyl handed the sector off to him many years ago he was warned that the sector is highly cyclical, highly competitive, interest rate sensitive and has very high research and development costs. Furthermore, it is very personal to people because, outside of their home, it is typically a person s largest purchase. Commenting on vehicle ownership in general, Mr. Docal noted that vehicle use is linearly correlated with per capita GDP and that, looking ahead, the growth in the global auto fleet is likely to come from non- OECD countries, notably China. In terms of events that impact the industry Mr. Docal cited California that has set a 2025 target of 15% of vehicles not powered by the internal combustion engines. Electric cars are still a very small subset of the market which has exhibited negative growth. Electric-only vehicles are still hampered by the lack of progress in achieving cheap and efficient batteries. Given the insufficient progress in battery technology he believes hybrid technology will be important for years to come. Toyota and Honda in Japan are busy pursuing fuel cells as a route towards zero emission vehicles. It was also noted that the auto companies are close to achieving self-driving cars which could have a major impact on urban commuting. Urban users are also moving towards vehicle sharing and the use of services such as Uber. Mr. Docal concluded by working through a summary analysis of one of the world s largest auto manufacturers. Page 4 of 8

5 IV. INVESTEMENT CONSULTANT & STAFF A. Investment Project Plans for Staff presented a high level draft of the plans for investment projects for the year which included a quarter-by-quarter schedule of projects. No revisions were suggested to the topics or scheduling contained within the plan. B. December 2014 Infrastructure Presentation follow-up. Staff recapped the impetus to study infrastructure which came from a Suggestion in the asset liability study held last year to consider adding infrastructure for an incremental impact on risk/return. Aon consultant Dan Kim presented to the Board in December and consensus was that it had been a worthwhile presentation. Given that the Board has several new members, it was suggested that we revisit infrastructure in February but not necessarily the full blown presentation given by Mr. Kim. Depending on the interest level and feedback, Staff indicated that a follow up step could be to arrange for an industry practitioner to make a general presentation on the asset class. C. Risk Philosophy Statement for the Investment Policy Statement. A follow-up item from the planning session was to consider the inclusion of a risk philosophy section in the Investment Policy Statement. Staff drafted such a statement which was provided to the Committee as a redlined draft. After some initial debate it was agreed to hold over the discussion to the following month when absent members could contribute. There was a trustee comment on the Plan s long time horizon and its impact on performance measurement which will be addressed in the redline version presented at the February Investment Committee meeting. D. Unconstrained Bond Manager Search update. Francois Otieno of Aon Hewitt joined the meeting by conference call. Mr. Failor prefaced Mr. Otieno s presentation by reviewing the selection process which whittled the list of candidates down to a small list of four finalists. Mr. Otieno then provided a brief synopsis of those managers that formed the initial Aon & Staff recommended manager list and the reasons why some contenders were dropped. He concluded by providing extra color on the four firms chosen as finalists. E. Novarca Cost Management Service. At SCERA s 2014 Planning Session Dr. Ashby Monk spoke on the topic of costs and fees within the investment industry. As a follow-up to his presentation, Staff Page 5 of 8

6 approached Dr. Monk for ideas to contain costs for a fund of SCERA s size. Dr. Monk works with very large funds but he disclosed that he has a financial interest in a Swiss firm called Novarca which may be able to help a fund like SCERA. Essentially Novarca negotiates on the client s behalf with service providers and if they produce any savings they are paid a share of that savings over a two year period. SCERA already works with Aon to contain the Plan s fees and it may be that there is no further saving available. Following discussion it was felt that as there would be no direct cost if no savings were obtained and there is the possibility they could reduce Plan expenses, we should research this option further. Mr. Failor reported that staff planned to raise the topic at the upcoming CALAPRS Investment Officer Roundtable and they would report back at the February Investment Committee meeting. F. Guggenheim Loan Fund. Mr. Failor reviewed the history of the relationship with Guggenheim and how SCERA had worked with Guggenheim to create a US fund as opposed to the Cayman Islands fund which was available at the time. SCERA became the seed investor in the new US domiciled fund by investing $60 million. Although the fund has grown to approximately $250 million Guggenheim would like to change the fund to feed into a master fund domiciled in the Cayman Islands. Guggenheim is restructuring a series of funds into this kind of master-feeder structure. Given SCERA s aversion to a Cayman Island structure Staff requested that Guggenheim make an exception to their account minimum and allow SCERA to spin-out a slice of the commingled fund s assets into a segregated account. Given the history and SCERA s support of the product Guggenheim was agreeable to the suggestion. A segregated account is SCERA s preferred option and the assets will be custodied at SCERA s custodial bank, State Street. Because of the specialized nature of bank loans and bank loan valuations the custody will be handled by a specialized team at State Street and it will entail additional custody charges in the range of $40-$50 thousand per annum. The custody and admin charges of the existing commingled fund vehicle have been running higher than this. The plan will be to take a slice of the current portfolio over to the new segregated account which will avoid incurring transaction costs. Staff is currently working with Guggenheim to establish an investment management agreement. SCERA hopes to make the transition to the separately managed account by the end of March. G. February Cash Raise. Mr. Marsh presented a plan to raise cash to cover Plan expenses for several months and carry the Fund to July when it normally receives the County s annual contribution. The Page 6 of 8

7 cash raised will be overlaid by Parametric (Clifton), the Plan s overlay manager, to maintain market exposure. As per our policy, the cash will be raised from those asset classes whose weighting is the furthest above their policy targets which currently appears to be in US large cap equities. The plan also includes a small trim from Real Estate which had very strong absolute and relative performance in H. PIMCO on Watch monthly reporting highlights. Mr. Otieno noted that Aon continues to monitor PIMCO very closely. He also commented that annual staff bonuses were recently paid-out and so this is a time when we could see additional departures. PIMCO has historically experienced 6%-8% turnover per year and Aon does not expect a reduction in this rate. On the retail side of their business they continue to lose assets and although the levels of outflows have subsided they are still positive. SCERA s Core Plus mandate falls under PIMCO s Total Return Strategy which is the flagship product on which their reputation is built. Aon moved their rating for this strategy from a Buy to a Hold last fall and it remains there today. Aon has no major concerns at this point but they will continue to monitor the flow of funds and the stability of the team. It was noted that the portfolio managers are very talented at PIMCO and the leadership on the Total Return strategy has now been working together as a reconstituted team for four months. Aon is looking for a prolonged period of performance improvement and proof that the team works together harmoniously. Mr. Otieno did not anticipate any change in rating over the next few months. V. COMMUNICATIONS A. Investment Benchmark Summary December B. Hewitt EnnisKnupp Announcement Regarding Name Change, December 15, C. Parametric Clifton Announcement Regarding Name Change, December 31, D. Bloomberg, December Employment Gain Caps Best Year for U.S. Since 1999, January 9, E. The Wall Street Journal, 2014 Year in Review: The Events That Shaped a Turbulent Year, December 30, VI. 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 Page 7 of 8

8 matter, or to direct staff to place a matter on a subsequent agenda. VII. VIII. PUBLIC COMMENT NEXT MEETING Currently scheduled for Wednesday, February 18, 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 GMO. IX. ADJOURNMENT The meeting was adjourned at 11:32 a.m. GREG JAHN, CHAIR Page 8 of 8