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) Investment Department To: Investment Committee From: Daniel L. Allen, Tony J. Lee, Kimberly K. Pollitt, CFA, and Lou Ann Fillingham, CPA Date: February 19, 2010 Re: Executive Summary of the Manager Development Program The SURS Manager Development Program (MDP), initiated in 2004, currently consists of thirteen managers across the U.S. equity, Non-U.S. equity, private equity, and fixed income asset classes. In the past year, one additional fixed income manager was added to the MDP while one passively managed equity portfolio was terminated from the program. The funds from the terminated passive equity manager were reallocated to three U.S. active equity MDP managers as part of a rebalancing effort to alleviate a growth bias within the portfolio. Taplin, Canida & Habacht, a fixed income manager, was reclassified out of the MDP when the firm was acquired by a non-minority entity. As of December 31, 2009, the Manager Development Program was valued at $384 million, representing 3.1% of the SURS Total Fund. The basic structure of the MDP is shown in the table below. Asset Class Domestic Equity # of Managers 6 12/31/09 Assets ($MM) $192 % of MDP 50% Fixed Income % Private Equity % Non-U.S. Equity % Total MDP 13 $ % SURS staff meets with MDP managers via quarterly conference calls as part of its regular due diligence process. In addition to these conference calls, staff regularly conducts in-person meetings as part of its efforts to facilitate interaction with the minority-, female-, and persons with a disability- owned investment manager community. In calendar year 2009, staff conducted 42 meetings with currently funded and prospective minority-, female-, and persons with a disability- owned investment management firms. A plan of expansion and increased diversification for the MDP was communicated in a memorandum presented at the March 2008 Investment Committee Meeting. This strategy was introduced to the current SURS Board at the September 2009 Investment Committee Meeting. The plan included increased funding to existing managers in the Non-U.S. and Active U.S. Equity asset classes for strong performance and the intent to conduct searches in multiple asset

2 classes (Non-U.S. Equity, Fixed Income, Real Estate, and U.S. Equity) to expand the program. Since that time, the Non-U.S. Equity, Fixed Income and Real Estate searches have been concluded. In the past year, the overall MDP outperformed its benchmark, returning 22.6% versus the benchmark return of 21.7%. Since inception, the program has slightly underperformed its benchmark return of 3.2% by 20 basis points. Risk-adjusted return charts for the U.S. active equity managers are shown at the end of this document. The Fixed Income managers in the program were reviewed at the February 2009 Investment Committee meeting and are not included in this MDP Executive Summary. In addition, the Muller & Monroe review was presented at the June 2009 Board Meeting as part of the overall Private Equity program review. Staff also provided a review of the Non-U.S. equity MDP managers at the October 2009 Investment Committee meeting as part of the overall International Equity program review. On the following page, a table lists the managers in the program along with their assets under management and performance since inception. The individual manager reviews follow this summary memorandum. Organizational Issues Listed below are organizational issues relating to investment managers in the SURS portfolio. Holland Capital Management closed a transaction on November 30, 2009, that completed the transfer of ownership from the firm s founder, Mr. Louis Holland to the current employee-owners, which include key employees of the firm. Mr. Holland previously controlled 90% ownership of the firm. The transaction resulted in broadening the equity ownership among staff. The firm is 100% employee-owned with the majority of the ownership in the hands of key employees who are minorities and/or female. Lombardia Capital Management added six new professionals while losing two in the past year. Andrew Absler, CPA, joined the firm in December 2009 as a Senior Research Analyst/Portfolio Manager on the small cap value product. Since January 2009, three additional investment professionals in the research area were hired including an analyst and two associates. One additional marketing professional has also been hired to the firm. Lombardia had one significant departure with the termination of Albert Chavez, Chief Operating Officer. Mr. Wendell Williams, Chief Compliance Officer for Lombardia, has assumed many of Mr. Chavez s former duties. NCM Capital Management had Ron Elmer, Healthcare Sector Leader, depart from the firm in January The firm is currently searching for Mr. Elmer s replacement. Additionally, Marc V. Reid, Head of Client Services, departed from the firm to pursue other opportunities. Profit Investment Management saw Jeannie Hsu, healthcare sector analyst, leave the firm in the past year to pursue other opportunities. There are no additional organizational issues.

3 Investment Performance Issues Since inception, the Active U.S. equity MDP portfolio has outperformed its blended benchmark by 60 basis points, returning 2.2%. The Total MDP has slightly underperformed its benchmark since inception, returning 3.0% versus a 3.2% benchmark return. The inclusion of the Private Equity asset class as well as slight underperformance by the Fixed Income segment of the program detracted from overall performance. However, all asset classes in the past year outperformed their respective blended benchmarks. While the performance of some managers was disappointing relative to their benchmarks, a number of managers have limited performance history. The following table shows each manager s performance relative to their benchmark for the one year and since inception time periods. SURS Manager Development Program Returns Investment Performance for Month Ended December 31, 2009 Manager Incep Benchmark Assets ($mil) 1YR Mgr 1YR Bmark Incep Mgr Incep Bmark TOTAL MDP Jan-05 Policy Portfolio % 21.7% 3.0% 3.2% U.S. Equity: Active Buford, Dickson, Harper & Sparrow Jun-05 Custom/Russell 2000 Grow th % 34.5% -0.5% 1.0% Channing Capital Mgmt Apr-05 Russell Midcap Value % 34.2% 1.6% 1.9% Holland Capital Mgmt Apr-05 Custom/Russell Midcap Grow th % 46.3% 3.1% 3.7% Lombardia Capital Partners Apr-05 Russell 2000 Value % 20.6% 4.3% 0.9% NCM Capital Mgmt Apr-05 Russell Midcap Growth % 46.3% 5.5% 2.9% Profit Investment Mgmt Apr-05 Russell % 27.2% 4.7% 1.7% TOTAL U.S. Equity Jan-05 Blended % 34.9% 2.2% 1.6% Non-U.S. Equity Ativo Capital Jul-08 MSCI ACWI Ex-U.S % 41.4% -7.4% -7.9% Atlanta Life Inv Advisors Aug-06 MSCI EAFE % 31.8% -0.1% -2.6% Strategic Global Advisors Aug-08 MSCI EAFE % 31.8% -7.1% -7.4% TOTAL Non-U.S. Equity Aug-06 Blended % 32.9% -0.3% -2.3% Private Equity Muller and Monroe ILPEFF Dec-04 DJ U.S. Total Stk Mkt + 5% % -21.4% -13.4% 4.1% Muller and Monroe MPEFF Mar-08 DJ U.S. Total Stk Mkt + 5% 8 NMF NMF NMF NMF TOTAL Private Equity Dec-04 DJ U.S. Total Stk Mkt + 5% % -21.4% -13.4% 4.1% Fixed Income Davis Hamilton Jackson Feb-09 Barclays Capital Aggregate % 7.3% 11.8% 7.3% Pugh Capital Mgmt Apr-06 Barclays Capital Aggregate % 5.9% 7.0% 6.2% Smith Graham & Company Apr-06 Barclays Capital Aggregate % 5.9% 5.9% 6.2% TOTAL Fixed Income Apr-06 Barclays Capital Aggregate % 5.9% 6.0% 6.2% Four of the six U.S. equity managers have underperformed their benchmarks in the past year. Additional comments on the four underperforming accounts are provided below. For a more detailed review, please see the individual manager reviews following this summary memorandum. Buford, Dickson, Harper & Sparrow (BDHS) lagged the benchmark by 1,951 basis points, with a return of 15.0% versus the benchmark return of 34.5%. High quality, low risk stocks detracted from the portfolio s performance over the past year.

4 Although BDHS exceeded the benchmark for the three-year period by 135 basis points, the portfolio lagged the benchmark since inception by 151 basis points. Channing Capital Management returned 30.7%, trailing the Russell Midcap Value benchmark return of 34.2% by 354 basis points. The 2009 underperformance was primarily the result of specific stock selections within the energy and industrial sectors that was partially offset by above benchmark performance of specific stock selections in the consumer discretionary and financial sectors. Over the past three years, Channing exceeded the benchmark return by 234 basis points. Since inception, Channing has underperformed the benchmark by 35 basis points annually, net of fees. Holland Capital Management significantly lagged its Russell Midcap Growth benchmark by 838 basis points in 2009, returning 37.9%. Stock selection within sectors detracted from performance in the past year, particularly in the consumer discretionary, technology, and producer durables sectors. The negative stock selection was partially offset by favorable sector allocation, primarily due to a sizeable overweight in the energy sector. Over the past three years, Holland exceeded its benchmark by 295 basis points. However, the weak relative performance in 2009 has negatively impacted the portfolio s long term return. Since inception, the Holland portfolio has returned 3.1%, net of fees, trailing the 3.7% benchmark return by 59 basis points. NCM Capital Management returned 45.5% during calendar year 2009 compared to the Russell Midcap Growth Index return of 46.3%. The primary drivers of NCM s underperformance during 2009 were poor stock selection within the consumer staples and health care sectors. The two sectors in aggregate contributed 364 basis points of negative performance in the past year. Despite the recent performance shortfall, NCM s since inception performance still compares favorably. Since inception, the portfolio has surpassed the benchmark by 260 basis points, returning 5.5%, net of fees, compared to the Russell Midcap Growth Index return of 2.9%. In addition to the comments above on the managers performance results, analytics charts outlining the performance are included following this memo. Performance attribution for the MDP is provided by Ennis Knupp & Associates. Proposed MDP Domestic Equity Search At the September 10, 2009 Investment Committee meeting, a work plan was proposed that tentatively slated, pending Board approval, the initiation of a search for domestic equity managers for the MDP in March This search was to follow the Treasury Inflation- Protected Securities (TIPS) search, authorized in December 2009 and scheduled to conclude at the March 10, 2010 Investment Committee Meeting. However, at the February 2010 Investment Committee Meeting, the Board authorized an extensive search to review the entire SURS fixed income portfolio. The search is currently ongoing. This search was not anticipated in the work plan presented in Due to the comprehensive scope of the fixed income search and the resulting utilization of staff resources, the MDP domestic equity search will begin after the completion of the fixed income search. Staff anticipates requesting authorization to conduct a domestic equity search at the June Investment Committee meeting. Recommendation The U.S. Equity asset class has outperformed its blended benchmark since inception as well as in the past year. A status update of the overall MDP Program will be presented at the June

5 Investment Committee Meeting. At this time, Staff is recommending retention of the existing U.S. Equity investment managers. SURS staff recommends the following: MDP U.S. Equity Portfolio: That Buford, Dickson, Harper & Sparrow be retained as a domestic equity manager. That Channing Capital Management be retained as a domestic equity manager. That Holland Capital Management be retained as a domestic equity manager. That Lombardia Capital Partners be retained as a domestic equity manager. That NCM Capital Management be retained as a domestic equity manager. That Profit Investment Management be retained as a domestic equity manager.

6 8 Total MDP Risk/Return (Annualized) January December Return 4 T-Bills Policy Benchmark Total MDP Risk 8 Active U.S. Equity MDP Risk/Return (Annualized) April December T-Bills Active U.S. Equity Return 2 0 Blended Index (2) (4) Risk

7 TOTAL FUND ATTRIBUTION ANALYSIS 1 YEAR ENDING 12/31/2009 U.S. Equity Private Equity Non-U.S. Equity 90 Fixed Income 116 Allocation Effect 0-38 Cash Flow Effect MDP TOTAL FUND ATTRIBUTION ANALYSIS 5 YEARS ENDING 12/31/2009 U.S. Equity Private Equity Non-U.S. Equity 16 Fixed Income 0-9 Allocation Effect -33 Cash Flow Effect -18 MDP

8 U.S. Equity Manager Attribution Analysis MANAGER ATTRIBUTION ANALYSIS 1 YEAR ENDING 12/31/ BDHS Channing -118 Holland Lombardia NCM Profit 313 Attucks Total U.S. Equity Cash Flow Effect MANAGER ATTRIBUTION ANALYSIS 5 YEARS ENDING 12/31/ BDHS Channing Holland Lombardia 57 NCM 23 Profit 31 Attucks 1 Cash Flow Effect Benchmark Effect Total U.S. Equity