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 Lou Ann Fillingham, CPA Date: May 31, 2012 Re: June 2012 Investment Manager Watch List Investment Department Summary The Investment Manager Watch List for June 2012 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 2012 Watch List SURS Investment Manager Watch List June 2012 U.S. Equity Managers on Watch List for Performance Investment Manager On Watch Since Benchmark Channing Capital Management Jun-12 Russell Midcap Value Holland Capital Management Dec-11 Russell Midcap Growth * Non-U.S. Equity Managers on Watch List for Performance Investment Manager On Watch Since Benchmark Martin Currie Inc. Jun-10 MSCI ACWI x-us * Benchmark through March 2007 was Russell Midcap Core. Since April 2007, Russell Midcap Growth has been manager's benchmark 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: 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.

2 Performance for the watch list managers is displayed on the table that follows, along with a complete explanation of performance. Watch List Managers As of March 31, 2012 Manager Incep $ millions 3 YR Mgr 3 YR Bmark Under Perform Prior 3 Yr Mgr Prior 3 Yr Bmark Under Perform Channing Capital Management Apr % 29.2% -5.9% 14.4% 18.2% -3.8% Holland Capital Management Apr % 29.2% -3.9% 19.0% 22.1% -3.1% Martin Currie Jul % 19.1% -3.2% 8.4% 10.7% -2.3% Holland Capital Management was added to the watch list in December 2011 due to below benchmark performance in the Mid Cap Growth U.S. Equity mandate. The Holland Capital Management portfolio performed well on a relative basis during the year ending March 31, 2012, exceeding the return of the benchmark index by 191 basis points. However, because the Holland portfolio lagged the benchmark by a wide margin in both calendar years 2009 and 2010, the portfolio s three-year return lags the benchmark by 385 basis points. Holland s emphasis on high quality stocks was detrimental during the time period as lower quality stocks generally outperformed. For the five-year period, the Holland portfolio has exceeded the benchmark by 139 basis points but lags the benchmark since inception by 99 basis points. Martin Currie has been on the watch list since June 2010 due to below benchmark performance in the Non-U.S. Equity mandate. For the three-year period ending March 31, 2012, the Martin Currie portfolio returned 15.89%, underperforming the MSCI ACWI ex-us benchmark return of 19.12%. Short term performance has improved. For the one-year period ending March 31, 2012, the Martin Currie portfolio returned -5.20%, exceeding the MSCI ACWI ex-us benchmark return of -7.17% by 197 basis points. Underperformance over the past three years has been primarily due to market conditions that were not favorable to their investment style. Martin Currie constructs the portfolio using a bottom-up fundamental driven approach that focuses on quality, value, growth, and change characteristics. During periods of extreme volatility, such as during the market collapse of 2008 and early 2009, the portfolio struggled and underperformed the benchmark. The portfolio also struggled during the market recovery of 2009 and early 2010 as lower quality stocks rallied. In addition to performance issues, Martin Currie has experienced organizational issues as well. Martin Currie announced in July 2011 changes to their joint venture in China. The changes resulted in their joint venture partner, Heartland Capital Management, exercising their right to acquire Martin Currie s interest in the Chinese joint venture partnership. Subsequently, in September 2011 Martin Currie announced a partnership with APS Asset Management, a Singapore-based Asia Pacific equity management firm. The partnership allows APS to leverage Martin Currie s distribution platform and client service capabilities, as well as commence portfolio management for Martin Currie s clients, effective November 1, In May 2012, Martin Currie announced that the firm had reached settlement agreements with the Financial Services Authority and Securities and Exchange Commission relating to a previous investment in a series of unlisted bonds, not

3 relating to the SURS account. Also in May 2012, Martin Currie announced a recapitalization of their business. The existing external shareholders, Crestview Advisors and RIT Capital Partners, increased their ownership percentages, thereby diluting Martin Currie s ownership percentage. Martin Currie now has a 44% voting interest, down from 75.1%. The SURS Board of Trustees approved a $200 million reduction to Martin Currie s funding at the October 2010 meeting. In addition, Martin Currie received a reduction of $83 million in November 2011 as a result of rebalancing SURS International portfolio. Staff met with representatives from Martin Currie in July 2011 and March 2012 in their New York offices, and again in November 2011 in Champaign. In addition, conference calls were conducted in April 2011, January 2012 and May 2012 to discuss the portfolio and the organization. Staff will continue to monitor the performance and organizational issues at Martin Currie. New Additions to Watch List Channing Capital Management experienced strong relative performance in calendar years 2007 and 2008, achieving 400 and 384 basis points, respectively, in excess of the benchmark return. Performance results were disappointing in each of the three succeeding calendar years, trailing the benchmark by 354, 654 and 177 basis points. The portfolio s emphasis on high quality stocks was detrimental in the strong equity markets during of that timeframe as lower quality stocks generally outperformed. Channing s relative underperformance in 2011 was primarily attributable to specific stock selections in the utilities, financials, and consumer staples sectors, while holdings in the information technology, energy and materials sectors outperformed. Since inception on March 31, 2005, the portfolio has annually provided 108 basis points of excess return, net of fees, versus the benchmark. Staff conducts quarterly conference calls with managers in the Manager Diversity Program. Staff plans to schedule an on-site meeting in the near future with each manager on the watch list to review the portfolio and discuss performance issues. Staff will continue to closely monitor the performance of the portfolios managed by firms on the watch list. Organizational Concerns No managers are currently on the watch list for organizational concerns. 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 CBRE Clarion Securities REITs Acquisition transition successful GlobeFlex Capital International Equity Performance improvement Taplin Canida & Habacht Fixed Income Acquisition transition and staffing changes successful CBRE Clarion Securities, formerly ING Clarion Real Estate Securities, currently manages U.S. and global Real Estate Investment Trust (REIT) accounts for SURS. On July 1, 2011, ING Clarion s parent company, ING Group, finalized the sale of ING Clarion Real Estate Securities to CB Richard Ellis Group, Inc (NYSE: CBG). CB Richard Ellis is a commercial real estate services

4 company, with approximately 31,000 employees in developed and emerging markets, and over 400 professionals involved in real estate market research. After the close of the transaction, ING Clarion merged with CBRE Investors, an independently operated business unit of CB Richard Ellis. At the close of the transaction, the firm name changed to CBRE Clarion Securities. CBRE Clarion Securities is majority owned by CB Richard Ellis and minority owned by employees on its own senior management team. Senior management of CBRE Clarion Securities has an equity stake in the new firm of approximately 23%. All staff and functions within CBRE Clarion Real Estate Securities remained the same. Portfolio management, client service, marketing, and all operational staff continued in their same roles in the firm s offices globally. Since being added to the watch list, SURS staff conducted in-person meetings with CBRE Clarion professionals in July and November SURS staff believes CBRE Clarion has adequately addressed its concerns regarding the acquisition of the firm by CB Richard Ellis Group, Inc. GlobeFlex Capital was removed from the watch list due to a change in their investment mandate. Staff and Callan thought it best to reset investment performance in order to develop an accurate assessment of the new strategy. Since inception of the new strategy in December 2011, GlobeFlex has outperformed the index, returning 10.5% versus 10.0%. 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 closed on July 5, 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, 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. In addition, Corey Amon, formerly Director of Research at TCH, left the firm in October 2011 for personal reasons. This departure is concerning because Mr. Amon was previously scheduled to move onto the portfolio management team to join Tere Alvarez Canida, Bill Canida and Alan Habacht. Scott Kimball, CFA, was also scheduled to make the move and did so as planned. Janelle Woodward, CFA, was promoted to the position of Director of Research. Ms. Woodward has been with TCH for over four years with ten years of professional experience. In addition, Eduardo Simpson, CFA, joined the research team. Mr. Simpson has 12 years of investment experience. SURS staff monitored the organizational developments at TCH and met with representatives from the firm in February and May SURS staff believes TCH has adequately addressed its concerns regarding the sale of the firm s parent company to the Bank of Montreal and the changes to the portfolio management team.

5 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. Circumstances under which the Investment Committee may elect to terminate an investment manager not on a watch list may also arise.

6 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.