SELECTING A STRATEGIC ASSET ALLOCATION San Diego County Employees Retirement Association April 2014 SEATTLE 206.622.3700 LOS ANGELES 310.297.1777 www.wurts.com
ACTIVITY TO DATE Asset / Liability Study Original Revised based on Board feedback Enterprise Risk Tolerance Assessment Response to Specific Questions from Board Retreat Education on trend strategies Impact of momentum within Risk Parity Updated mix proposal Additional Fee Analysis 2
THE CRITICAL IMPORTANCE OF RISK Risk is not the result of returns; it is the driver of returns You take the risk, then you get the return Risk comes first! General Rule of Thumb: Geometric Return ~ = Arithmetic Return x ½ Variance Portfolio A Arithmetic Return: 8% Standard Deviation: 0% Geometric Return: 8.0% Portfolio B Arithmetic Return: 8% Standard Deviation: 10% Geometric Return: 7.5% Portfolio C Arithmetic Return: 8% Standard Deviation: 20% Geometric Return: 6.0% $10 Billion Invested for 20 Years: $46.6 Billion $42.5 Billion $32.1 Billion 3
ASSESSING ENTERPRISE RISK TOLERANCE Enterprise Risk Tolerance is determined by measuring investor willingness and ability to assume risk Willingness Resolve Inconsistency Low Risk Moderate to High Risk Low to Moderate Risk Ability 4
DIVERSIFICATION OF RISKS SDCERA s Targets SDCERA s Risk Decomposition Liquid Alts/HFoF, 20% Private Equity/VC, 15% Large Cap US Equity, 10% International Large, 10% Emerging Markets, 5% High Yield Fixed Income, 5% 120% 100% 80% Real Estate, 10% Emerging Market Debt, 10% TIPS, 5% 60% 40% 66% Commodities, 5% 20% T Bills, 40% Asset-diversified, but 0% Rates Credit Equity Inflation Currency Hedge Fund/Other Risk diversified? Because many assets are inextricably tied to the risks embedded in global equity markets and that risk is greater than other types of risk, an MVO-constructed portfolio derives the majority of its risk from equities. Source: BarraOne Risk Analytics 5
RISK FACTOR DECOMPOSITION 120% Risk Contribution by Risk Factor 100% 80% 60% 25% 40% 66% 86% 84% 63% 61% 59% 20% 0% 20% Average Pension Permanent Portfolio Risk Parity Opt 1 Opt. 2 Revised Mix Rates Credit Equity Inflation Currency Hedge Fund/Other 6
DIVERSIFICATION OF ECONOMIC SENSITIVITY Low Growth Low Inflation Low Growth High Inflation High Growth Low Inflation High Growth High Inflation SDCERA Average Pension Permanent Portfolio Risk Parity Option 1 Option 2 Revised Mix Note: Based on historical risk and return. 7
TAIL-RISK ANALYSIS & STRESS TESTS Tail Risk Scenario Analysis Tail Risk Stress Tests 2009 2010 July January 2007 2009 Subprime Mortgage Meltdown (Oct. to Feb.) 2001 Dot com Slowdown Average Pension Risk Parity 10v Permanent Portfolio Option 1 Option 2 Revised Mix Commodity 20% USD +20% 1997 1999 Oil Price Decline Average Pension Risk Parity 10v Permanent Portfolio Option 1 Option 2 Revised Mix 1994 US Rate Hike 1992 1993 European Currency Crisis 1989 1990 Nikkei Stock Price Correction Global Equity 20% Global Credit Spreads +100 bps 1987 Market Crash (Oct. 14 to Oct. 19) 1972 1974 Oil Crisis (Dec. to Sep.) Global Interest Rate +200bps 40% 30% 20% 10% 0% 10% 20% 30% 40% 12% 10% 8% 6% 4% 2% 0% Analysis performed using BarraOne Risk Analytics. 8
STOCHASTIC MODELING: EMPLOYER CONTRIBUTIONS $1,400 10 Year Projections Employer Contributions Employer Contributions (Millions) $1,200 $1,000 $800 $600 $400 $200 $ Average Pension Risk Parity Permanent Portfolio Option 1 Option 2 Revised Mix 10 Year Projection Employer Contributions Average Pension Risk Parity Permanent Portfolio Option 1 Option 2 Revised Mix Worst Case Scenario $1,110,090,785 $1,088,950,590 $1,169,981,080 $1,131,486,004 $1,123,042,671 $1,128,407,450 $1,134,857,083 Median $485,049,508 $563,057,162 $463,698,505 $641,812,500 $473,997,141 $443,191,194 $438,467,970 Best Case Scenario* Normal Cost Normal Cost Normal Cost Normal Cost Normal Cost Normal Cost Normal Cost *SDCERA policy requires a minimum employer contribution equal to normal cost. For modeling purposes, we assumed Employee Contributions may go to $0. 9
STOCHASTIC MODELING: FUNDED RATIO 250 10 Year Projection Funded Ratio 200 Funded Ratio (%) 150 100 50 0 Average Pension Risk Parity Permanent Portfolio Option 1 Option 2 Revised Mix 10 Year Projection Funded Ratio (%) Average Pension Risk Parity Permanent Portfolio Option 1 Option 2 Revised Mix Best Case Scenario 189.39 165.26 230.46 151.28 185.81 193.60 197.62 Median 91.83 86.33 92.99 80.85 91.91 93.86 95.09 Worst Case Scenario 42.72 46.19 42.40 45.60 43.17 42.04 41.84 10
SDCERA POLICY VS. ALTERNATIVE PORTFOLIOS SDCERA Average Pension Risk Parity Permanent Portfolio Option 1 Option 2 Revised Mix CMA's (10 Yr) Large Cap US Equity 10.0 22.5 10.0 10.0 10.0 10.0 5.9 Small/Mid Cap US Equity 5.1 Total Domestic Equity 10.0 22.5 0.0 10.0 10.0 10.0 10.0 International Developed 10.0 22.5 10.0 7.0 7.0 7.0 8.3 Emerging Markets 5.0 5.0 3.0 3.0 3.0 10.1 Total Int'l Equity 15.0 22.5 0.0 15.0 10.0 10.0 10.0 Total Equity 25.0 45.0 0.0 25.0 20.0 20.0 20.0 US Core Fixed Income 35.0 25.0 10.0 5.0 5.0 4.1 High Yield Fixed Income 5.0 5.0 5.0 5.0 4.4 Emerging Market Debt 10.0 5.0 5.0 5.0 6.6 TIPS 5.0 3.1 US Treasuries 40.0 3.0 Total Fixed Income 60.0 35.0 0.0 25.0 20.0 15.0 15.0 Commodities 5.0 5.0 5.0 5.0 5.0 4.5 Gold 25.0 5.0 Real Estate 10.0 5.0 10.0 10.0 10.0 6.5 Total Real Assets 15.0 10.0 0.0 25.0 15.0 15.0 15.0 Liquid Alts/HFoF 20.0 5.0 15.0 15.0 10.0 6.6 Private Equity/VC 15.0 5.0 15.0 15.0 15.0 8.1 Private Credit 5.0 5.0 5.0 6.6 Total Non-Public Investments 35.0 10.0 0.0 0.0 35.0 35.0 30.0 Cash -35.0 0.0 25.0 2.5 Risk Parity (10 Vol) 100.0 7.1 Risk Parity (15 Vol) 10.0 15.0 20.0 10.7 Total Allocation 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Forecasted Return 7.3% 6.4% 7.1% 5.3% 7.4% 7.7% 7.9% Standard Deviation 9.0 8.6 10.0 7.4 9.1 9.6 9.7 Sharpe Ratio 0.53 0.45 0.46 0.38 0.54 0.54 0.56 Sharpe Ratio assumes a Cash Return of 2.5% from Wurts 2014 CMAs Natural Resources has been modeled as 50% Commodities and 50% Private Equity The Risk Parity component of the Mixes utilizes a 15 Volatility Risk Parity sleeve 11
RECOMMENDATION & NEXT STEPS Original Recommendation We originally recommended Mix 2 for the following primary reasons: Good fit with enterprise risk tolerance Favorable economic and risk diversification (which should mitigate tail risk and drawdown severity) Modestly favorable expected outcomes in key metrics (contributions and funded ratio) Updated Recommendation We remain in favor of Mix 2 for reasons stated above We also approve of the Revised Mix should the Board be interested in increasing the Risk Parity allocation, primarily due to: Additional intuitive economic and risk factor diversification Lower implementation cost Next Steps Once the Board selects an asset mix, next steps include: Selecting an implementation framework Revising the IPS Updating the Risk Dashboard Migrating the portfolio to the approved allocation 12