Institutional Investors: It's a Whole New World Tuesday, April 28, 2009 4:00 PM - 5:15 PM Moderator Liam Kennedy, Editor, Investment & Pensions Europe Speaker Christopher Ailman, Chief Investment Officer, California State Teachers' Retirement System Harold Bradley, Chief Investment Officer, Ewing Marion Kauffman Foundation Joseph Dear, Chief Investment Officer, California Public Employees' Retirement System Catherine Lynch, CEO and Chief Investment Officer, National Railroad Retirement Investment Trust Scott Minerd, Managing Partner, Guggenheim Partners; CEO and Chief Investment Officer, Guggenheim Partners Asset Management Inc. 1
Global equity index January 2005 = 100 280 240 Emerging markets 200 EU 160 120 80 40 Apr 06 Jul 06 Oct 06 Jan 07 Apr 07 Jul 07 World Oct 07 Jan 08 U.S. Apr 08 Jul 08 Oct 08 Jan 09 Apr 09 Source: Datastream. 2
Correlation of global stock markets with S&P 500 250-day rolling correlation 1 FTSE 100 DAX 30 0.5 0-0.5 Source: Datastream. Nikkei 225 MSCI Emerging Market 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 3
Stock market volatility Volatility is off its peak A rolling 100-day standard deviation of equity prices 5 4 S&P 500 MSCI Emerging Market DAX 30 FTSE 100 Nikkei 225 3 2 1 0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Note: The data is as of April 15, 2009; Source: Datastream. 4
Private equity activities slow globally Deal value announced (US$ millions) Fund raised (US$ millions) 2007 2008 2007 2008 United States 368,400 59,600 325,200 256,900 Western Europe 185,900 88,000 101,500 96,100 Asia 67,000 52,500 28,700 37,100 Middle East 898 1,700 5,000 6,400 Eastern Europe 27,900 8,000 14,600 5,400 Latin America 4,600 1,200 4,400 4,000 Africa 7,900 2,200 2,300 2,600 Total 662,598 213,200 481,700 408,500 Sources: Dow Jones, Dealogic. 5
Worldwide hedge fund assets drop by 40 percent since Q2 2008 US$ trillions 3.5 3.0 2.5 2.0 1.5 1.0 0.8 1.0 1.1 1.2 1.3 1.4 1.4 1.5 1.5 1.7 1.9 2.0 2.2 2.4 2.6 2.7 2.9 2.8 2.9 2.5 1.9 1.8 0.5 0.0 2004 2005 2006 2007 2008 2009 Sources: Hedgefund.net, The Milken Institute. 6
Hedge fund returns, different strategy Annualized return, January 1994 March 2009 Global macro Distressed Event driven Event-driven multi-strategy Multi-strategy Risk arbitrage Emerging markets Convertible arbitrage Equity market neutral Fixed income arbitrage Dedicated short bias All hedge funds -0.7% Sources: Bloomberg, The Milken Institute. 5.2% 3.6% 7.5% 7.1% 6.6% 5.9% 10.3% 9.4% 9.0% 8.6% 12.4% -5% 0% 5% 10% 15% Annualized return, March 2008 March 2009 Dedicated short bias 5.8% Risk arbitrage -3.3% Global macro -8.5% Event-driven multi-strategy -12.5% Event driven -15.1% Multi-strategy -17.6% Distressed -19.3% Convertible arbitrage -20.2% Fixed income arbitrage -21.2% Emerging markets -27.4% Equity market neutral -43.4% Hedge fund -16.7% -45% -30% -15% 0% 15% 7
Total returns of selected asset classes Crude Oil Emerging markets Hedge funds U.S. Treasuries Commodities Corporate bonds Small Cap High Yield S&P 500-3.0% Annualized return Q1 1998- Q1 2009 10.8% 9.7% 7.0% 6.2% 5.0% 4.4% 3.6% 3.5% Annualized return Q1 2008- Q1 2009 U.S. Treasuries -8.1% Corporate bonds High Yield -12.6% Hedge funds -16.7% Emerging markets -36.5% Small Cap -37.9% S&P 500-38.1% Commodities -56.5% Crude Oil -67.1% 7.2% -5% 0% 5% 10% 15% Sources: Bloomberg, Datastream, The Milken Institute. -100% -50% 0% 50% 8
Liam Kennedy s Slides 9
81% of (European) pension plans surveyed had raised risk management issues at board level in the 6-9 months to March 2009 What were the outcomes of your risk management discussions? Undertake asset allocation review; longevity risk management and real interest risk management reviews. Operational risk management procedures became more relevant. These were found to be adequate. We performed an ALM study that confirmed the current asset allocation. Source: Investment & Pensions Europe survey, March/April 2009 10
Are you confident that the models used by your asset and liability modeling (ALM) provider take into account current economic and financial market conditions? Source: Investment & Pensions Europe survey of pension funds, March/April 2009. 11
Overall, have consultants added value to your investment portfolio, taking their fees into account? Especially with manager searches they bring up external managers based on reputation and size. Like who gets fired for buying IBM?. We prefer boutiques. Source: Investment & Pensions Europe survey of pension funds, January 2009. 12
I expect my fund to invest in undervalued assets or investment classes in 2009 Source: Investment & Pensions Europe survey of pension funds, December 2008. 13
Over the four-year market cycle 2004-08 S&P 500 outperformed 71.9% of actively managed large cap funds S&P MidCap 400 outperformed 75.9% of mid cap funds S&P SmallCap 600 outperformed 85.5% of small cap funds Source: Standard & Poor s Index Versus Active Fund Scorecard (SPIVA), April 2009. 14
Harold Bradley s Slides 15
Hedge funds as an asset class survivorship bias: Many fund-of-funds stopped reporting in Q4 2008 1600 1500 1400 1300 1200 1100 1000 900 Source: HFRI database. Number of FOF Reporting to HFR 2007 Q4 2008 Q1 2008 Q2 2008 Q3 2008 Q4 16
Constituents for HFR fund of funds index Does anybody know the real returns and volatility? Number of index constituents Source: HFRI. 900 600 790 funds 675 funds 300 0 Q3 2008 Q4 2008 17
Hedge funds as an asset class: How did they perform? 0% HFRI FOF Composite 2008 Adjusted For Survivorship Bias -10% -20% -30% -21.3% -25.6% Assumption: funds that stopped reporting lost half their value on average. 18
Private equity performance by investor type (Funds between 1992 and 2001) S&P 500 Banks Funds-of-Funds Public Pensions Insurance Companies Private Pensions Endowments Source: Lerner, Schoar and Wang [2007]. -5% 0% 5% 10% 15% 20% Courtesy of Josh Lerner, HBS 19
Why do we pay GPs to get huge $2 billion fund $650 million fund $400 million in fees over the life of the fund GP Source: Andrew Metrick and Ayako Yasuda, The Economics of Private Equity Funds, the Wharton School, University of Pennsylvania, 2007 $130 million fees in fees plus $270 million in carried interest, if invested capital returns 3.1x 20
Using variable fee schedules for equity accounts Annual fee (bps) Fund A variable fee schedule 40 bps + 20%*ER, min 5, max 120 150 100 50 120 65 bps standard fixed fee 5 0-8% -6% -4% -2% 0% 2% 4% 6% 8% Excess return over benchmark 21
Using variable fee schedules for equity accounts Annual Fee (bps) Fund B variable fee schedule 40 bps + 15%*ER, min 20, max 120 150 120 100 50 75 bps standard fixed fee 20 0-8% -6% -4% -2% 0% 2% 4% 6% 8% Excess return over benchmark 22
Equity-oriented mutual funds net Inflows as a share average assets 2008 % 30 25 20 15 10 5 0 (5) (10) Actively-Managed Equities Indexed Equities Equity ETFs Lifecycle and Like Funds Source: Strategic Insight Simfund. Courtesy: Empirical Research 23
Further threats to street research the dependability of investor behavior Expected Dec. 31 Value Sources: Standard & Poor s, Compustat, EcoWin, FactSet, JPMorgan Asset Management.. 24
Share of general equity funds underperforming the S&P500 (1963 through 2008) % 100 90 80 70 60 50 40 30 20 10 0 63 6567 69 7173 75 7779 81 8385 Stocks are expensive 87 8991 93 9597 S&P 500 returns are negative 99 0103 05 07 Source: The Vanguard Group, Empirical Research Partners Analysis. 25
Joseph Dear s Slides 26
Risk managed absolute return strategies $5.9 Billion as of March 1, 2009 26 direct hedge fund investments - $4.6B (78%) 9 FoHFs with a niche focus - $1.3B (22%) FoHFs invest in Asian-focused hedge funds, European-focused hedge funds and emerging hedge funds Invest in funds that actively seek to add value in both the long & short portfolios Avoid beta funds, activists, acronym funds (ABL, ABS, CLO, CDO, etc.) Allocation to a maximum of 8% of total Global Equity portfolio 27
The three pillars of hedge fund governance Pillar 1: Alignment of Interests Fee structures that reward long-term performance, deter asset-gathering and encourage the development of institutional caliber businesses When our beneficiaries win, you win Pillar 2: Control of Assets Removes game theory of fund redemptions; eliminates gates, suspensions and side pockets; allows immediate termination of trading authority Without the return of capital there is no return on capital Pillar 3: Transparency of Risks and Exposures Builds on existing security-level transparency received from 90% of current hedge funds; improves ability to tailor portfolio-wide risk exposures; provides valuable trust but verify capability If you do not trust us with information, we cannot trust you with our capital 28
Risk management measures Leverage Determine aggregate debt across asset classes. For public equities aggregate at the benchmark level and for private assets at the investment company level Concentration Determine aggregate industry/factor exposures across asset classes Credit Risk Evaluate counterparty risk by monitoring trends in credit default swap spreads Liquidity Risk Assess by aggregating portfolios into liquidity categories. Bid/ask spread is one measure of liquidity Stress Testing Use the quantitative risk system to evaluate extreme market conditions Reputation Risk Safeguarding our reputation through disciplined communications, rigorous codes of conduct and thorough compliance monitoring. 29
Five principles for financial regulation reform: a model for change Transparency - Greater disclosure and transparency Independence - True regulatory independence Corporate Governance - An increased and effective shareowner voice in the capital markets Investment Opportunities - The preservation of institutional investors freedom to invest in the full. range of investment opportunities Systemic Risk - Earlier identification by regulators of issues that give rise to overall market risk that threaten global markets 30
CalPERS investment portfolio (as of April 14, 2009) Asset Class Market Value ($ in Billions) Actual (%) Target (%) Cash Equivalents Fixed Income $12.6 7.2% 0% Domestic 39.3 22.5 17 International 4.0 2.3 2 Equities Domestic 35.0 20.0 28 International 37.4 21.4 28 AIM (Private Equity) 22.9 13.1 10 Real Estate 19.5 11.1 10 Inflation Linked 4.3 2.4 5 Cash U.S. Equity Intl Equity U.S. Fixed Intl Fixed AIM Real Estate Inflation linked Total Fund $175.0 100% 100% 31
Only the desperate are selling? 19 venture partnerships Raised between 1995 and 2004 Cap weighted age of 10 years old (1999 vintage) Written down by 8% from cost to comply with FASB 157 Recently received a bid for 45 cents It s crazy to take a 55% loss right? 32
55% discount is consistent with public market -49% 33
Selling might make sense Illiquidity in private equity is poorly understood New accounting rules still are not fully capturing true value Everything is an opportunity cost trade Sell old venture capital at 45 cents Buy distressed real estate and credits at 20 cents? 34
Cumulative Index Returns 1800% 1600% 1400% S&P 500 and Private Equity Index Cumulative Returns 1200% 1000% 800% 600% 400% 200% 0% -200% Sep-88 Sep-89 Sep-90 Sep-91 Sep-92 Sep-93 Sep-94 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 S&P 500 with Dividends Reinvested Cambridge Associates US Private Equity End-to-End Index* Russell 2000 * Excludes venture capital finds. Source: Cambridge Associates, Bloomberg 35
Index Comparison Russell 2000 S&P 500 Private Equity* Average Annual Returns Standard Deviation of Returns 9.78% 11.60% 15.86% 20.08% 18.72% 13.92% Sharpe Ratio 0.34 0.46 0.91 Note: Risk free rate assumed to be 10 Year Treasury Note as of 4/23/09. * Excludes venture capital finds. Source: Cambridge Associates, Bloomberg 36
Build America Infrastructure Bonds Issuer University of Minnesota University of Virginia NJ Turnpike Authority Pricing Date Amount ($ in millions) Rating Category Spread to 30-Year Indicative Rate 4/15 $37.5 AA 255 6.35% 4/15 $250 AAA 255 6.35% 4/20 $1,300 A-Plus/A3 370 7.50% California 4/22 $5,000 A 365 7.45% NY MTA 4/23 $750 AA / A-Plus 350 7.30% Source: Thompson Reuters, The Bond Buyer, Guggenheim Partners 37