October 4, 2012 BOARD MATTER NO. D-3 ACTION: AUTHORITY: Hiring Fixed Income Investment Managers W.S. 9-4-718(a)(iv) ANALYSIS: The State issued requests for proposal on behalf of the State Treasurer in June 2012 to provide fixed income investment management services in four strategies: Core (RFP 0485- V), Credit (RFP 0486-V), Emerging Market Debt (RFP 0487-V), and TIPS - Treasury Inflation Protected Securities (RFP 0488-V). Responses were due July 11, 2012. The Treasurer received 43 responses: 12 Core, 12 Credit, 9 Emerging market, and 10 TIPS. The Treasurer, Treasurer's staff and R.V. Kuhns & Associates, investment advisor to the State Loan and Investment Board, reviewed responses. Sixteen firms were interviewed in Cheyenne August 21-23, 2012 by the Treasurer and staff, representatives of SLIB members and R.V. Kuhns. The attached memo from R.V. Kuhns & Associates details the process. Eleven managers are recommended for hire: Core CS McKee, L.P. JP Morgan Asset Management MacKay Shields LLC Neuberger Berman Group LLC Pacific Investment Management Company Wells Capital Management, Inc. Credit Neuberger Berman Group LLC Seix Investment Advisors LLC Emerging Markets Investec Asset Management Stone Harbor Investment Partners LP TIPS State Street Global Advisors Josh Kevan and Matthias Bauer of R.V. Kuhns & Associates will be present to respond to questions from the Board. DIRECTOR'S RECOMMENDATION: The State Treasurer recommends that the Board hire CS McKee, L.P., JP Morgan Asset Management, MacKay Shields LLC, Neuberger Berman Group LLC, Pacific Investment Management Company, Wells Capital Management, Inc. to manage core fixed income; Neuberger Berman Group, LLC and Seix Investment Advisors LLC to manage credit fixed income; Investec Asset Management and Stone Harbor Investment Partners LP to manage emerging market fixed income; and State Street Global Advisors to manage TIPS; conditioned upon successful contract negotiations with each. BOARD ACTION:
MEMORANDUM To: Wyoming State Loan and Investment Board From: R.V. Kuhns & Associates, Inc. ( RVK ) Subject: Wyoming Fixed Income Portfolio Structure Study and RFP Process Memo Date: October 4, 2012 The purpose of this memo is to summarize Wyoming s Fixed Income Portfolio Structure Study, outline the process to date of the Active Fixed Income search (0485-V through 0488-V), and provide a recommendation on the slate of fixed income managers for Wyoming. Recommendation Summary As detailed in this memo, RVK recommends that the State Loan and Investment Board (SLIB) approve the following fixed income portfolio structure and selection of external managers: Structure Summary Core Fixed Income ( Core ): 70% Treasury Inflation Protected Securities ( TIPS ): 8% Credit (Investment Grade/ High Yield/ Bank Loans): 10% Emerging Markets Debt Local Currency ( EMD LC ): 5% Internal Portfolio (Government Securities): 4% Opportunistic Fixed Income: 3% Manager Summary 6 Core Managers CS McKee, L.P. J.P. Morgan Asset Management MacKay Shields LLC Neuberger Berman Group LLC Pacific Investment Management Company ( PIMCO ) Wells Capital Management, Inc. 1 TIPS Manager State Street Global Advisors (passively managed) 2 Credit Managers Neuberger Berman Group LLC Seix Investment Advisors LLC 2 EMD LC Managers Investec Asset Management Stone Harbor Investment Partners LP 1
Rationale and Key Benefits: Higher expected returns o Expected excess returns (above the broad fixed income market) for the new structure improve from 20 bps net of fees to 37 bps net of fees. Similar to lower expected risk o Expected volatility of returns of new structure expected to be slightly lower than current structure, partially driven by modest decline in expected duration and maintenance of a similar average credit quality. Improved Diversification o While maintaining an overall conservative posture, the introduction of asset classes such as TIPS, EMD LC, and floating rate bank loans add additional diversification and should help to improve returns in an environment that may be characterized by structurally higher levels of future inflation, rising interest rates, and a weaker US dollar. Simpler and more streamlined structure o Replaces the current structure in which the core allocation is divided amongst several unique mandates (MBS and investment grade credit) in order to complement a relatively large internally managed government portfolio with a core-satellite structure that consolidates the core segments and separates out specialist satellite managers results in a more streamlined approach. The resulting structure can also be implemented with significantly lower levels of derivative usage. Fixed Income Portfolio Structure Study The Wyoming State Treasurer s Office and RVK jointly set out to determine an optimal structure that best meets the State s fixed income portfolio needs over the next 5 years and subsequent process for implementation. The Wyoming fixed income portfolio structure has undergone past iterations of diversification improvements. One of the primary objectives in 2005/2006 was to diversify away from a portfolio that was heavily dominated by internally managed government securities consisting primarily of callable agency debt. This process has provided additional return, additional diversification benefits to the portfolio and reduced the volatility or variability of the fixed income portfolio s returns relative to the benchmark. Since the initial structure work for improved diversification was completed in 2006 the investment environment for fixed income has changed significantly. Interest rates have fallen to historic lows, massive amounts of liquidity have been injected into the world financial system through central bank intervention and a significant shift appears to be underway in global growth leadership from aging and over-levered developed economies to developing nations. All of these aforementioned considerations influenced the proposed fixed income portfolio structure. In addition, objectives and constraints that have and will continue to be of great importance to the State were closely considered throughout this process. Potential fixed income strategies were analyzed with a steadfast focus on the key fixed income attributes of safety, liquidity, and protection of capital. Additional objectives and considerations included: 1. Protect the portfolio from a potential environment characterized by rising interest rates and inflation. 2
2. Deflation risk remains a primary concern for Wyoming given its exposure to natural resource prices. 3. Income is important, and by association large realized losses should be avoided. 4. Minimize idiosyncratic risks, such as single manager exposure. 5. Preference to avoid or minimize derivative usage due to the difficulty of managing shortterm gain/loss recognition. 6. Preference for a simple portfolio structure that is not overly encumbered by an excess amount of nuanced buckets and managers. 7. Currently no direct investment in private placement 144A securities is allowed. As part of this process, the State Treasurer s Office also invited incumbent and other fixed income managers to propose the fashion in which they would construct Wyoming s fixed income portfolio given free rein of the entire portfolio. Armed with that information while considering the specific fixed income portfolio objectives mentioned previously, we indicated that a core-and-satellite approach may best meet Wyoming s needs over the next 5 year period for the following reasons: Core Portfolios the anchor : a) In fixed income terms, Core means the broad investment grade US fixed income market. It is best characterized by the Barclays Capital Aggregate benchmark, and includes significant allocations to Government Treasuries and Agencies, Agency Mortgage Backed Securities, and Investment Grade Credit. We believe that it may be more suitable as a primary anchor of the portfolio relative to the existing Core Plus exposure as it would better serve the needs of capital preservation and safety. With regards to active vs. passive management, we believe active is more likely to result in higher risk-adjusted returns and also provides risk mitigation relative to a benchmark that is comprised predominately of U.S. government debt obligations, either explicitly or implicitly. b) TIPS are US Treasury issued securities that are explicitly linked to changes in the Consumer Price Index, thus providing a measure of inflation protection without sacrificing capital preservation. c) The Internal Portfolio, which is comprised of government securities, is recommended at a relatively small allocation due to lower expected returns. It does however continue to provide some diversification benefit and protection against deflation. The Satellite strategies detailed below are intended to improve returns, enhance income, and increase diversification in a complementary fashion to the Core portfolios. Satellite Portfolios: d) Credit consists of floating rate bank loans, high yield, and investment grade credit as a combined mandate with flexibility for managers to actively rotate among these sectors. A more flexible or tactical approach will better capture relative value in these sectors over time while streamlining the portfolio to a more contained list of mandates. Floating rate bank loans are emphasized as they provide protection against rising interest rates as the underlying securities interest rate is tied to a floating reference rate. While this is a flexible mandate, the neutral weighting of the underlying strategies is 60% bank loans, 20% high yield, and 20% investment grade credit. e) EMD LC exposure is anticipated to capitalize on global growth trends that continue to become of greater importance. Many emerging countries offer the attractive combination of higher yields and cleaner balance sheets than their developed counterparts. It also 3
serves as a good diversifier in a predominately US Dollar denominated fixed income portfolio. f) Opportunistic Fixed Income should provide the necessary flexibility to capitalize on severe market dislocations as they might arise. While many of these opportunities involve multi-year lock-up periods, we do not anticipate the loss of liquidity to be an issue for such a small allocation. The opportunistic nature of these investments and limited timeframe available for engagement may preclude a full RFP process when seeking these types of investment opportunities. The Treasuries office will bring these directly to the Board. The actual strategic target allocations for each of the aforementioned fixed income sub-asset classes were determined through quantitative modeling as part of the structure study that utilized assumptions about expected return (relative to the market), risk (both absolute and relative), and correlation among substrategies (diversification benefits). There is no single measure of risk that perfectly captures all types of potential risk exposure that investors should be concerned about. As a result, we analyzed three unique risk factors in this structure study, all providing unique insight to different potential risk exposures to help better make portfolio structure decisions. As part of the decision making process, we considered the following weighting scheme for each risk measurement, reflective of our interpretation of each risk measurement s relative importance to the State s portfolio: 50% Absolute Risk The portfolio s total risk as measured by standard deviation. Risk of loss is ultimately the most important consideration. 30% Equity Beta The portfolio s sensitivity to equity market returns as measured by Beta. A critically important consideration for fixed income portfolios, since they act as the portfolio anchor during times of market stress, is that they behave as such and do not exhibit high degrees of correlation to equity markets. 20% Tracking Error Relative risk which measures the degree of potential deviation from the broad market s returns as measured by tracking error. An important consideration as it is the measure that best ties the fixed income structure to the asset allocation decision. Utilizing the weighting scheme described above and with due consideration given to the unique objectives and constraints of Wyoming, we believe that this structure is an improvement that should serve the State s needs well over the next 5 year period. Fixed Income Search Process Outline Field of Respondents The search process began on March 14, 2012 with an email notification to all the asset managers included in each respective mandate universe. Participation interests were due to RVK on March 21, 2012. The number of respondents for each mandate was as follows: Core: total of 88 firms responded, with some respondents offering multiple products, bringing the total to 96 different investment products. 4
TIPS: total of 22 firms responded, with some respondents offering multiple products, bringing the total to 25 different investment products. Of those responses, 19 strategies were for active investment services while 6 were for passive services. Credit: total of 45 firms responded with investment products in either two or three of the credit sleeves required (Investment Grade/ High Yield/ Bank Loans). EMD LC: total of 25 firms and investment products. Application of the Minimum Qualifications The four searches contained a list of minimum qualifications necessary for investment managers to meet in order to be considered. Minimum qualifications are important for several reasons. First, by establishing minimum criteria for assets and track record, it ensures that the managers under consideration have an appropriate body of evidence with which to evaluate their past results. Secondly, it helps protect large investors such as the State of Wyoming from the potential operational risks associated with becoming too large as a percentage of any single managers book of business. The minimum qualifications necessary to proceed in the review process included: 1. $1 billion of firm verifiable assets under management (AUM) in the proposed product. 2. Candidates should have been in business for a minimum of five (5) years, or if recently established, employ principals who have ten (10) years of investment experience. 3. Five (5) years of verifiable core fixed income investment experience and have at least three (3) years tenure at the firm 4. A five (5) year (the most recent five year period ending March 31, 2012) verifiable GIPS compliant investment performance record. If track record is shorter than five (5) years, the principal managers must have a successful record of managing similar portfolios for ten (10) years total. Of those candidates that responded to each respective mandate, Core: 37 did not pass the minimum qualifications TIPS: 9 did not pass the minimum qualifications Credit: 29 did not pass the minimum qualifications EMD LC: 16 did not pass the minimum qualifications Selection of Request for Information ( RFP ) respondents In addition to assessing minimum qualifications for each manager, RVK reviewed the data the candidates submitted to the evestment Alliance database. This first screening involved Wyoming State Treasurer s Staff and RVK analyzing quantitative measures. Additional candidates were cut from the list based on the following quantitative criteria: Consistency of calendar year, 3- year rolling, and 5-year rolling excess return Consistency of rolling 3-year and 5-year Sharpe Ratio Information ratio for 3-years and 5-years 5
Stability of assets under management Stability of fixed income assets under management Stability of product assets under management Average 3-year and 5-year excess return Wyoming s RFP questionnaire was then sent to the following number of managers for each mandate: Core: 11 managers, including the 3 core plus incumbents TIPS: 10 managers and 11 products, 6 Active and 5 Passive Credit: 12 managers, including the 2 investment grade credit incumbents EMD LC: 10 managers Selection of Managers to Interview RVK convened with Wyoming State Treasurer s Staff via conference call on August 2, 2012 to review the responses to the questions posed in the RFP as well as the quantitative data submitted to evestment Alliance database for the shortlist of candidates for each mandate. RVK provided a quantitative review of each product for the following broad categories: Product, Consistency of Sharpe Ratio and Returns, Information Ratio, and Risk Metrics. This quantitative summary along with RVK s knowledge of the investment management teams were considered in our review. The following are samples of some qualitative, but certainly not all, of the criteria considered in the review process: Stability of Team Experience of Team Depth of Resources Decision Making Process Risk Controls Use of Derivatives For credit mandate only: Bank Loan Track Record Proposed Vehicle After considerable discussion, the following managers were identified by Wyoming State Treasurer s Staff and RVK for in-person interviews in Cheyenne: Core: TIPS: CS McKee, L.P. Aggregate Fixed Income J.P. Morgan Asset Management Core Bond (Columbus) MacKay Shields LLC Core Investment Grade Neuberger Berman Group LLC Core Bond PIMCO Core Plus Total Return Full Authority Wells Capital Management Inc. Montgomery U.S. Core Fixed Income Brown Brothers Harriman & Co. Inflation-Indexed Securities Fischer Francis Trees & Watts U.S. Inflation Linked Bonds State Street Global Advisors U.S. Treasury Inflation Protected Securities Index Strategy Credit: BlackRock, Inc. Credit Neuberger Berman Group LLC Credit 6
Seix Investment Advisors LLC Credit Western Asset Management Company Credit EMD LC: Investec Asset Management Emerging Markets Debt LC Dynamic PIMCO Emerging Local Bond Stone Harbor Investment Partners LP Emerging Markets Local Currency Debt Manager Interviews RVK, Wyoming State Treasurer s Staff and representatives of Board members participated in interviews with the finalist managers in Cheyenne over three days, beginning on August 21, 2012. The goal of the in-person interviews was to hire the following number of managers: Core: 5-6 managers TIPS: 1-2 managers Credit: 2-4 managers EMD LC: 1-2 managers During the in-person manager interviews, the managers presented their firm, team, investment philosophy and process, detailing differentiating factors between them and competing firms and discussing what gave their firm a unique advantage. After significant discussion, analysis, and pending successful on-site due diligence visits and contract negotiation with each of the selected managers, the interview panel concluded that the recommended slate of managers, as detailed below are the best fit for Wyoming: Core Managers CS McKee, L.P. J.P. Morgan Asset Management MacKay Shields LLC Neuberger Berman Group LLC PIMCO Wells Capital Management, Inc. TIPS Manager State Street Global Advisors (passively managed) Credit Managers Neuberger Berman Group LLC Seix Investment Advisors LLC EMD LC Managers: Investec Asset Management Stone Harbor Investment Partners LP 7