City of Fresno Retirement Systems

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City of Fresno Retirement Systems Real Assets Education October 25, 2016 Don Stracke, Senior Consultant Tony Ferrara, CAIA, Sr. Consultant Support Analyst

Real Assets Overview What are Real Assets? Physical/tangible asset or an investment whose value is derived from a contractual claim on an underlying physical/tangible asset There are several strategy types within Real Assets: Commodities, Inflation-linked products, Private Energy/Infrastructure, Real Estate, Timber, Treasury Inflation Protected Securities (TIPS), inflation-sensitive equities, etc. Why invest in Real Assets? Offers an Inflation Hedge Components within in Real Assets are sensitive to rising prices and thus, over the long term, should provide a hedge against inflation As a result, Real Assets tend to provide a real (after inflation) return Diversification Real Assets have historically exhibited a low correlation to stocks and bonds which should serve as a benefit to the overall portfolio What are the challenges associated with investing in Real Assets? Liquidity Risk Similar to other illiquid investments, investors may take on liquidity risk depending on the Real Asset strategy type Liquidity can also impact the correlation to periods of rising inflation Return Expectations Real Assets generally have lower expected returns than equities which may prove problematic in a low return environment Can underperform traditional markets for extended periods of time Is now the right time for inflation protection? 2

What are Real Assets? Public Market or Liquid Strategies Private Market or Illiquid Strategies US TIPs Emerging Markets Currency/Bonds Real Estate Energy Commodities Infrastructure Timber Agriculture Real Estate Energy Commodities (Metals & Mining) Infrastructure Timber Agriculture Active and Passively Managed Funds Open-end and Closed- End PE Funds 3

Attributes of an Effective Real Assets Program Attractive real and relative returns during extended periods of high inflation Reasonable long-term return expectations (earn a risk premium for holding risky assets) Low correlation and diversification Diversification along the liquidity spectrum A well-diversified Real Assets program enables better risk-adjusted returns through a full cycle 4

Real Assets Portfolio Structure Considerations Real Assets are not a one size fits all investment program They offer a broad range of risk/return strategies to be customized based on fund objectives In constructing a real assets portfolio there are several key considerations that impact the allocation, including: Fund inflation sensitivity Fund investment policy Liquidity requirements of fund Allocation to illiquid alternatives Existing investments with inflation hedging characteristics Return, risk, and volatility expectations Size of fund assets Timing and pacing considerations 5

Real Estate Overview Institutional quality/commercial real estate is property intended to generate a return from rental income and/or capital appreciation Can be publicly traded or privately held Strategies exist spanning the risk/return spectrum from stabilized core real estate to development-oriented opportunistic real estate Main property types include apartments, office buildings, shopping centers, hotels, industrial properties, etc. Large real estate investable universe Over $400 billion of privately-owned institutional quality real estate in the US Nearly $1 trillion of total capital raised by closed-end fund managers since 2005 US publicly-traded REITs with an aggregate market cap of over $800 billion Two components of real estate return: Current Income: Derived from tenant rents/leases that typically increase with inflation Capital Appreciation: Increase in the value of an asset between acquisition and sale Leverage can amplify (both positively and negatively) returns from current income and capital appreciation Market size data as of December 31, 2014; private real estate represented by the NCREIF Property Index gross asset value, closed-end fundraising data from Prequin, REIT market cap represented by the NAREIT All Equity REITs Index 6

Real Estate Economic Return Drivers Current income is derived from tenant rents/leases that typically increase with inflation Capital appreciation is the increase in the value of an asset between acquisition and sale Typically the result of lease-up, repositioning, renovation, development, etc. Assets may require capital investment for the repositioning of the asset Both current income and capital appreciation returns are driven by changes in net operating income (NOI), which in turn is largely driven by rent and occupancy levels Appreciation return is also affected by changing market cap rates and (to a lesser extent) debt financing available to potential buyers Drivers of rent Occupancy (to an extent) Job growth GDP growth Inflation Drivers of Occupancy New supply Job growth Economic factors (including GDP growth, homeownership rates, etc.; vary by property type) 7

Real Estate as Part of an Investment Plan NEPC believes that real estate plays an important role as part of an overall investment plan: 1. Low historical correlation to stocks and bonds 2. Provides diversification benefits to the overall portfolio 3. Provides both current income and the potential for capital appreciation (each of which can be enhanced with leverage) 4. Over the long term, provides a partial hedge against inflation as certain components of real estate are sensitive to inflation 5. Offers a spectrum of investment strategies (with different return and risk expectations) that can be customized to meet plan objectives However, there are considerations of investing in real estate: 1. Investments are generally illiquid, particularly during falling markets (excluding public REIT investments) 2. Limited and imperfect benchmarks exist to gauge investment performance 3. Valuations are based on underlying transaction markets which have limited transparency and property appraisals can lag real-time market valuations 4. Investments outside of the base currency are affected by currency movements 5. The use of leverage amplifies negative performance 8

Spectrum of Real Estate Investment Strategies Real Estate Investment Style / Overview Investment Strategy Portfolio Role Considerations Core Strategies Core Return driver: income Primary vehicle: open-end funds Historical avg. returns: 7-8% Leverage: 15-30% Hold period: long-term REITs Return driver: income Primary vehicle: REIT funds Historical avg. returns: 7-9% Leverage: 30-50% Hold period: long-term Stabilized income producing assets Stabilized income producing assets Current income Broad exposure to commercial real estate (asset class beta) Inflation protection Current income (dividends) Long-term exposure to commercial real estate (beta) Long-term inflation protection Vehicles are semi-liquid (entrance/exit queues) Limited alpha producing opportunities Volatility Equity correlation Non-Core Strategies Value-Add Return driver: income/appreciation Primary vehicle: varies Historical avg returns: 8-10% Leverage: 40-70% Hold period: 3-5 years Opportunistic Return driver: appreciation Primary vehicle: closed-end funds Historical avg. returns: 10-12% Leverage: 60%+ Hold period: varies Real Estate Debt Return driver: varies Primary vehicle: closed-end funds Historical avg. returns: 8-10% Leverage: varies Hold period: varies Properties requiring lease-up, repositioning, renovation or rehabilitation Distressed investments, recapitalizations, development, etc. Varying risk/return profiles (senior loans to higher risk structures) Provides part current income and capital appreciation Some inflation protection Real estate alpha through capital appreciation with minimal current income Mixed strategies: Current income w/downside protection Higher risk opportunistic/mezz. debt strategies Vehicles are semi-liquid or illiquid Vintage year is important Higher leverage vs core Poor benchmarks Vehicles are illiquid Vintage year is important High leverage Poor benchmarks Limited return upside (asymmetric risk profile) Minimal inflation protection Vintage year is important Poor benchmarks 9

Geographic Considerations Real estate investment strategies vary in geographic scope Global or non-us (e.g. Europe-only) strategies may allow for managers to pursue more attractive markets Global managers tend to be large platforms with investment professionals around the world while non-us managers may be more localized in a particular region or country A global real estate investment strategy may benefit from diversification as various regions are at different points in an economic cycle Considerations of investing in real estate outside the US: Currency risk Geopolitical risk Market liquidity risk Limited inflation hedge Within particular markets, managers may target specific sub-markets Investing in good markets is important, but a manager s ability to identify attractive submarket locations is critical as well For example, visibility from major roadways may boost retail center performance, access to key highways or ports are key for industrial properties 10

Relative Expected Risk Return Profile of Real Estate Sectors and Geographic / Market Focus Illustrative Risk / Return Profile Low High Current Income Viewed as more risky with higher return expectations Return Driver Viewed as less risky with lower return expectations Capital Appreciation Low Expected Risk High Notes: - Debt-related strategies can span the illustrative risk / return spectrum depending on the specific strategy - Manager-specific risk, operations and leverage can skew expected risk / return profile 11

What are Commodities? Commodities are real assets Corn, wheat, lean hogs, live cattle, gold, silver, crude oil, natural gas Commodity trading The Chicago Board of Trade is the oldest exchange, and the first commodity contract was traded there in 1851 Commodity exposure is achieved through indirect investment Indirect investment is achieved through commodity futures, options and swap contracts Direct investment in hard assets is impractical Delivery and storage are specialized businesses Commodities generate wealth as they are consumed Holding commodities in physical form precludes adding value Futures markets offer benefits to financial investors Compensation for assuming risk from commodity producers Reward for providing liquidity to commodity consumers Access to commodity returns without dealing in physical commodities Futures contracts are a way to standardize deals 12

What is Infrastructure? Investments in physical assets or companies that operate assets that provides essential services to society and typically exhibit one or more of the following: Monopolistic or quasi-monopolistic High barriers to entry Long term assets Regulatory or permitting constraints Sector types include: Transportation Energy and Utilities Communications Social Infrastructure Time Horizon to Liquidity is usually 6-12 years IRR s range from 6-10%, primarily driven by current income and capital appreciation Favorable conditions for investing: Improving economy High levels of deal flow that provide an opportunity to choose from a broad range of investment opportunities Assets with significant upside potential 13

Sustainable Real Assets What are sustainable real assets? Strategies that are focused on investments that address issues related to natural resources or physical/tangible assets Incorporate environmental, social and governance ( ESG ) issues into investment philosophy Positive impact is measurable and is reported Why are sustainable real assets important? ESG factors becoming increasingly important to investors and fund managers as sustainability is seen as an important aspect of an investment philosophy Superior business models with appealing long-term principals attractive to customers and investors with potential long-term performance advantages Provides enhanced return potential by optimizing asset values 14

Sustainable Real Assets Sustainable strategies include: Green real estate Developing or renovating properties to be energy efficient and environmental sustainable based off industry certifications and programs Renewable energy A naturally generated source of energy that is not derived from fossil or nuclear fuel Examples include: Solar, wind, hydro, biomass Timber Harvest practices that take into consideration the regeneration and the long-term well being of the forest Agriculture Production of agricultural products using farming techniques that protect the natural environment and the surrounding social and economic conditions Land and water resources Restore natural resources and generate environmental credits and other ancillary revenues Examples include: mitigation banking and water assets 15

Timberland Sustainable forestry management Certified as Sustainably Managed Criteria and indicators developed by various organizations to implement and evaluate sustainable management Forests that are certified can realize price premiums and market interest Forestry Stewardship Council, Sustainable Forestry Initiative, American Tree Farm Systems Balance between economic interests and preservation of forest health, productivity and future growth Non-Timber Forest Revenues Working forestland conservation easements Carbon sequestration, wind power leases, water resource protection credits, biomass and alternative energy supply agreements Restoration or conservation activities State and Federal Legislation helps support conservation New Markets Tax Credit program provides low-cost debt that can be used for timberland investments Public support for conservation is strong 16

Agriculture Sustainable investments across the value chain Growers, processers, and distributors of produce with a focus on sustainable farm practices and organic produce These practices can be best practices and can maximize returns Reduce costs, improve yields, increase quality of product Sustainable Farming Strategies Micro and drip irrigation and micro application fertilizer Environmentally friendly pest control Improve worker health and productivity Organic Produce Market for organic and sustainable products is increasing From 2004 to 2011 organic food sales grew from $11B to $25B Certifications include: USDA Organic, Sustainable Farm Certification International, Rainforest Alliance, Fair Trade, UTZ Certified Price premium for organic products as consumers become more conscious of food sources 17

Land & Water Resources Mitigation Banking Acquire, restore, manage and ultimately divest large rural properties that generate revenues through the sale of environmental credits Support the No Net Loss of natural resources requirements of federal, state and local environmental laws Capitalize on the Land-Based Environmental Offset markets established to mitigate unavoidable, permitted impacts to wetlands, streams and other important natural resources Other revenue sources from ancillary land-based activities including conservation finance, sustainable timber management and agricultural and recreational leasing Water Target water assets that can provide freshwater for consumptive and environmental uses Water rights and entitlements that allow for storage/conveyance/delivery of water Acquire water rights/entitlements directly or indirectly through a bundled transaction inclusive of other assets such as land, interests in mutual water companies or interests in ditch companies Measurable Impact Acres under conservation easement Jobs maintained and supported Number of ecosystem services provided 18

Other Real Assets Strategies Incorporating ESG: Metals and Mining Metals and mining managers commitment to responsible investing Supporters of UN Global Compact, Universal Declaration of Human Rights, International Labor Organization, International Council for Mining and Metals and the UN Principles for Responsible Investing, Identify and manage project risks responsibly Social, political, environmental, ethical and corruption risks Even these investments can have a positive impact Many metals and mining investments are in under-developed communities Sustainable development at the community level, such as education and healthcare programs Contribute to poverty reduction and job creation Improved infrastructure systems Consideration for long-term impact on community post investment ESG in due diligence process Pledge to invest in companies and projects which undertake ESG practices Risk mitigation strategy Many managers produce an annual ESG Report Details and quantifies aspects of their positive impact on the local community Documents projects rejected due to socio-political risks, legislation issues, community safety, health and safety risks for workers 19

Disclaimer Past performance is no guarantee of future results. The opinions presented herein represent the good faith views of NEPC as of the date of this report and are subject to change at any time. Data used to prepare this report was obtained directly from the investment manager(s). While NEPC has exercised reasonable professional care in preparing this report, we cannot guarantee the accuracy of all source information contained within. This report may contain confidential or proprietary information and is intended only for the designated recipient(s). If you are not a designated recipient, you may not copy or distribute this document.

Alternative Investment Disclosures It is important that investors understand the following characteristics of nontraditional investment strategies including hedge funds and private equity: 1. Performance can be volatile and investors could lose all or a substantial portion of their investment 2. Leverage and other speculative practices may increase the risk of loss 3. Past performance may be revised due to the revaluation of investments 4. These investments can be illiquid, and investors may be subject to lock-ups or lengthy redemption terms 5. A secondary market may not be available for all funds, and any sales that occur may take place at a discount to value 6. These funds are not subject to the same regulatory requirements as registered investment vehicles 7. Managers may not be required to provide periodic pricing or valuation information to investors 8. These funds may have complex tax structures and delays in distributing important tax information 9. These funds often charge high fees 10.Investment agreements often give the manager authority to trade in securities, markets or currencies that are not within the manager s realm of expertise or contemplated investment strategy