ORANGE COUNTY EMPLOYEES RETIREMENT SYSTEM BOARD OF RETIREMENT 2223 E. WELLINGTON AVENUE, SUITE 100 SANTA ANA, CALIFORNIA INVESTMENT MANAGER MONITORING SUBCOMMITTEE MEETING 9:00 a.m. MINUTES The Chair called the meeting to order at 9:03 a.m. and read the opening statement into the record. Attendance was as follows: Present: Absent: Also present: Chris Prevatt, Chair; Roger Hilton David Ball and Frank Eley Susanne Jenike, Assistant Chief Executive Officer; Girard Miller, CFA, Chief Investment Officer; Shanta Chary, Director of Investment Operations; David Beeson, Investment Officer; William Popper, Investment Officer; Anthony Beltran, Visual Technician; and Stina Walander-Sarkin, Recording Secretary A. CIO COMMENTS Mr. Miller discussed the reduction in the real return allocation from 10% to 8% and how it will impact the managers in that space. He stated that he recommends decreasing the multi-strategy managers assets under management rather than completely eliminating their mandates, which would provide the flexibility to increase their mandates in a time of increased or potential inflation. B. INDIVIDUAL MANAGER PRESENTATIONS Mr. Beeson discussed the inclusion of a new exhibit in the materials provided to the Committee members, including a summary of the managers fee schedules. Wellington Management Presentation by Kenneth Baumgartner, CFA & Charles Ruch, CFA Mr. Beeson introduced Wellington and stated that their Diversified Inflation Hedges (DIH) strategy strives to provide strong relative returns to bonds and stocks in rising inflation environments. He also stated that multi-strategy managers have had a challenging time and performed poorly due to the low inflation environment and fall in commodity prices. In 2014, the main detractors to DIH s performance were the natural resource equity positions. Mr. Beeson stated OCERS two multi-strategy managers, AQR and Wellington, have performed better than OCERS pure commodity strategies, PIMCO Commodities Plus and Schroder Commodity, and the commodity indices. Ms. Chary stated that it has been a bearish market for some time for inflation-linked assets, but there have also been time periods where inflation has spiked. During July of 2010 through June of 2011 the year-over-year Consumer Price Index (CPI) went from 1.2% to 3.6% and during this time Wellington had a return above 34%. Also, during October of 2013 through June of 2014 the year-over-year CPI went
from 0.9% to 2.1%, and Wellington s DIH strategy was up 12%. She noted that Wellington s DIH strategy is highly correlated to inflation and could be viewed as an insurance policy against inflation. The key highlights of the presentation were: Firm update: Wellington has $914 billion in assets under management globally and manages $47.5 million in a diversified inflation hedges strategy on behalf of OCERS. Wellington has 590 investment professionals globally and 152 active partners. In June of 2014, the President, Brendon Swards, transitioned in to the role as Chief Executive Officer. Market Overview: It has been a difficult time for inflation-linked assets, but as a result there are many cheap assets in the space, both cheap commodity equities along with cheap commodities. The complacency in the space has led to attractive valuations which Wellington is positioned to take advantage of. Outlook for 2015: The substantial drop in energy prices has led to lowered inflation expectations, but tighter labor market conditions are beginning to put upward pressure on wages and Wellington is expecting inflation to bottom and turn higher in the second half of 2015. Wellington currently has a neutral energy exposure, but they see an increase in the energy exposure once oil prices normalize. Portfolio Strategy: Wellington seeks to provide strong relative performance versus broad equity and fixed income markets during rising inflation environments. Wellington invests in assets with linkages to general inflation and in sectors where supply/demand dynamics are expected to lead to localized inflation pressures, such as energy, agriculture, metals and mining, infrastructure, and precious metals equities and commodities, and U.S. and emerging markets inflation-linked bonds. The DIH strategy has a diversified global exposure to multiple asset classes and Wellington seeks to add value from top-down allocations and bottom-up security selection decisions. Performance: Since OCERS inception in 2008, Wellington has returned -5.3% (net of fees) and underperformed their internal multi-asset inflation index along with OCERS real return benchmark. In 2014, the DIH strategy posted a -12.8% return (net of fees) which was mainly due to the fall in energy prices and other commodities. Mr. Miller stated that Wellington should expect a reduction in assets under management. Ms. Chary stated that over the last couple of years, NEPC has struggled with the benchmark for this space. She also stated that the return objective for the space was CPI + 5%, previously, and in June 2014, the return objective was changed to CPI + 3%. Mr. Beeson noted that the volatility of the CPI versus the manager s commodity assets is very different, which adds to the difficulty of having the CPI as a benchmark. The Committee recessed at 9:56 a.m. The Committee reconvened at 10:01 a.m. 2
William Blair Presentation by Casey Preyss, CFA, Todd McClone, CFA & John McLaughlin, CFA Mr. Beeson introduced William Blair and stated that they manage an emerging markets equity mandate on behalf of OCERS. Mr. Beeson stated that they have a bottom-up fundamental analysis investment process that seeks to invest in companies with above average sustainable growth aspects. He also stated that William Blair has been a good turnaround story for OCERS. They have performed very well and are performing above the benchmark over all time periods. Mr. Beeson stated that William Blair is OCERS best performing emerging markets equity manager and their story shows that patience can ultimately pay off in times when a specific manager s style is out of favor. The key highlights of the presentation were: Firm update: William Blair has $66.3 billion in assets under management, with $5.5 billion managed in the emerging markets growth strategy. The emerging markets growth strategy is closed to new clients. Market Overview: With U.S. interest rates at zero, a drastically larger percent of emerging markets local bond markets issuances are now owned by foreigners. As a result, the risk of another taper tantrum could cause a lot of currency volatility in the emerging markets as foreigners are redeeming their assets. On the other hand, many of the emerging markets now have a current account surplus, such as India and Indonesia, and they will be better able to withstand any U.S. interest rate hike. However, countries such as Turkey and Brazil would be vulnerable to a U.S. interest rate hike and William Blair is underweight these markets. Outlook for 2015: In most instances historically, emerging markets have outperformed developed equity markets in times of U.S. interest rate uptrends. If the Federal Reserve increases the interest rate slowly, the rate hike could potentially lead to outperformance of the emerging markets. Emerging markets correlations to commodities have come down after the commodity super cycle bust and as China is rebalancing from being an investment driven to a consumption driven economy. As a result, William Blair will be underweight materials and commodity sectors in China. India is one of the winners in the commodity bust cycle as they are a net importer of oil and India will continue to be an overweight position in the portfolio as the economic indicators are continuing to be positive. Portfolio Strategy: 80% bottom-up focused manager with a robust quantitative team that supports the investment team. The quantitative team sets up a number of models that look for quality growth companies; companies with high returns on capital, high returns on equity, high cash flow percentage of earnings, and a low debt to capital ratio. As of March 31, 2015, the return on equity and return on invested capital has been 35% and 30% higher, respectively, relative to the MSCI Emerging Markets Index, but with a 10% lower leverage ratio. Also, the 5-year historic earnings per share growth rate is 40% higher for William Blair s emerging markets growth strategy vs. the index. Performance: Since OCERS inception in May of 2006, William Blair has produced a 7.1% (gross of fees) return vs. 5.7% for the index. In 2014, William Blair posted a 5.4% return vs. -1.8% for the index. For the quarter and calendar year ending March 31, 2015, the largest contributor to the performance has been the overweight position in India vs. the index. The underweight in energy and materials vs. the index also contributed to positive performance. 3
The Committee recessed at 10:44 a.m. The Committee reconvened at 10:53 a.m. Grantham, Mayo, Van Otterloo Presentation by Rick Friedman, Tom Rosalanko & Lisa Stanton, CFA Mr. Beeson introduced GMO and the two strategies they manage on behalf of OCERS; Global Equity and Benchmark-Free. He stated that across both strategies, GMO s philosophy is based on mean reversion and 7-year asset class forecasts. Mr. Beeson noted that due to the long-term forecasts, their strategies can be out of favor at times. Mr. Beeson stated that the Benchmark-Free strategy is a fairly new mandate for OCERS (August 2013 inception). He also stated that the performance has been somewhat muted at 1.4% over the last 12 months and at 4% since inception. Mr. Beeson stated that GMO s equity exposures have been challenging as it has been geared towards Europe, while U.S. equity markets have continued to be strong. He also stated that the manager s asset flows have been stable as both strategies increased their assets under management during 2014. The key highlights of the presentation were: Firm update: GMO has $116 billion in assets under management and employs more than 550 employees worldwide, of which more than 100 are investment professionals. GMO has a low turnover of investment professionals. Market Overview: The U.S. economy is growing better than the rest of the world and there is still room for a continued expansion. U.S. high-quality stocks look to be the most attractive, while U.S. lower quality stocks look overvalued. Also, Europe has most recently had some positive surprise indicators, with Germany showing positive growth. European value stocks are attractive within developed markets on an absolute and relative basis. European value stocks are trading cheap and are priced at a 55% discount to other markets. Also, earnings growth for European value stocks appears cyclically depressed while profits are showing signs of recovery. Outlook for 2015: GMO s 7-year asset class real return forecasts shows that U.S. high quality and emerging markets stocks along with emerging markets debt are the most attractive asset classes going forward. GMO believes the outlook for U.S. large and small cap equities, except for high quality stocks, is negative after a period of strong performance. GMO also believes U.S. and developed market bonds are facing a headwind and mean reversion is to be expected. GMO believes credit spreads look decent, but they see some signs that suggest that we are in the later stage of this credit cycle. From a top-down perspective, GMO sees some pockets of opportunities where value can be found. They believe international value stocks are looking much more attractive than international growth stocks. GMO also believes emerging markets are cheap relative to their own history and they have a positive outlook on emerging markets value stocks. Global Equity Portfolio Strategy: GMO has a disciplined, value oriented, investment research, risk control, and size limitation investment process. They use quantitative methods, 7-year asset class forecasts and their capital markets outlook, to identify undervalued securities and markets. The investment process is value 4
oriented, with a combination of big picture asset class valuations to define the overall shape of the opportunity set and quantitative analysis to refine the asset class forecasts. Also, the positions are sized to the opportunity, subject to liquidity and diversification constraints. Performance: Since OCERS inception in February of 2010, the Global Equity strategy has returned 10.2% (net of fees) vs. 11.0% for the MSCI World Index. Over the 1-year period, the strategy produced -0.3% vs. 6.0% for the index. The main reason for the underperformance has been GMO s underweight in U.S. stocks in the second half of 2014 versus the index, as the U.S. equity markets have performed strongly. GMO s underweight is explained by their long-term view of U.S. stocks being overvalued. Benchmark-Free Portfolio Strategy: The Benchmark-Free strategy s investment process is based upon the firm s 7-year asset class forecasts. The investment team allocates to asset classes which they believe are best positioned to generate the highest real returns in the long-term, while staying within the fund s risk parameters. Also, the strategy seeks out alternative strategies, such as merger arbitrage, special opportunities, and systematic global macro, to get paid in more ways for taking the same risks as with traditional stocks and bonds. Performance: The Benchmark-Free strategy has returned 4.0% (net of fees) since OCERS inception in August of 2013. Over the 1-year period, the strategy has produced a more modest return of 1.4%. Mr. Hilton and Mr. Prevatt moved to receive and file the manager presentations. C. CIO COMMENTS No further comments. PUBLIC COMMENTS: COMMITTEE MEMBER COMMENTS: CHIEF EXECUTIVE OFFICER/STAFF COMMENTS: COUNSEL COMMENTS: 5