How to Increase Investment Returns in Public Safety Health & - PowerPoint PPT Presentation

2016 Public Safety Employees’ Pension & Benefits Conference How to Increase Investment Returns in Public Safety Health & Welfare Funds Jennifer Mink Principal Investment Performance Services Philadelphia, PA

What We Know • Asset Allocation for Health & Welfare Funds is typically 75% ‐100% fixed income (bonds) • Bond prices have an inverse relationship with interest rates • Interest rates are currently near all‐time lows

Historical Perspective on Interest Rates The Last Full Interest Rate Cycle 1958 - 2015 10-Year Treasury Rate 16.0% 14.0% 27 Years 35 Years 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Source: Federal Reserve, Ibbotson, JPMorgan ‐ Market yield on Jan 1st of each year

Interest Rate Impact on Bond Returns • interest rate environment; below long‐term average returns • interest rate environment; above long‐term average returns Classification Term Corporate Bond Returns Long‐term 1926‐2015 5.4% Rising Rates 1958‐1981 3.0% Declining Rates 1981‐2015 8.2%

Measuring Interest Rate Sensitivity Duration New Word! Term used to describe the "average life" or maturity of the bonds in a portfolio Expressed in years "Risk multiplier" used to mathematically measure interest rate sensitivity

Measuring Interest Rate Sensitivity A "duration of 5 years" means the risk multiplier is 5 times the change in interest rates

Example: Portfolio Duration of 5 years A 1% increase in interest rates means the portfolio will lose 5% 1% x 5 =5% If rates increase by 2%, the portfolio will lose 10% (and so on) 2% x 5 =10%

Measuring Interest Rate Sensitivity 12 Month Holding Period ‐Annualized returns as of 6/30/16 Yield 10 Yr Barclays ML ML Defensive ML Short Duration Change Treasury Agg 1‐3 yr US HY BB/B US HY BB/B (basis points) ‐50 6.72 4.82 1.88 8.18 6.02 Rates decrease ‐25 4.19 3.36 1.42 7.02 5.59 0 1.66 1.90 0.95 5.87 5.15 25 ‐0.87 0.44 0.49 4.72 4.72 50 ‐3.4 ‐1.02 0.02 3.57 4.28 Rates increase 100 ‐8.45 ‐3.93 ‐0.91 1.26 3.41 150 ‐13.5 ‐6.85 ‐1.84 ‐1.05 2.54 Source: Penn Capital

Idea #1 –High Yield Bonds Rating Agencies Standard & Poor's Moody's AAA Aaa AA Aa Investment Grade A A BBB Baa BB Ba High Quality High Yield B B High Yield CCC Caa Junk CC Ca Bonds C C

High Yield Bonds Annualized Corporate Returns by Credit Rating 1989 - 2015 Return % Chart Source: Bond Rating Chartwell Investment Partners

High Yield Bonds High Yield Risk vs. Return Standard Deviation (risk) Chart Source: Chartwell Investment Partners

How Have High Yield Bonds Performed? Calendar Year Returns YTD Index 2015 2014 2013 2012 2011 2010 2009 2008 Sept 2016 5.8% 0.6% 6.0% ‐2.0% 4.2% 7.8% 6.5% 5.9% 5.2% Barclays Agg Barclays High Yield 12.0% ‐2.7% 3.5% 6.2% 15.0% 6.0% 13.9% 45.2% ‐22.0% Ba+B 2% Capped Barclays High Yield 15.1% ‐4.5% 2.5% 7.4% 15.8% 5.0% 15.1% 58.6% ‐26.2% Source: Wilshire Compass

How Have High Yield Bonds Performed? Annualized Returns (as of September 30, 2016) Index 1 year 3 Year 5 year 7 year 10 Year 5.2% 4.0% 3.1% 4.1% 4.8% Barclays Agg Barclays High Yield Ba+B 11.7% 5.5% 8.0% 8.3% 7.3% 2% Capped 12.7% 5.3% 8.3% 8.8% 7.7% Barclays High Yield Source: Wilshire Compass

High Yield Bond Diversification 10 years + Annualized Expected Returns Asset Allocation #1 #2 #3 100% 80% 65% Core Fixed Income 0% 20% 35% High Quality High Yield 3.3% 3.9% 4.3% Return 5.0% 4.8% 5.1% Risk Source: IPS Investment Committee Risk/Return Assumptions

Idea #2 –Real Estate Forms of Institutional Real Estate Investments Type Form Primary Drawback Direct real estate (buy a building) Private Not liquid Limited Partnership Private Not liquid Real Estate Investment Trust (REIT) Public Volatility Less liquid than Institutional commingled fund Private stocks & bonds

How Real Estate Returns are Generated 4‐Qtr Rolling Return : Dec 1977 –Dec 2016 Total NFI‐ODCE return Income Appreciation/Depreciation

Types of Real Estate Investments Property Type: Geographic Location: • Office • Northeast • Apartments • Southeast • Warehouse • Northwest • Hotel • West Coast • Retail

How Has Real Estate Performed? Annualized Returns (as of June 30, 2016) Index 1 year 3 Year 5 year 7 year 10 Year Barclays Agg 6.0% 4.1% 3.8% 4.6% 5.1% NFI‐ODCE (equal weighted) 12.3% 13.0% 12.7% 10.6% 5.9% Wilshire REIT 17.9% 14.3% 15.8% 15.7% 5.9% Source: Wilshire Compass

How Has Real Estate Performed? Calendar Year Returns YTD Index June 30, 2015 2014 2013 2012 2011 2010 2009 2008 2016 Barclays Agg 5.8% 0.6% 6.0% ‐2.0% 4.2% 7.8% 6.5% 5.9% 5.2% NFI‐ODCE (equal weighted) 4.7% 15.1% 12.4% 13.3% 11.0% 16.0% 16.1% ‐30.7% ‐10.4% Wilshire REIT 11.1% 4.2% 31.8% 1.9% 17.6% 9.2% 28.6% 28.6% ‐39.2% Source: Wilshire Compass

Public vs. Private Real Estate Source: Wilshire Compass

Public vs. Private Real Estate Risk/Return Wilshire REIT December 31, 1978 –June 30, 2016 US Large Cap S&P 500 US Small Cap Russell 2000 NFI‐ODCE US Bonds Barclays Agg Source: Wilshire Compass

Real Estate Diversification 10 years + Annualized Expected Returns Asset Allocation #1 #2 #3 100% 65% 60% Core Fixed Income 0% 25% 25% High Quality High Yield 0% 10% 15% Real Estate 3.3% 4.5% 4.8% Return 5.0% 4.4% 4.2% Risk Source: IPS Investment Committee Risk/Return Assumptions

Idea #3 –Opportunistic Hedge Funds Low Correlation to Barclays Agg (and equity indices) HFRI Credit Index Barclays US Aggregate MSCI World 3‐year Correlation ‐0.03 0.79 5‐year Correlation ‐0.12 0.83 Provides downside protection during periods of credit (and equity) market stress The HFRI Credit Index is a composite index of strategies trading primarily in credit markets. It is an aggregation of following 7 HFRI substrategy indices. HFRI ED: Credit Arbitrage Index, HFRI ED: Distressed/Restructuring Index, HFRI ED: Multi‐Strategy Index, HFRI RV: Fixed Income‐Asset Backed Index, HFRI RV: Fixed Income‐Convertible Arbitrage Index, HFRI RV: Fixed Income‐Corporate Index, and HFRI RV: Multi‐Strategy Index. Source: HFRI

Opportunistic Credit HFoFs • Bank deleveraging and increased regulatory requirements for banks have led to new opportunities: Distressed asset sales New loan origination Orphaned markets

Credit HFs vs. Core Bonds Source: Wilshire Compass

Credit HFs vs. Core Bonds Source: Wilshire Compass

Opportunistic Credit HFoFs Characteristics Diversified, high yielding credit portfolio Dynamically allocate across credit classes Niche situations; Global markets Nimble fund size Medium to low duration Premium ‐ Target returns 8‐10%+ Open‐ended fund structure

Hedge Fund Diversification 10 years + Annualized Expected Returns Asset Allocation #1 #2 #3 100% 55% 50% Core Fixed Income 0% 25% 25% High Quality High Yield 0% 15% 15% Real Estate 0% 5% 10% Opportunistic HFoF 3.3% 5.1% 5.4% Return 5.0% 4.5% 4.8% Risk Source: IPS Investment Committee Risk/Return Assumptions

The Power of Diversification 10 years + Annualized Expected Returns Asset Allocation #1 #2 #3 #4 #5 #6 #7 Core Fixed Income 100% 80% 65% 65% 60% 55% 50% High Quality High Yield 0% 20% 35% 25% 25% 25% 25% Real Estate 0% 0% 0% 10% 15% 15% 15% Opportunistic HFoF 0% 0% 0% 0% 0% 5% 10% 3.3% 3.9% 4.3% 4.5% 4.8% 5.1% 5.4% Return 5.0% 4.8% 5.1% 4.4% 4.2% 4.5% 4.8% Risk Source: IPS Investment Committee Risk/Return Assumptions

Risks/Drawbacks High Yield Increased credit risk Risk of defaults Real Estate Less liquidity than bonds Depreciation Hedge Funds Less Liquidity than bonds Poor investment thesis

Next Steps Define your investment goals Know your Fund's liquidity needs Understand risk exposures/risk tolerance Establish meaningful asset allocation guidelines Work with experienced professionals

Questions? Jennifer Mink Principal | Senior Consultant jmink@ips‐net.com