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>> HENRY JONES: Eric, you may proceed, please. Thank you.
>> ERIC BAGGESEN: Very good, Mr. Chairman. Thank you very much. So first and foremost,
I would also like to just echo my thanks. I thought that was a terrific panel
>> HENRY JONES: Excuse me, excuse me, the audience, please, you are drowning out our
speaker! (Laughter).
>> ERIC BAGGESEN: Okay. Anyway. As staff, we would very much like to recognize the panel
that Robert glazer just put together. That was a terrific discussion, I think, I'm really
pleased that that took place. The other thing I would like to do briefly
is to recognize Ryan Ong and Tiffany Harder for the work they have done for putting the
technology together for putting on the meeting yesterday and today. Please recognize the
hard work that these folks have done. (Applause).
All right. Now we start with the actual fun part of this entire ALM work, which is the
infamous clicker exercise. What we are going to be asking you to do is express a preference,
if you will, for what I would really identify as kind of a risk and return zone or space
in relation to the potential candidate portfolios. What we would like to imply to you, though
is that the actual asset components and the mixes of, let's say equities and fixed income
and things like that are really a second of secondary importance right now. What we really
want to focus on are the lines that identify the expected returns, the blended long term
return and the expected volatility, and with it the implication for potential discount
rates. Once we have identified the sort of zone that
equates to the level of risk and return that you as board members prefer within the asset
allocation mix, we'll then step into an exercise. We will ask a question about the whole issue
of a margin, attached to the discount rate. So you want to explicitly get your preference
in that area. And then we will drop down through a review
of all of the binding constraints that are driving some of these asset class representations.
And to the extent that you as board members would like us to shift some of those binding
constraints, what we'll do is collect that information, along with the sort of risk and
return zone that you think is most appropriate for the strategic asset allocation and we
will go back and see if we can, in essence, build portfolios that satisfy both any changes
to the constraints that you would like to make and also, again, that target risk and
return zone and by implication sort of discount rate area. That will be the work that we go
back and do and we bring back to you at a future time point. Hopefully we can preview
that with you in December, if we moved the decision point off to February, that's when
an actual decision can be made. So it's most important that you think about
what we are really talking about is the risk return, volatility, less than the individual
asset mixes at this moment. So that will I just want to make sure that you are focused
on the area that we really need some feedback on at the moment.
So I think with that, if we are ready to actually get started are you ready, Tiffany with the
clicker exercise? So basically, what we would like you to do
is identify, given the brackets and I think everyone has received a handout at this point.
So you have this material principled in front of you, as far as which of the candidate portfolios
we have listed. You can see that these are identified by their title. So we have the
lower risk alternative. We have the lower risk, base case and so on.
We also have the current policy portfolio and then we have a choice on other. And if
the majority of members identify other, 9 plan is to put up a schematic of the efficient
frontier that would allow you to express a preference for either a higher risk or lower risk area
on the efficient frontier. So these things don't necessarily have to be completely mutually
exclusive. We want to know if feel like you are too penned in, if there's an appetite
to push into another area of opportunity set. We can collect these pieces of information.
They may, to some extent seem a bit contradictory but that's the kind of feedback that we need
to identify the alternatives that you would like to have brought back to you the first
voting exercise is based on the bracket and we'll let Alan make a comment around the actuarial considerations.
>> ALAN MILLIGAN: I want everyone to think that we are this really should be a single
decision about what 9 risk levels you want to take in the funding of the system are and
not two decision. So the next vote, presumably, will be whether
or not you wish to have a margin for adverse deviation. Ideally, we would have liked to
have had all of this put together in a single vote so you could have both the candidate
portfolio and the asset allocation, unfortunately there are only ten buttons on the clicker
and we would have needed more buttons. So we have broken this out into two votes. But
when you are thinking about what is the candidate portfolio, you also need to be thinking about
whether there should be a margin for adverse deviation. Because those combined really give
you the risk characteristics you want to. Have.
So it will be two separate votes, but it is, I think, very important to be thinking ahead
to the next vote as well because it's they both have a significant impact.
>> ERIC BAGGESEN: Okay. So before we actually start I'm sorry, any other questions?
Are there any questions or comments that anyone would like to make before we actually try
to take a first pass at the vote? Dr. Diehr? >> GEORGE DIEHR: On the current policy portfolio,
the I'm trying to figure out why somebody would want that. Because the because there's
no I don't know. It looks to me it has a for the same return, it has a poor risk than others.
So does it get into the potential discount rate because it would be 7.5 and the others
are or have a quarter percent margin in them? How do we interpret these?
>> ERIC BAGGESEN: Maybe I would ask Alan Milligan to comment because it's a bracketing exercise
on return which spins down into the discount rate thing.
>> ALAN MILLIGAN: So, yeah, if you if you if you select the current policy portfolio,
you can expect us to be asking you a lot of questions about why you chose that.
>> GEORGE DIEHR: Okay. >> ALAN MILLIGAN: Because relative to the
base case, you've got a very similar return with a significantly higher standard.
>> GEORGE DIEHR: It's off the efficient frontier. >> ALAN MILLIGAN: It's off the efficient frontier.
>> BEN MENG: Yes, it's off the efficient frontier slightly and we try to show it on the chart
but it doesn't show what's off the efficient frontier but your observation is exactly right.
>> ERIC BAGGESEN: Exactly. Other observations or questions?
Okay. Seeing none, I guess we would go to the first clicker exercise, Tiffany or Ben,
can we get that on the screen? And we would just ask you to make a vote on any of these
categories and then we'll see how that turns out.
Okay. Let's see, what we have identified then is three and four, which is base case and
higher return. Okay. There's an other. And then there's one lower.
Would anyone who this voting is anonymous, but to the extent that someone, for example,
picked an other, I mean, we can go through the other exercise and see if people basically
determine that they would really have an appetite for that, but if anyone would care to make
a comment about that, that would also potentially be helpful.
>> PRIYA MATHUR: So I'm the one would picked other. I can understand why you would want
to know what that is all about. I guess it really reflects, I would like to see a couple
of other scenarios. It's not that I'm certain that there's something else that I want but
there are other things I would like to explore, including one of the things we talked about
yesterday was having a lower absolute return strategies allocation, but perhaps with some
so I would like to see that, I guess is what I'm saying.
>> ERIC BAGGESEN: Basically, so when we come back and we actually talk about the constraint
set, that's another place for you to express that kind of a consideration. So the question
from my perspective would be if you know, is there a space I mean, do you really desire
a different risk level or return level or is what's going into that, that's the real
consternation. >> PRIYA MATHUR: I guess the return level
I'm happy with but I would like to see a lower risk level in conjunction with the return,
if that's possible. >> ERIC BAGGESEN: So we seem to be looking
at the base case and the higher return. So maintaining the existing rate of return and
the cost structure and not talking about the margin, would appear to be. Mr. Jelincic.
>> JJ JELINCIC: Eric, have we done any work with looking at private equity to taking part
of the equity and leveraging it up? >> ERIC BAGGESEN: You know, in the risk factor
work that Ben and his team have done, I think one of the priors, one of the beliefs that
we had going into that work was that we would literally see private equity being represented
as a levered version of public equities. The actual risk calculations, though, and
the factor calculations do not part that prior belief. There actually appears to be a more
unique characteristic to that. So we honestly don't, at this point have an analytic support
for simply replacing private equity with a geared or a levered public equity portfolio.
I think looking for alternatives on that space is probably a valid concept.
>> JJ JELINCIC: At some point, I would like to hear the discussion on why that doesn't
work. I mean, what the unique characteristics you think are. That's probably not the time
for it, but >> BEN MENG: You are absolutely right. There
have been a number of academic exercise on understanding what the true return drivers
on asset, levered public equity or not. And 9 research that we have seen is inconclusive
and we will be happy to come back and do a comprehensive view of the work that we have
done and the internal work we have done. >> JJ JELINCIC: Thank you.
>> ERIC BAGGESEN: Mr. Jones? >> HENRY JONES: Yeah, Eric and Ben on the
best case and I think Priya alluded to the absolute return strategy and if we take another
round and we say, well, we want that to go to zero, would that that didn't automatically
go up into global equity and to what degree or effect did it have on the expected compounding
return? >> ERIC BAGGESEN: So what we can do at the
end of all of this clicker exercise, let's say we are operating from either the base
case or the higher return as kind of the bracket, we will go down through the exercise on the
various constraints that have been applied, and if it's a desire of the board, for example,
to change, let's say the constraint that has been applied to ARS and change that number,
we can then have the ability to month of that number around. It's not as elegant and precise
as an obligation. We will be able to explore that and I will suggest we do that after we
get down through an understanding of the constraints and your appetite for those constraints or
your desire to change them. >> HENRY JONES: Okay. Thank you.
>> ERIC BAGGESEN: That will be the last exercise we have planned for today, Mr. Jones.
Other questions or comments? I think we have what we need out of that slide.
At this point, we would skip the movement on the frontier. I think we have a consensus
around the brackets. So I don't think we need to do that.
The next question we would like to collect your Freedback on is the actuarial deviation.
Alan, do you have anything more you would like to say about that?
>> ALAN MILLIGAN: New York I think probably the thing to do is say, assuming that we are
looking at the base case or something very similar to the base case, I'm a little bit
worried that if somebody was voting for a higher return, the higher return portfolio,
with a margin, for them to now vote for a margin would I think give us a very confusing
picture. So I think we assume that the consensus of the board really was for something very
close to the base case. It seemed like there was some desire for a higher return, but in
talking in giving us your vote on the discount rate margin, I think it would be best if it
was done in on the basis of the base case portfolio.
>> HENRY JONES: Alan, would you remind us, because I thought the a verse deviation was
embodied in our discussion of derisking the support folio.
>> ALAN MILLIGAN: Yes. We did certainly, the flexible derisking we talked a little bit
about it, about using the margin, actually to accomplish the derisking. What we are really
talking about here today is not the derisking, but rather what level of risk and return do
you want to run forward with as, you know, so staff will be coming back with a recommendation
on both the asset allocation as well as the margin for adverse deviation that really kind
of reflects the guidance that we get here today.
And so, you know, adding flexible derisking is something we would be looking at out beyond
that, but this sort of sets the it doesn't actually set the base that we go forward with.
That will happen in February, but certainly this will give staff guidance as to what to
come back with in February. But the if you were to select a higher risk the higher risk
portfolio, with a 1.25% margin, you would actually end up with a 7.5% discount rate,
whereas if you select the base case with zero margin, you would also end up at a 7.5%.
If you were to select the base case with a quarter percent margin, you would end up at
a 7.25% discount rate, selecting the higher risk portfolio with no margin would give you
a 7.75% discount rate. So in terms of us understanding what your
direction is, it helps us a lot if you actually regardless of what your initial rote was,
give us this vote on the basis of the base case. So this would be, do you want a 7.25%
margin? Sorry, a 7.25% discount rate, which would be a vote for a quarter percent margin
or a 7.5% rate which would be a vote for no margin and, of course, it's not really you
are not really you shouldn't be voting on what discount rate you want. You should be
voting on what risk characteristics you. >> GEORGE DIEHR: Why don't we do base case,
with or without margin and then vote again and go without those two. There may somebody
people who think well, I don't know. They can think whatever way they want. I think
it's not inconsistent to say I want to be more aggressive in the investment but I want
to have the cushion. >> ALAN MILLIGAN: That's correct. And that's
kind of >> GEORGE DIEHR: So to narrow down what people
are interested in, pretty much those two, Priya will be forced to join one of the groups
too. So >> BEN MENG: So if I understand correctly.
>> HENRY JONES: Anne had a comment. >>> Anne Stausboll: We don't use a margin
now in the current calculation of discount rate. I just wanted to say, I don't think
we should be saying voting, because you are not voting and you are not making a decision
today and if someone comes in and out of the webcast, they might get confused.
>> ERIC BAGGESEN: I apologize for that. >> HENRY JONES: I think it's important to
restate that statement. So that it's clear to the public out there on the webcast.
>> ERIC BAGGESEN: Most certainly. The board is not voting and selecting a portfolio. It's
simply indicating a preference zone to the staff for the future work that we'll do and
bring back to the board for an actual vote, I think in February is our current time frame
on that. >> HENRY JONES: Thank you.
>> ERIC BAGGESEN: Absolutely right. We should not use the word "vote."
>> BEN MENG: Just to recap what Dr. Diehr just said. The recommendation is that we do
this vote twice, one vote is based on A, if you think it should be the base portfolio,
do you want a barn or not and then we clear it and if it's a higher return portfolio,
do you want a margin or not? Not voting, clicking. Clicking.
(Laughter). >> Could you please express your soup preference?
>> ERIC BAGGESEN: Okay. Are there other comments before we start or you already started this
it's already voted. That's okay. It's being voted right now.
Basically for the base case portfolio, no margin. Okay. Tiffany, can you clear it now?
Then for the higher return category. Okay. So it's yep. Okay. Excellent. Are there
any other questions or conversations before we move on to review of the constraints?
So the slide that you see in front of you now is a reflection of the yellow blocks represent
the binding constraints that have impacted some of the candidate portfolios.
So what we would really like to do now is understand the board's either agreement with
the constraint level where it was set, or desire to potentially move the constraints
away from that level and the direction and magnitude. So that will become apparent when
we actually put up the voting blocks. So I think we will go right down in order
of the constraints. So I think the first one that we would see is what has been applied
to private equity. So if you see what we have, we have identified
well, it doesn't matter Ben. So basically, Mr. Jelincic.
>> JJ JELINCIC: From the discussion yesterday, 12% really was about all that could be put
in without really diminishing the value of it. So voting for or not voting for a 16%,
what would that mean? >> So if you see what we have, we've identified -- so basically,
Mr. Jelincic? >> JJ JELINCIC: From the discussion yesterday,
12% really was about all that could be put in without really diminishing the value of
it. So voting for -- or not voting for 16%, what would that mean? Lifting the constraint
beyond that which is practical, I mean, what does it mean?
>> ERIC BAGGESEN: I think what that would really mean is that we'd probably have more
education to do with you as a board and with ourselves as to actually what constitutes
the elements that cause the belief to center around a 12% capacity, in contrast with potentially
a desire to have more exposure. Whether that is completely doable or not is not clear,
and I think that that's just a dialogue that we would have to have and see whether we can,
you know, further test the beliefs that have gone into establishment of those things. Mr.
Emkin? >> ALLAN EMKIN: I think for you to go above
what the staff is recommending, you would have to ask them to come back and say, what
vehicles or what structures would be necessary to do it in a prudent manner? And I don't
know what those might be. There are other large institutions that have bigger allocations.
You don't have the largest private equity portfolio in the world. I can't believe that
anyone wants to do anything that's suboptimal. So there may well be room to move it, but
your staff has given this a lot of thought and they're not comfortable going much higher,
so they'd have to go back to the drawing board, in my opinion.
>> MICHAEL BILBREY: Eric? >> ERIC BAGGESEN: I'm sorry, Michael.
>> MICHAEL BILBREY: Last time in 2010 when you did this, you had a special function built
into your allocation work, you had declining returns to scale. So as private equity allocations
got higher and higher, the return premium would decrease to reflect the fact that at
some infinite size you can't obtain superior returns. That is not built into the model
this time, but if you're voting 15 or 16% thinks this is a great way to spend our -- even
if it's not included in the math this time around.
>> ERIC BAGGESEN: Yeah, that's absolutely right. Mr. Jelincic?
>> JJ JELINCIC: Allan, who has a bigger private equity portfolio? In terms of dollar amounts,
not necessarily percents. >> ALLAN EMKIN: The percent -- have to go
north. Mr. Diehr is quite familiar with that. In terms of size evening you'd have to go
outside the United States to find a larger portfolio. You'd have to go to one of the
sovereign wealth funds. >> ERIC BAGGESEN: Okay, because that's one
of the -- both advantages and disadvantages of size.
>> ALLAN EMKIN: Right. >> JJ JELINCIC: Yeah.
>> ERIC BAGGESEN: Other comments or comments before we get an indication as to your preference
around this constraint? Mr. Jelincic again? (laughter).
>> JJ JELINCIC: Not yet. >> ERIC BAGGESEN: Why don't we try taking
a vote on this, then. As you see, No. 6 -- >> Preference, click -- (laughter).
>> ERIC BAGGESEN: Yeah, I'm sorry. We're going to get an indication. Excellent. Okay. I think
we have 11. Okay. So it appears we have a sort of consensus around the constraint, where
it exists, basically, you know, with a desire to potentially try to bump it up or potentially
a desire to move it way back. Would anyone care to speak to the really pushing private
equity way back kind of an element? All right. That's fine. We don't have to -- we don't
have to call that out. All right. Any comments, questions, from what we see here? All right.
All right. Fixed income. In fixed income the constraint again applying to fixed income
is the minimum amount of fixed income. The lower level constraint is the binding constraint
in relation to fixed income. There's been discussion within the staff about trying to
peg the level of fixed income at 18%. That was the recommendation that came out in some
areas, but we may or may not be able to achieve the desired rate of return if we actually
have that much fixed income. So why don't we work off the 15% number that is indicated
right now. Mr. Jelincic? >> JJ JELINCIC: Can you give us some insight
into the discussion about why staff thought maybe 18 rather than 15?
>> ERIC BAGGESEN: Sure. The discussion really revolves around having something that actually
operates as a real hedge, especially in times of distress against the equity risk in the
portfolio. And the only real hedge that we've had, diversification that we've had, has been
consistent with the fixed income portfolio, and the other element of this was -- in our
target allocation fixed income right now is 16%. It is bumped up by 1% on an interim basis
because of the interim target being applied to real estate. So 1% shifted from real estate
to fixed income. But 16% is our underlying strategic target.
It was also believed that if we reduce potentially the allocation to liquidity, that in order
to diminish -- avoid diminishing the amount of diversification that we have in the portfolio,
that fixed income could potentially be a location for that other 2% reduction, if that's decided
upon from the liquidity allocation. >> JJ JELINCIC: Thank you.
>> ERIC BAGGESEN: Are there other questions or comments? Okay. So we'd like to get your
indication. Okay. So let's see. 6 is where we are, and then some desire to bump it, and
that's actually a fairly strong desire to bump it. What's the percent, Ben, can you
read that? >> BEN MENG: 36 and 20 -- or, no, and 18,
36 and 18. >> ERIC BAGGESEN: Yes, Allen, please.
>> ALLAN EMKIN: I know it's a small amount, but the committee should really understand
that that's going to be coming out of public equity most likely, and there's a significant
return difference, so that's going to reduce the return of the portfolio.
>> So I would also -- I would want to point out that under the base case were he do have,
I think it's an 18 1/2% allocation to fixed income, and so unless there are other changes,
this constraint is not currently operating, nor would it operate as either the 17 or 18%
level, which did have votes. >> ERIC BAGGESEN: Thank you for that comment,
Alan. That's exactly right. >> Under the base case, the 6 for inflation
assets, is that constrained or not? The question is whether more fixed income might come out
of fixed assets. >> ERIC BAGGESEN: That's entirely a possibility.
So let's -- why don't -- so the indication would be for at least maintaining the constraint
as it was at 15% and potentially allocating a couple of percent or so more into fixed
income. So if we just hold that indication for the time being I think then we can go
through this exercise and see if we come up against something mutually exclusive. Okay,
so we have that one, Tiffany? Okay, on real estate. And real estate -- I'm
sorry, was there another comment? On real estate, basically, we have put forward an
allocation to real estate of 11%, which is 1% higher than its current sort of long-term
strategic target, and it's 2% higher than the current interim target that the real estate
team has been operating under as they have been restructuring their portfolio. So if
we can get -- any questions or comments before we get an indication on this one? Mr. Jelincic?
>> JJ JELINCIC: And this one is -- it's the cap that's --
>> ERIC BAGGESEN: It's the cap, the upside is the constraint, right. Mr. Jones, did you
have something 1234. >> HENRY JONES: Yeah, if we were to take the
real estate and infrastructure and look at the asset class of real, then how does it
compare, with the two things that are here? Is it the same?
>> ERIC BAGGESEN: I believe in essence -- does it stay the same, Ben?
>> BEN MENG: Yes, so income -- it stays the same, 1% to real estate and down 1% to infrastructure
so that is flat. >> HENRY JONES: Thanks.
>> ERIC BAGGESEN: Are there other -- Mr. Slaton? >> BILL SLATON: To be sure what I might be
clicking on. Is the other one coming up? Is this driving infrastructure and forest land?
>> No, I believe that we have those -- >> BILL SLATON: It's counter-intuitive if
this is going to affect the other and we'll vote on the other which will affect this.
I'm not quite sure -- click on it. >> ERIC BAGGESEN: I think you should consider
those to be independent elements that can be voted on independently.
>> BILL SLATON: Thank you. >> BEN MENG: For now we're just collecting
your feedback -- we're collecting your indication on each one of the individual constraints
and toward the end we'll put up the Excel work sheet to see if it's workable or not,
because the sum has to be exactly 100%, cannot be lower, cannot be higher. So we may not
be able to accommodate all the constraints or preference that you are indicating, but
for now let's gather all the individual -- your feedback on the individual constraints and
toward the end we'll work it together. >> BILL SLATON: But with leverage you could
be over 100%. >> BEN MENG: That's another policy question.
>> ERIC BAGGESEN: Other questions or comments before we indicate on real estate? Excellent.
Okay. So this seems to be a decided preference for staying pretty much where -- where it's
been pegged, maybe a slight bump to the upside, which -- any -- yes, sir?
>> ALLAN EMKIN: It's important also to keep in mind that just seeing the target doesn't
limit the range, and there will be a range around every target, so if there are opportunities
or disadvantages, it can be higher or lower, depending what the market dictates.
>> ERIC BAGGESEN: Absolutely. That's a great point, Alan, thank you for that. Let's go
to the next category, which is the infrastructure forest land, and again, this is set at 2%.
I think that is pretty much exactly where we are currently operating under an interim
target for infrastructure. The original -- the original target for infrastructure was bumped
up to 2% infrastructure, 1% to forest land, but it has been operating under a -- under
a constraint for -- you know, as they try to work into that program. Okay. We've got
11. All right. So let's see. So 3 is -- okay. So the indication on infrastructure/forest
land centers on the maintenance around 2 with a directionality to increasing it.
>> HENRY JONES: Eric? >> ERIC BAGGESEN: Mr. Jones.
>> HENRY JONES: How much of infrastructure that is uncommitted currently? Maybe that's
a Ted question. >> ERIC BAGGESEN: I think our current uncommitted
on infrastructure is about half a billion dollars. I want to say about 500 million.
Joe has the information. >> It's about half a billion dollars.
>> HENRY JONES: Okay. It's a low number. Thanks. >> 440?
>> 440. (laughter). >> ERIC BAGGESEN: Are there other comments
or questions before we move on? All right. Inflation assets.
>> Is there a constraint or what is it here -- it says do you want more or less --
>> The 6% is a bending -- >> Is that lower or upper?
>> BEN MENG: It's a cap. A cap. >> What is it about this asset class that
leads the 6 cap to being a constraint? Why does the optimizer want to put more into it?
>> BEN MENG: Currently -- good question -- the correlation with the other classes tend to
be on the lower end, so that's why the optimizer likes the inflation asset class.
>> JJ JELINCIC: So it's the low correlation. >> BEN MENG: Yes. As you may recall we can't
inflation class bucket for inflation class purpose. So for people that invest in global
TIPS and U.S. TIPS, among -- investing in commodities. Yes?
>> TERRY McGUIRE: Excuse me. Thank you. Sort of a question I have is --
>> Your microphone. >> TERRY McGUIRE: It's on, sorry. The question
I have is that if your expectations, let's say over the next three years, are that inflation
is not going to be a significant factor, that would somewhat -- or reduce your desire to
have a high cap in this analysis, I would assume?
>> ALLAN EMKIN: I would argue that would be a tactical move and not a strategic move and
that would be a bet that the staff would make, that within the range they would be at the
lower end of the range as opposed to you as a matter of policy, long-term policy, would
say you want to change that. And that's really a question of whether that's a board strategic
decision or it's staff tactical decision. >> TERRY McGUIRE: But I thought that the caps,
whether they're upper bounds or lower bonds, are policy.
>> ALLAN EMKIN: That's the policy, but the staff has discretion, and you can set the
range. You could have a wider range if you wanted them to have more discretion.
>> TERRY McGUIRE: That's true. >> I just would also point out that there's
another constraint in the investment policy statement, which is the total fund tracking
error limit, which is I think a percent and a half, up to half of which can come from
asset class deviations. So if even if there is some sense on the staff that they really
need to be tactical and protect against inflation, that may become a binding constraint, even
within the range. So if the target is 6% but they can go 2 to 10, they may not be able
to go to 10 because it may introduce too much tracking error into the total fund. So we
may want to after all of this discuss ranges in that total fund tracking error to allow
for whatever level of flexibility the board would like to see staff have.
>> ERIC BAGGESEN: That's an excellent comment, Andrew. I would point out the correlation
assumed on the inflation assets is .03 so any reduction in that is going to in essence
drive up the volatility of the resulting mix to some extent. This is one of the most diversifying
components within the -- within the program. The only thing with a lower correlation is
the liquidity area, which we assume is zero correlation. Everything beyond that, though,
moves up into sort of the .2 range on up from there. So reducing -- reducing the inflation
assets would potentially have an impact on the overall risk. But we can explore that
afterwards. >> As long as we've got nine people who expressed
a preference. >> ERIC BAGGESEN: Okay, do we have -- we need
one more indication. Okay. I think we're there. All right. So -- okay. So basically the indication
then has been just pointed out on inflation assets is the same with movement towards reduction.
All right. Can we move on to our next category, Tiffany? Okay. This is liquidity, so there's
been a fair amount of discussion about liquidity. We've put forward a 2% -- Mr. McGuire. (laughter)
Excellent. Thank you. >> TERRY McGUIRE: I couldn't pass on the opportunity.
I'd like to comment that I'm somewhat uncomfortable voting even on this without having --
>> Indicating. >> TERRY McGUIRE: Clicking. I'm uncomfortable
clicking until we get more information from staff relative to the December meeting, because
we may find out relative to the discussion there are significant opportunities for liquidity
that we haven't been focused on. Within the existing portfolio. Therefore, there is potential
that the target for asset allocation could be zero. So I -- I really feel that constraint
of 2% is potentially too high, and so I'm uncomfortable voting on that at this time.
>> ERIC BAGGESEN: Okay. So taking exactly that comment, I think that we can -- we can
commit to bringing back information to you during the December Investment Committee meeting
on those aspects in the portfolio where liquidity can be raised. Perhaps if today we can just
get an indication, and then depending on, you know, where we end up with the material
that we put in front of you in December, then to some extent we can modify what we ultimately
end up bringing back in February, if it's warranted. Excellent. Thank you. Okay. So
the fair consensus around the 2% with again an indication to reduction would be the directionality,
I think, if we're going to change it. Is there agreement on that? Indication? Perfect. Let's
go to our last category, ARS, one of our favorite topics of discussion.
Are there comments or questions before we obtain your indication on this?
>> (inaudible). >> ERIC BAGGESEN: This is basically a fixed
number. It's been pegged at 2%. ARS is an area I think that you can expand or you can
contract, in essence. It's not necessarily capacity constrained, I think, at the levels
we're talking about. This is one of the benefits of ARS.
>> This is the upper constraint and it has been the case that whatever the upper constraint
is in the optimization has been selected. Is that correct?
>> ERIC BAGGESEN: Well, this is just a pegged number. If we unconstraint the optimization
-- as I said, the more we unconstrain it, basically ARS would take an allocation and
it basically takes that allocation from fixed income. So if you unconstrain fixed income
and you unconstrain ARS you will see money directionally move because of the -- basically
the risk profile, and that should not, though, invalidate Curtis's comments, basically, about
fixed income. We think is in a real adverse -- in a real adverse event we think fixed
income is a better diversifier to equity risk so we don't want to minimize that comment.
So basically it's the interaction of two constraints, Andrew, that determine that. But the higher
return to ARS is still about a 7% volatility estimate, albeit the correlation on ARS is
higher, it still pulls money out from fixed income, if you unconstrain that. Mr. Jelincic?
>> JJ JELINCIC: So if -- if I understood you correctly, the ARS is in some ways a fixed
income substitute. The -- in normal -- in a normal environment it provides somewhat
better diversification than fixed income. In a stressed environment it provides less
diversification than fixed income? >> ERIC BAGGESEN: I don't think we would assume
that it provides more diversification in almost any environment. What it really provides,
though, is a significant uptick in the expected return and not -- and not a real shift in
the volatility. The correlation -- the correlation that we assume for ARS is .5 with the equity
market. The correlation that we assume for fixed income is basically .2 -- .21. So fixed
income is believed to be a more diversifying asset, albeit you give up the return. And
I think Curtis had a comment. >> CURTIS ISHII: The other part of it is that
fixed income expected return uses market yields today, and remember, hedge funds use expectational
returns, what we expect it, so we're expecting it to yield T-bills plus 5. That, I think,
is a case that needs to be played out. And so that's why the difference is. And the same
thing that drives TIPS. Look what the expectational return differences are 50 basis points. A
lot of this gets driven in the optimizer because of expectational returns of something. Whether
that plays out, and I think Wilshire says that for bonds, using the ten-year return,
you have a higher probability of achieving that over the ten years than you do on expectational
returns. >> ERIC BAGGESEN: Yes, I think that's a fair
comment. Michael, do you have something you wanted to add? Mr. Jones?
>> HENRY JONES: Yeah, if we were to make this zero, that doesn't mean that we still cannot
have a strategy in the hedge fund area? >> ERIC BAGGESEN: That's exactly correct.
That's the confusion that I think I created yesterday, basically. That is absolutely right.
>> HENRY JONES: So when will -- when will we address that second part -- that issue?
>> ERIC BAGGESEN: , you know, that can be addressed really at almost any time point.
You know, what we're really trying to get an indication of today is whether or not you
really want ARS incorporated as a separate strategic component of the overall fund benchmark,
and I think the issue as to whether you participate in hedge funds is a question that we don't
have to necessarily answer today. We can -- we can bring that back. And that question has
been explored to a fair amount over the last year and probably more than that the last
several years, you know. Again, I think it's still a bit inconclusive, but I think that,
you know, we -- again, we should just take the indication that we get today and then
think about how we would move forward. >> The benchmark for ARS, T-bills plus 5,
is very challenging in a low interest rate environment. When we get to more normal or
yield curve which is not subject to as much central bank manipulation, perhaps the interest
rate will be higher, and that target will be easier to hit. As Eric indicated, if the
committee's decision is not to do hedge funds, staff won't do hedge funds. If the intent
expressed here is zero but go ahead and, you know, do an overlay and do it as you did before,
that's certainly feasible. I just want to emphasize one other issue,
I think, that's important, because there's a belief if you use hedge funds, that active
management has returned, that active managers can -- do have knowledge and skill which can
be applied, and in the case of hedge funds, broadly across all asset classes, that firms
are -- some firms are there who can get that return, and secondly, this staff can find
them and do business with them. If you don't have that belief, then you shouldn't be --
And finally, we have not emphasized return increase for hedge funds for ARS, but rather
risk diversification away from growth risk, and that's why Eric says it's -- think of
it as a substitute for fixed income, and why Curtis would say, think of it as an expensive
substitute for fixed income. But I do want -- just so you know, I mean, I'm -- I think
to say, well, there's a whole class of managers because of the publicity of the industry and
the compensation scheme they use, we don't want to do business with them. You know, I
just don't know. I mean, there's smart people in the industry and some of them do get paid
as hedge fund managers. And the second thing is Ed Robertiello is
building team and we've invested in that, and to go to zero is to tell them we don't
need you, and they'll go, because it's a good team. And I would also admit, case is not
proved, whether we can diversify risk, whether we do select managers, the recent performance
shows that, but we haven't proved it to my satisfaction, to the satisfaction of the team.
But I just want those elements -- it's active management, I believe in that, is the risk
diversifying, and there are some people who work here who will take your signal really
seriously. >> Can you just remind me how much of the
-- as a percent of the total fund we have allocated to hedge funds right now? Obviously
it's not allocated by the board, but by the staff --
>> It's almost exactly the 2% number that you see in front of you, that basically is
maintaining the status quo. >> Yeah, and we took half the overlay off,
so it -- 1% off, so we have another 1% to go to make it an actual asset allocation.
So we're very close to that. >> And I know it's hard to predict, but how
long do you think you need to prove the case? And obviously it depends on what happens in
the markets. We would like to see how it performs in both good and bad markets, I suppose but
-- >> Yeah, we need to downmark -- (laughter)
-- like a hole in the head. (laughter) For certain proofs of active management's value,
a full market cycle is required. How is that for a more bureaucratic answer.
>> We hope we never prove it. (laughter). >> Didn't define the full market cycle.
>> And how long has this asset been in operation, the hedge fund --
>> We've had a hedge fund program for 11 years. >> The absolute returns, strategy, for 11
years? >> Yes.
>> How long has it been since we established this class?
>> You -- basically in February you decided the policy and strategy, February this year,
and I think that was -- that was enormously clarifying, that discussion, and that was
again the risk diversifying and then make it an asset allocation so the board is in
control of that rather than the staff, because we could go from two to ten, just by more
equity futures. >> There are limits. It's not completely unconstrained,
but -- >> JOE DEAR: Mr. Jones, the ARS allocation
has never been part of the strategic asset allocation until this moment in time, though.
So it has never been incorporated in the ALM work up until this time point. Are there other
questions or comments? >> ERIC BAGGESEN: Everybody is waiting. Exactly.
So basically -- interesting. So we obviously have a central tendency around the 2%, 1%
number, and then we have a significant dispersion from that point forward. Okay. All right.
Do we need anything else on that, then, Ben? I think basically if we could take maybe just
a couple-minute break at this point, we can collate a bunch of this information and then
we can put up -- I'm sorry, Ms. Mathur. >> PRIYA MATHUR: Back at the margin question.
Clearly there was a preference for a 7.5% return -- or discount rate. But I'm really
interested to know which reduce -- which option reduces volatility more, the base case with
no margin or the higher end with margin. Because I think it would be useful to be able to express
a preference between those two options. >> ERIC BAGGESEN: I think Alan has the response
to that. >> PRIYA MATHUR: But in terms of riskiness
-- which actually protects us more in terms of our ability to manage contribution rates,
et cetera? >> One point that I would make if you look
back to the sheet that has all the candidate portfolios listed, if you simply look down
between the base case and the higher return, there's a 25% basis point difference in return,
and yet there's nearly a 100 point basis point difference. So this is a trade-off where you're
increasing risk by 4 units for every unit of excess return that you don't pick up. So
there is not a lot of room to maintain -- and you can see what drives that. It's a much
higher allocation, if we stop out private equity at sort of the 12% number, you then
basically have to use public equities as the return generator to do that, because every
other asset segment has an expected rate of return lower --
>> ALAN MILLIGAN: So there's actually a graph on attachment 6, page 17. I don't know what
the -- not having my iPAD up I don't know what it is on the iPAD. Actually attached
-- pages 17 through 22, the middle of the three graphs, if you compare the base case
with no margin with the higher return with a quarter percent margin, you'll see that
the base case with no margin at least with the state mouse has less risk volatility.
>> PRIYA MATHUR: Thank you. >> ALAN MILLIGAN: And I believe that's consistent
through all the different plans we looked at.
>> PRIYA MATHUR: That's really helpful. Thank you.
>> ERIC BAGGESEN: Yeah, thank you, Alan. Are there other comments before we -- we can go
back and we'll bring up the work sheet where we can manipulate these constraints and see
the effects in a few minutes. All right. Perfect.