asset allocation review - nebraska · 2017. 12. 27. · aon hewitt retirement and investment...

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Nebraska Investment Council

Asset Allocation Review

July 2017

Aon Hewitt | Retirement and Investment

Proprietary & Confidential

Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 2

Overview

The A/L Study conducted last summer supported NIC’s existing 80% Return Seeking / 20% Risk

Reducing asset mix

– Please note that ≈2/3 of the 30% fixed income allocation is invested in core bonds

Given existing market conditions, meeting or exceeding the assumed rate of 7.5% is likely to prove

challenging

– That said, there are changes that can be made to the return-seeking portfolio to enhance long-

term return forecasts (and/or reduce portfolio volatility)….at least at the margin

Long-Term Policy

Allocation

Annualized Return (10

Year Forecast)**

Standard Deviation (10

Year Forecast)**

U.S. Equity 29.5% 6.5% 17.4%

Non-U.S. Equity 13.5 7.6 20.9

Global Equity 15.0 7.1 18.5

Fixed Income* 30.0 2.8 3.8

Private Equity 5.0 8.5 24.0

Real Estate 7.5 5.8 12.5

Total Fund 100.0% 6.1% 12.1%

*Modeled as 20% core bonds, 1.5% international bonds, 3.5% high yield bonds, and 5% bank loans

**Based on 3Q 2016 AHIC 10-year CMAs




Asset Allocation – Peer Comparison

*Greenwich Associates – Institutional Investors Market Trends 2016 **Based on 3Q 2016 AHIC 10-year CMAs

37.0%

20.5%

30.0%

7.5%

5.0%

0.0% 0.0% 0.0%

26.2%

19.6%

26.2%

9.0%9.8%

4.1%

1.1%

4.0%

28.1%

19.0%

23.6%

8.6%

5.5%4.5%

0.8%

9.9%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

U.S. Stocks Non-U.S.Stocks

Core-PlusFixed

Income

Real Estate PrivateEquity

HedgeFunds

Cash Other

NIC Public Funds > $5 billion Public Funds $1-$5 Billion

NIC Public Funds > $5 Billion Public Fund $1-$5 Billion

Forecasted Return** 6.1% 6.1% 5.9%

Forecasted Volatility** 12.1% 11.5% 11.4%




Other Asset Classes -- Worth Considering for NIC?

Asset Class

Forecasted

Return*

Forecasted

Volatility*

Worthy of

Further

Consideration? Comments

Hedge Funds 4.8% 9.0% Likely No

Can be a good diversifier, but high fees, ever

increasing competition, disappointing performance for

several years, and a poor fit with “Efficiency” approach

Infrastructure 6.3% 14.5% No

Intriguing in theory, but privatization has not taken hold

in the U.S. like some predicted. More of a Private

Equity sub-component than a standalone asset class

Commodities 3.5% 17.0% No

Makes sense for investors with extreme sensitivity to

inflation. For others, commodities offer low real returns

and high volatility

Multi-Asset /

TAAN/A N/A No

Timing markets is exceptionally difficult; very few

managers have shown an ability to add value with

tactical asset allocation

Risk Parity 5.6% 10.0% Likely NoSuccessful long-term track record, but track record

achieved during a secular decline in bond yields

Timber 5.4% 15.0% NoNiche asset class that can serve as a good diversifier;

long lock-up for middling returns, however.

Emerging

Market

Debt**

5.0% 12.0% Perhaps

High yields, some diversification potential, but relatively

volatile. Better as a part of a diversified credit

allocation than a standalone asset class in our view

Private

Credit***5.7% 9.0% Perhaps

High yields, compelling investment thesis; relatively

high fees and a give up in liquidity required

*Based on 3Q 2016 AHIC 10-year CMAs **Modeled as 50% USD EMD / 50% Local Currency EMD ***Modeled as 50% Direct Lending / 50% Multi-Asset Credit




Three Changes to NIC’s Long-Term Target Asset Allocation Policy Worth

Considering

Constructing a realistic asset allocation policy with a better than average chance of meeting the

assumed rate is not possible in the current return environment, given our capital market assumptions

There are, however, changes that could increase forward looking return prospects and/or reduce

portfolio volatility

Three asset allocation changes that we believe are worthy of consideration

1) Constructing the equity portfolio such that it is more in-line with global equity market

capitalization

• i.e., reducing home country bias within equities

2) Separating the bond allocation into “risk reducing” and “return seeking” fixed income, and

establishing a target to less liquid fixed income opportunities within the return-seeking

component

3) Reducing the allocation to public equities, increasing the allocation to private equity and real

estate*Based on current AHIC CMAs

Core Fixed Income,

20%

Real Estate, 5%

Private Equity, 75%

Solving for 7.5%*




Potential Asset Allocation Scenarios for Consideration

Current AA Policy

Scenario #1 –

50/50 U.S. / Non

U.S Equity

Scenario #2 – 10%

Credit

(Public/Private)

Scenario #3 –

Reduce Equity,

Increase Alts

Scenario #4 –

Combine

Scenarios 1&2

Scenario #5 –

Combine

Scenarios 1, 2 & 3

U.S. Equity 29.0% 19.5% 29.0 25.0% 19.5% 17.0%

Non-U.S. Equity 13.5 19.0 13.5 12.0 19.0 17.0

Global Equity 15.0 19.0 15.0 13.0 19.0 16.0

Core Fixed Income 20.0 20.0 20.0 20.0 20.0 20.0

HY Corp 3.5 3.5 -- 3.5 -- --

Bank Loans 5.0 5.0 -- 5.0 -- --

Int’l Bonds 1.5 1.5 -- 1.5 -- --

Public Credit* -- -- 5.0 -- 5.0 5.0

Private Credit** -- -- 5.0 -- 5.0 5.0

Private Equity 5.0 5.0 5.0 10.0 5.0 10.0

Real Estate 7.5 7.5 7.5 10.0 7.5 10.0

Total Fund 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Forecasted Return 6.1% 6.2% 6.2% 6.2% 6.3% 6.4%

Forecasted Volatility 12.1 12.3 12.2 11.9 12.4 12.1

Sharpe Ratio 0.40 0.41 0.41 0.42 0.41 0.43

Distribution (1 Year)

5th Percentile 27.8% 28.2% 28.0% 27.4% 28.5% 28.0

25th Percentile 14.5 14.7 14.7 14.4 14.9 14.8

50th Percentile 6.1 6.2 6.2 6.2 6.3 6.4

75th Percentile -1.7 -1.4 -1.6 -1.4 -1.6 -1.4

95th Percentile -11.9 -12.0 -11.9 -11.5 -12.0 -11.5

*Modeled as 50% HY bonds / 50% Bank Loans

**Modeled as 50% Direct Lending, 50% Multi-Asset Credit




Cap-Weighted Equities – Why and Why Not?

Arguments for:

– Efficiency pick-up

– Current valuation picture

– Peer practice 6.4%

6.6%

6.8%

7.0%

7.2%

7.4%

7.6%

17.0% 18.0% 19.0% 20.0% 21.0% 22.0%

Exp

ecte

d N

om

inal

Geo

metr

ic R

etu

rn

Expected Risk (Volatility)

U.S. Equity Non-U.S. Equity Cap-Weighted

Current NIC Equity

Russell 1000 Forward P/E Ratio (Large-Cap U.S.

Stocks)

MSCI EAFE Forward P/E Ratio (Developed

Market International Stocks)Russell 2000 Forward P/E Ratio (Small-Cap

U.S. Stocks) MSCI Emerging Markets Forward P/E Ratio

56.7%

43.3%

0%10%20%30%40%50%60%70%80%90%

100%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

U.S. Stocks Non-U.S. Stocks

Composition of Equity Allocation: Public Funds >$5 Billion*

*Greenwich Associates – Institutional Investors Market Trends 2007-2016

Arguments against:

– Increased currency exposure (liabilities denominated in dollars)

– Higher fees (potentially)

– Current allocation provides most of the diversification benefit of international stock exposure




Splitting the Bond Allocation and adding a Targeted Allocation to Private

Credit – Why and Why Not?

Benefits and Drawbacks of separating the fixed income allocation into “Risk Reducing” and “Return

Seeking”

Benefits Drawbacks

More control over asset allocation Complexity

More control over risk Higher cost

DiversificationTakes tactical decisions out of the hands of those

best positioned (in theory) to make them

Benefits and Drawbacks of establishing a targeted allocation to Private Credit within the “Return

Seeking” fixed income allocation

Benefits Drawbacks

Increased Return Potential Complexity

Understandable investment thesis Higher cost

Diversification potential Liquidity give up




Increasing the Allocation to Real Estate and Private Equity / Reducing

the Allocation to Public Equities – Why and Why Not?

Arguments for:

– Increased Returns (Private Equity), Reduced Volatility (Real Estate)

– Performance persistence (i.e., past outperformers outperforming in the future) is stronger in alternative

asset classes than it is in public markets

– Reduced equity risk

– Leverages NIC’s liquidity advantage

0%

20%

40%

60%

80%

100%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%C

on

trib

uti

on

to

To

tal R

isk

Alternatives as % of Return-Seeking Assets

Equity Diversifying Assets* Alternatives Bonds

Contribution to Risk at Varying Levels of

Alternatives Allocations

Net Outflow Analysis: (Benefit Payments less Contributions) / MVA

School Retirement System

Arguments against:

– Costs in private equity and real estate are substantially higher than in public equity

– Additional complexity

– Private equity yet to “prove itself” for NIC

– Reduced liquidity




NIC’s Private Equity Allocation – Pacing Considerations

0%

1%

2%

3%

4%

5%

6%

Current 2016 2017 2018 2019 2020 2021 2022

Projected NAV of Private Equity as a Percent of Total Program

2.1% Asset Growth 3.6% Asset Growth

5.1% Asset Growth Target Policy Allocation

2016 2017 2018 2019 2020 2021 2022

Private Equity NAV @ Beginning of Year $559.0 $567.8 $625.8 $678.1 $721.5 $754.8 $781.0

Capital Called (23.4) (112.4) (123.3) (128.2) (129.0) (130.7) (130.9)

Capital Called - Existing Commitments (23.4) (95.6) (79.1) (54.5) (34.2) (19.1) (8.6)

Capital Called - New Commitments 0.0 (16.7) (44.2) (73.7) (94.8) (111.6) (122.3)

Distributions 36.0 153.3 173.1 190.4 197.5 211.2 218.7

Distributions - Existing Commitments 36.0 152.6 169.4 179.9 173.7 164.3 143.2

Distributions - New Commitments 0.0 0.7 3.7 10.5 23.8 46.9 75.4

Net Cash Flow 12.5 40.9 49.8 62.2 68.5 80.5 87.8

Appreciation 21.3 98.9 102.1 105.6 101.8 106.7 107.6

Appreciation - Existing Commitments 21.3 99.9 102.9 101.2 85.0 73.6 58.3

Appreciation - New Commitments 0.0 (0.9) (0.7) 4.4 16.8 33.1 49.3

Private Equity NAV @ End of Year $567.8 $625.8 $678.1 $721.5 $754.8 $781.0 $800.8

Private Equity as % of Total Program (1) 4.6% 4.8% 5.1% 5.2% 5.3% 5.2% 5.2%

Annual Commitment Pace

In $ Millions

Year Investment

2017 150.0

2018 150.0

2019 150.0

2020 150.0

2021 150.0

2022 150.0

• Based on current

pacing, 5% PE

target should be

reached in 2018




NIC’s Real Estate Allocation – Pacing Considerations

Forecast

6.2%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

2007 2008 2009 2010 2011 2012 2013 2014 2015 Q42016

2017 2018 2019 2020 2021 2022

Core Allocation Non-Core Allocation Target Policy Allocation 6.0% Total Program Growth Actual Net Asset Value

$ in millions

Inception to

Q4 2016 2016 2017 2018 2019 2020 2021 2022

Commitments 870 80 50 50 20 20 20 20

- Core 60 30 30 - - - -

- Non-Core 20 20 20 20 20 20 20

Capital Calls (945) (18) (177) (82) (28) (23) (27) -

Distributions 536 26 43 40 50 56 64 -

Annual Net Cash Flows (409) 8 (134) (41) 22 32 37 -

Real Estate NAV 775 775 966 1,079 1,137 1,189 1,240 1,305

Total Plan Value 12,471 12,471 13,219 14,012 14,853 15,744 16,689 17,690

RE Value as a % of Total 6.2% 6.2% 7.3% 7.7% 7.7% 7.5% 7.4% 7.4%

Real Estate program is maturing, commitment pace will slow in upcoming years




Efficient Execution in Core Portion of Real Estate Portfolio

Notes: Average Fund Tracking Error includes the 16 NFI-ODCE funds which have a greater than 10 year history as of 12/31/2016, “Largest” portfolio scenarios take a weighted

average approach starting in Q1 2016 and rebalancing every three years to account for changes in index components

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

Annual Average (2007 - 2016) Trailing 10-Year Ending12/31/16

NFI-ODCE Dispersion of Return (Top to Bottom Quartile)

0.00%

0.25%

0.50%

0.75%

1.00%

1.25%

1.50%

1.75%

2.00%

2.25%

2.50%

2.75%

3.00%

3.25%

3.50%

3.75%

4.00%

4.25%

4.50%

4.75%

5.00%

Tracking Error (Rolling 3-Year)

Average Fund Largest 2 Largest 3 Largest 4 Largest 5

While short-term dispersion between Core funds can be wide, long-term dispersion is relatively tight

Some investors have difficulty avoiding flipping in and out of Core funds during periods of short term

underperformance

Efforts are best spent taking a “passive” approach in Core and spending more time on manager selection in

the Non-Core portion of the portfolio




Appendix: AHIC Medium-Term Views

MTVs are shown against strategic benchmark weights. Fundamental, valuation and near-term columns convey the

positives and negatives that build up to the aggregate MTV for an asset class.

MTV May 2017

May 2017 April 2017 Fundamental Valuation Near Term

Global Equity (ACWI) = = = = =

US LC Equity = = = - =

US SC Equity = = = - =

EAFE Equity + + + + ↑+

EM Equity + + + + +

High Yield = = = - =

Bank Loans + + + + +

USD EMD = = = - =

Local EMD + + + + =

Hedge Funds + + N/A N/A N/A

Commodities = = = = +

Direct Real Estate = = = = N/A

IG Credit - - = - =

US Government Bonds -- -- -- - -

Cash = = = -- =

USD = = = - ↓ -

Key:

“+++++/- - - - -” = max over / underweight, “=” = neutral. Currency “+” scores indicate a stronger USD and “-” scores indicate a weaker USD.

↑ / ↓ = positive /negative change in view or component of view from last update.

Reg

ion

al

Equ

ity v

iew

s

rela

tive

to

AC

WI E

qu

ity

asset allocation review - nebraska · 2017. 12. 27. · aon hewitt retirement and investment...

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