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North Dakota State Investment Board
From the Director's Chair
The Return Factory
"A little nonsense now and then, is cherished by the wisest men." ~ Roald Dahl, Charlie and the Chocolate Factory
During my recent meetings with money managers and fellow CIOs, I can't help but wonder if I am watching the latest reality show entitled, "CIOs and the Return Factory." Just as the characters young and old, rich and poor, rushed to the candy stores in search of the Golden Ticket in Willy Wonka, investors worldwide are looking for the Golden Investment, with access to the Return Factory and the Magical 8% Return.
Make no mistake, the current investment climate is challenging. Short-term, high quality investments such as Treasury bills, commercial paper, etc. have yields close to zero. That's right, invest money for 6-12 months, and at the end you get your money back. Given this alternative, stuffing the mattress looks like a pretty good idea. As one moves out the risk spectrum, the prospects don't appear any more appealing. The S&P 500 index returned 2.11% for the year ended 2011. The time period matters a lot when looking at equity returns. The equity market returned 11.82% for the fourth quarter of 2011, 14.11% annualized for the last 3 years, but lost 0.25% over the last 5 years. When looking at the output from the "Return Factory," the time period does matter.
I am concerned the investors lined up at the Return Factory have forgotten the benefits of being a long term investor. They are trying to manufacture a specific return year in and year out. The long term investor has become the short term speculator. Hedge funds, promising positive absolute returns in all market environments, continue to gain in popularity. Faced with the prospect of low market returns in the short term, investors have been lured by the promise of "alpha." Successful investors have been shown, through solid analytical analysis and hard work, to outperform the broad markets by 1-2% per year over long time periods, yet investors are looking for more. One CIO for a large sovereign wealth fund was overheard stating his alpha return objective for his hedge fund portfolio was 9%! If you are making assumptions, why stop at 9%, why not assume your managers will outperform by 10%? It reminds me of sitting at my child's parent/teacher conference and hearing how everyone's child is "above average." Think about it, how can everyone be above average? The Return Factory is promising everyone to be above average!
John Wooden, the Men's Basketball coach at UCLA, whose teams won the NCAA Championship 10 times from 1964 to 1975, including winning 7 years in a row, can provide some pointers on how to successfully invest for the long term. John Wooden and his teams were fastidious in terms of preparation, with complete focus on the things under their control. Wooden and his coaching staff did not spend hours analyzing game tapes of their opponents. Time was spent in preparation and focusing on the things under their control, including little things. Wooden taught his players how to put on their socks so there were no creases to cause blisters, and kept their hair short to minimize perspiration getting on their hands or impacting their vision. Trivial? Maybe, but it is hard to argue his success. Two of Wooden's maxims continue to stay with me: 1) "Big things are accomplished only through the perfection of minor details," and 2) "The more concerned we become over the things we can't control, the less we will do with the things we can control."
In the game of investing, what are the things that are beyond our control, and what are the things that are within our control? Investors can control the types of risks they are exposed to in the pursuit of investment returns. Bear in mind, investment returns are achieved only though the exposure to different types of risks. Investments that on the surface appear to be risk free may not be. As an example, consider the investment in a 3-month certificate of deposit issued by a bank with FDIC insurance. This investment appears to be safe; principal will be returned in three months and you know in advance the interest you will receive at maturity. But what if your investment horizon is longer than three months? What if it is five years, and you are pursuing an investment strategy of reinvesting in 3-month CDs? If this is the case, you do not know what the future interest rates will be; your rate of return over your investment horizon is unknown. You have taken on reinvestment risk, in what you thought was a risk-free investment.
Investors can control how they diversify across different investment risks, commonly called asset allocation. Investors can also control and manage these risks as realized returns vary over time through a rebalancing strategy. Recognizing the benefits of possessing a longer term investment horizon, the State Investment Board follows a rigorous rebalancing strategy and does not deviate from the asset allocation policies determined by the client funds. When one follows this strategy, and markets are volatile, a benefit accrues to the portfolio: buy low and sell high. Assets that have outperformed are sold to purchase assets that have underperformed. Recognizing that trees can't grow to the sky, the gain from the outperforming asset is harvested and reseeded.
The allure of the Return Factory is tempting. Resist the temptation and focus on the things under your control!
New Asset Allocation Framework
Callan Associates was engaged by the Teachers' Fund for Retirement (TFFR) and the Public Employees Retirement System (PERS) to conduct an asset allocation and liability study for the defined benefit pension plans. Each pension plan has approved a new asset allocation. The tables below show the old and new asset allocation for each fund.
The new framework defines broad asset classes (Global) that capture the opportunity set, with clearly defined components that are specific enough to enable clear accounting of market exposures. At the same time, the framework is flexible enough to allow for innovation and the inclusion of new strategies as they arise and are appropriately vetted.
The benefits of the new framework start with a more specific and clear definition of asset classes, where investments are housed under appropriate market categories and true market exposures are more clearly articulated. The framework allows flexibility in the implementation of the investment program by better identifying the full opportunity set. Not all strategies identified must be pursued, and the structure remains open to new strategies as they arise. In essence, the framework divides the portfolio into three basic categories, defined by their reactions to specific capital market factors:
While more detailed than the previous asset class designations, this framework actually simplifies the broad strategic asset allocation into three basic categories. Conveniently, the basic building blocks for implementing this framework are currently in place. In essence, the framework is a new lens for viewing the pension fund's investment program.
Net Investment Performance
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Actuarial Assumed Return
The North Dakota Retirement and Investment Office (RIO) recently hired Darren Schulz to fill the newly created position of Deputy Chief Investment Officer. He reports directly to John Geissinger, Executive Director and Chief Investment Officer. This position was created by the 2011 Legislative Assembly to provide additional resources and expertise to RIO.
Darren has over 15 years of investment management experience. He joins RIO from Wellpoint, Inc., where he held the position of Investment Manager and was responsible for the oversight of the company's defined benefit, defined contribution, non-qualified plans, and foundation assets. Prior to joining Wellpoint, Darren was in the investment consulting business with Morgan Keegan and Tioga Consulting, and spent 9 years in investment management for the Retirement Systems of Alabama.
Darren received his Bachelor's degree in finance from Georgia State University, and is a charter holder from the CFA Institute.
Darren and his wife, along with their young son are getting acclimated to North Dakota. And if you ask them, they don't see why everybody thinks ND winters are so horrible.
The North Dakota Retirement and Investment Office Comprehensive Annual Financial Report (CAFR) has been published and may be viewed from our website, www.nd.gov/rio. This report is a complete review of the financial, investment, and actuarial conditions of the State Investment Board and Teachers' Fund for Retirement.
State Investment Board
Lt. Governor Drew Wrigley, Chair
Mike Sandal , PERS Trustee, Vice Chair
Clarence Corneil, TFFR Trustee
Levi Erdmann , PERS Trustee
Lance Gaebe , Land Commissioner
Mike Gessner, TFFR Trustee
Adam Hamm, State Insurance Commissioner
Howard Sage, PERS Trustee
Kelly Schmidt, State Treasurer
Cindy Ternes, CPA, Designee WSI
Bob Toso, TFFR Trustee
RIO Administrative Office
John Geissinger, Executive Director / CIO
Fay Kopp, Deputy Executive Director / Retirement Officer
Darren Schulz, Deputy CIO
Shelly Schumacher, Editor
ND Retirement and Investment Office
1930 Burnt Boat Drive, P.O. Box 7100
Bismarck, ND 58507-7100
701-328-9885, Toll free: 1-800-952-2970
Articles are for general information only and are not intended to provide specific advice or recommendation. Any views, opinions or conclusions expressed herein are those of the author(s) and do not necessarily reflect the position or policy of the SIB or North Dakota Government. Other forms of this newsletter are available upon request.
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