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Total-Return Investment Pool (TRIP) Asset Allocation & Investment Policy Review and Recommendations

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ATTACHMENT 2 Total-Return Investment Pool (TRIP) Asset Allocation & Investment Policy Review and Recommendations May 27, 2015 Office of the Chief Investment Officer Contents For Discussion at Committee
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ATTACHMENT 2 Total-Return Investment Pool (TRIP) Asset Allocation & Investment Policy Review and Recommendations May 27, 2015 Office of the Chief Investment Officer Contents For Discussion at Committee on Investments: Working Capital Rethinking Liquidity Management Asset Allocation and Investment Policy Recommendations To be Approved by Board of Regents July 23, Working Capital We have two investment portfolios that serve the university s ongoing operational needs. 52% 48% Working with the investments, operations and finance teams across the campuses and with the Office of the President, we help shape our capital and liquidity strategy to meet the objectives that make the university work. Short-Term Investment Pool: $8.3B Total-Return Investment Pool: $7.6B 3 Capital, Working The Working Capital Short-Term Investment Pool was established by the UC Board of Regents in This is a highly liquid cash pool, available to all university groups for funding day-to-day operations. The pool allows participants to maximize income on their short-term cash balances. By investing in this larger pool and its broad range of maturities, we can take advantage of the economies of scale granted by our institutional size. We make investments appropriately to control liquidity, interest rate, credit and maturity risk. The Working Capital Short-Term Investment Pool is supplemented by our Working Capital Total-Return Investment Pool, which was set up in This allows all campuses, as well as the Office of the President, to maximize the return on their long-term capital, subject to acceptable risk. 4 Short-Term Investment Pool Allocation Shifts Fixed Income & Cash March 31, 2015 June 30, 2009 June 30, 2004 $8.3B $6.6B $6.7B 5 Short-Term Investment Pool (STIP) Investment Highlights Assets Under Management March 31, 2014 Market Gains Value Added Net Cash Flow Assets Under Management March 31, 2015 $8.1 billion $29 million $87 million $100 million $8.3 billion 6 Short-Term Investment Pool (STIP) Performance as of March 31, 2015 Net Returns 0.3% 1.1% 1.4% 1.8% 2.1% 3.1% 4.2% Value Added Policy Benchmark STIP Policy Benchmark is weighted composite of Two Year US Treasury Note and 30 Days US Treasury Bills. Weights will be actual average weights of bond and cash equivalent components of the pool. Rebalanced monthly. 4 % Q3 Fiscal Fiscal Year to 1 Year 3 Year 5 Year 10 Year 20 Year Year Date (3 Months) (9 Months) Total-Return Investment Pool (TRIP) Allocation Shifts Equity Fixed Income & Cash Alternatives March 31, 2015 June 30, 2009 August 31, % 22% 25% 50% $7.6B 37% $1.5B $1.5B 78% 75% Equity allocation has doubled while Fixed Income cut in half. In August 2013, introduced liquid alternatives. 8 Total-Return Investment Pool (TRIP) Investment Highlights Assets Under Management March 31, 2014 Market Gains Value Added Net Cash Flow Assets Under Management March 31, 2015 $7.1 billion $0.5 billion $0.2 billion ($0.2 billion) $7.6 billion 9 Total-Return Investment Pool (TRIP) Performance as of March 31, 2015 Net Returns Value Added Policy Benchmark % 3.0% 7.6% 8.8% 8.6% 8.3% TRIP Aggregate Policy Benchmark is a weighted composite of 15% Russell 3000 Tobacco Free Index+7.5% MSCI World Ex- US (Net) Tobacco Free+ 7.5% MSCI Emerging Market (Net) + 10% MSCI ACWI (Net) % Barclays US Credit + 2.5% Barclays US Credit + 5% Merrill Lynch High Yield Cash Pay Index + 5% JP Morgan Emerging Markets Bond Index Global Diversified + 10% Equally Weighted HFRX Absolute Return Index and HFRX Market Directional Index +10% FTSE EPRA NAREIT Global Index % Aggregate TRIP Portfolio. As of March 31, % Q3 Fiscal Year (3 Months) Fiscal Year to Date (9 Months) Year 3 Year 5 Year Since Inception August Opportunities for 2014/2015 Review long-term asset allocation Optimize portfolios for the different plan objectives Manage costs in a low-return environment Active management will play an increasing role in seeking returns Our competitive advantages are size, scale and patience 11 Rethinking Liquidity Management 12 Rethinking Liquidity Management Develop holistic view of STIP and TRIP Hold STIP at constant levels based on campus financial controls Blend STIP and TRIP to maximize returns and balance liquidity needs Based on system-wide cash flows Non-Campus financial control funds in STIP (e.g. bond proceeds, foundation assets, UCRP funds) will not be included as part of the operational liquidity levels UCOP will guarantee operational liquidity for campus access Office of the Chief Investment Officer will propose a revised asset allocation within TRIP to the Committee on Investments Combination of assets in STIP and TRIP will help meet liquidity requirements for rating agencies (operational and self-liquidity) Income from STIP and TRIP will be part of operational budgets going forward 13 Growing Working Capital 14 Growth in STIP* and TRIP ($ Billions) $8 Billion 12 TRIP $3 Billion $4 Billion STIP $5 Billion 10 $1 Billion $2 Billion $ Billions 8 6 $8 Billion $8 Billion $8 Billion $7 Billion $8 Billion $7 Billion $8 Billion 4 Maintain Minimum Short-Term Financial Controls at a $3 Billion Threshold 2 $2.5 Billion Short-Term Ratings and Self-Liquidity Requirements * STIP amounts include Financial Control and the other portion of STIP comprised of: Gifts, Endowment Funds, Plant internal Loans and Other Loans, OP/Bond Proceeds amount includes Bond Proceeds, Commercial Paper Proceeds), MOP, and 3 rd Parties includes amounts held for Agencies, Foundations, and OPEB 14 Managing our Assets System-Wide Working Capital (STIP and TRIP) As of March 31, 2015 $5 $3 $8 $ Billions $0 $2 $4 $6 $8 $10 $12 $14 Campus Financial Control STIP Other STIP TRIP Reallocation System-Wide (Hypothetical Reallocation) Pro-Forma $3 $3 $8 $2 65% Fixed Income $2.5 Billion in Treasuries and Agencies 20% Public Equities 15% Absolute Return $ Billions $0 $2 $4 $6 $8 $10 $12 $14 15 Timeline of Key STIP and TRIP Movements Since TRIP s inception, more than $4.5 billion has been moved from STIP to TRIP, and $1.8 billion from STIP to UCRP August 2008: TRIP formed with an initial investment of about $1.5 Billion April 2011: The University moved $1.1 Billion from STIP to fund UCRP By March 2012: Reached a 70%STIP and 30% TRIP ratio August 2014 Transferred $700 Million from STIP to fund UCRP August : STIP to TRIP Ratio (System-wide): moved an additional $2 Billion from STIP to TRIP. Maximum ceiling of 40% STIP and 60% TRIP TRIP Asset Allocation: increased public equities and alternatives, decreased fixed income TRIP Pay-out Structure: revised to pay campuses income earned (or reinvested if they choose) and 4.75% of NAV (less income earned) on a 60 month moving basis, to avoid volatility September 2014: OCIO offered campuses a TRIP Window of Liquidity to take extraordinary gains from TRIP Campuses took the opportunity to harvest $105 Million April 2015: Move towards a holistic policy, control systemwide Conversion of Funds Two campuses have converted $225 Million to set-up a FFE May 2015: Recommend new asset allocation 16 STIP and TRIP Annual Fiscal Year Returns 20% 16% 14.0% 14.6% TRIP 12% 11.3% 8.3% 8% 6.7% 4% 3.7% 2.7% 2.6% 2.4% 2.1% 1.6% STIP 0% -1.6% -4% Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 17 Various Pools Available to Stakeholders with Different Objectives, Purpose, Risk, and Liquidity Requirements STIP TRIP GEP Purpose Pooled investment vehicle for UC entities cash balances. Supplements budgets, supports MOP and medical centers, and meets ratings requirements Pooled investment vehicle for UC entities longer-term cash balances Pooled investment vehicle, which will generate a stable and continuously growing income stream for designated endowments Objective Maximize return consistent with safety of Principal, liquidity and cash flow requirements Generate rate of return consistent with liquidity, cash flow, and risk budget Preserve purchasing power of future stream of endowment Investment Mandate Income Total-Return Total-Return Risk Exposures Interest Rates, Credit, Reinvestment Interest Rates, Credit, Reinvestment, Equity, Country, Sector, Currency Interest Rates, Credit, Reinvestment, Equity, Country, Sector, Currency Liquidity Daily, cash flow and modeling should support management of portfolio Quarterly withdrawals and 3- year lock-up Withdrawals subject to liquidity Payout Income plus realized gains/losses paid monthly Annual Payout Annual Payout 18 TRIP Historical Policy Asset Allocation 100 Total Fixed Income Total Liquid Alternatives Total Equity % Aug-08 Jan-11 Aug-13 Aug 2013 Long Term May-15 Proposed July, Understanding our Stakeholders Objectives Asset allocation should reflect stakeholder objectives, liabilities, cash management practices, liquidity, time horizon, and risk tolerances. STIP is the primary vehicle for day to day operating needs Funds should be sufficient to cover extraordinary liquidity needs and be comparable to other universities days of cash-on-hand metrics Investments should be sufficient and liquid enough to cover daily operating needs (such as payroll, debt service, expenses, coverage ratios, etc.) Maintain an amount of daily operating needs to meet requirements; benchmark relative to peers; stress test for extreme events STIP should hold enough rating agency-defined investments to meet coverage requirements for self-liquidity. Change in absolute value of STIP impacts long-term ratings. TRIP is the vehicle for operating needs over the coming 3-5 years Objective of earning a 2-3% return above STIP Asset allocation optimized to minimize drawdown over 5 year period There are trade-offs to any investment portfolio, and a higher return/income is correlated with a higher risk profile. In addition, higher return portfolios do not always result in higher annual income. 20 Asset Allocation and Investment Policy Recommendations 21 Asset Allocation Considerations to Meet Stakeholders Objectives Proposed changes will result in greater accountability in portfolio construction of underlying asset class policy portfolios. Shift from specific benchmarks and discrete weightings to broad benchmarks and greater discretion. Objective of TRIP is to generate returns between those earned in GEP and STIP over an intermediate time horizon with a moderate risk profile and adequate liquidity 1. Reduce Equity Allocation 2. Remove Global REITS 3. Remove Cross Asset Class 4. Increase Fixed Income Allocation 5. Increase Absolute Return Allocation 22 Assumptions and Constraints Asset Class 3-Year 5-Year 10-Year Long Term Equilibrium Return Standard Deviation Global Equity 7.1% 7.1% 7.1% 7.6% 19.5% Constraints / Notes Liquid Real Estate 6.2% 6.2% 6.2% 6.2% 21.3% US Short Government/Credit Fixed Income Source: Mercer and Office of Chief Investment Officer 1.8% 2.3% 3.0% 3.9% 3.4% STIP Assumption US Broad - Aggregate Fixed Income 1.8% 2.3% 3.0% 4.2% 5.3% US High Yield Fixed Income 1.9% 2.5% 4.8% 6.4% 9.7% Emerging Markets Fixed Income - Hard Currency ($ Denominated) 1.1% 1.9% 4.7% 6.1% 10.6% Absolute Return 4.2% 4.7% 5.4% 6.0% 7.1% Return Drivers CPI 1.9% 2.0% 2.0% 2.0% GDP 2.9% 2.8% 2.8% 2.7% 90 Day Real Yield -0.6% -0.4% -0.2% -0.1% 30 Year Treasury Yield 3.3% 3.3% 3.4% 3.4% High Yield Spread to Treasury Curve 4.7% 4.9% 5.1% 5.2% Fixed Income allocation 80% Broad 10% US High Yield Fixed Income 10% Emerging Markets Fixed Income 75% Global Macro and 25% Moderate Maximum 20% Allocation 23 Reduce Equity Allocation Current Policy Benchmark Current Benchmark MSCI ACWI IMI Index Asset Class % TRIP Portfolio % TRIP Equity Portfolio Equity Weighted Policy Benchmark % Exposure U.S. 15.0% 37.5% 50.5% 52.0% Non-U.S. 7.5% 18.75% 28.2% 37.6% Emerging Market 7.5% 18.75% 21.3% 10.3% Opportunistic 10.0% 25.0% Opportunistic Regional Breakdown U.S. Exposure 5.2% Non-U.S. Exposure 3.8% Emerging Market Exposure 1.0% Total 40.0% 100.0% 100.0% 100.0% 24 Rationale for Change in Equity Policy Benchmark Current allocation mix between US, Non-US Developed, and Emerging Markets is making a sizeable bet on Non-US Developed and Emerging Markets Emerging Markets target allocation is more than twice the MSCI ACWI IMI index weight and Non-US Developed Allocation is 10% less than the global benchmark weight Current Equity Policy MSCI ACWI IMI EM, 10% EM, 21% Non-US, 28% US, 50% Non-US, 38% US, 52% 25 Benchmark Performance Comparison 70.0 Rolling 12-Month Return % Equity Policy Benchmark MSCI - AC World IMI Index ($Net) Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 26 Remove Global REITS Remove Public Real Estate (REITS) as a category (allocation of 10%): current target is twice as much as the equity index exposure to Real Estate which represents less than 5% REITS presents downside risk, given elevated valuations, slowing economic growth, and likely Fed rate hike 27 Rationale for Change in Cross Asset Class Strategy Remove Cross Asset Class as a category Upon strategic review and exposure analysis determined the cross asset class strategy should be restructured First phase was to reduce the amount of redundant beta exposures and return capital to provide both liquidity to the entity and to fund better opportunities. Remaining portfolio was tilted to alternatives. Restructuring taken place with liquidity raised from duplicative investment exposures. Value added positions will be reallocated to more appropriate portfolios Greater detail on Cross Asset Class provided in the Appendix (in $mm) NAV 6/30/14 NAV 9/30/14 NAV 12/31/14 NAV 3/31/15 NAV 4/30/15 NAV 5/11/15 NAV 6/30/2015 Estimated Satellite Strategies Pool Core Strategic Partners Pool 1,728 1, Total CAC NAV 2,274 2,284 1, of which: UCRP 1,352 1, GEP TRIP Increase Fixed Income Allocation Current Policy Category Current Policy Implied Weights BC US Aggregate Asset Class % TRIP Portfolio % Fixed Income Portfolio Sectors % Fixed Income Portfolio % Exposure Core 19.5% 66.2% Government 74.6% 46.0% Government 17.0% 57.6% Credit 2.5% 8.6% Collateral 0.0% 0.0% Credit 25.4% 23.0% High Yield 5.0% 16.9% Credit 5.0% 16.9% Emerging Market Debt 5.0% 16.9% Collateralized (Securitized) 0.0% 31.0% Government 5.0% 16.9% Total 29.5% 100.0% of Total TRIP Portfolio Total 100.0% 100.0% 29 Rationale for Change in Fixed Income Policy Benchmark Propose moving Fixed Income to Barclays Capital US Aggregate Index as the benchmark, which is comprised of Government, Credit, and Collateralized securities Allocation to Emerging Market Debt and High Yield represents opportunistic bets in fixed income markets and removing from benchmark will provide the ability to better assess the impact of our decision to over or underweight these exposures given market conditions Rolling 12-Month Return Weighted FI BC Aggregate Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 30 Role of Absolute Return An absolute return program should provide consistent, superior riskadjusted returns throughout market cycles. Combine disciplined manager selection with robust portfolio construction. The role of an absolute return program is to provide diversification benefits to a broader portfolio, which includes traditional asset classes such as equities and bonds. Mine for less crowded strategies where there is high potential for alpha. A good program should also be a source of investment idea generation and market intelligence. Idea generation is only valuable if it is communicated and executable 31 Increase Absolute Return Absolute Return is constructed to diversify the public equity and fixed income allocations. Focused on a smaller set of strategies with low beta to the traditional equity and fixed income strategies. Over a full market cycle, expect the TRIP Absolute Return strategy to deliver consistent absolute returns % 0.0 % HFRX - Absolute Return Index HFRX - Market Directional Index Custom - Libor+3 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan Custom - AR BM - HFRX 50/ Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 32 Recommended TRIP Asset Allocation STIP TRIP Current TRIP Long- Term Policy GEP Option 1 Min Max Draw Down Options Option 2 Recommended Option 3 Recommended Range Equity 0.0% 50.0% 50.0% 44.5% 37.0% 35.0% 40.0% +/- 5% Fixed Income 100.0% 29.5% 20.0% 14.1% 43.0% 50.0% 40.0% +/- 5% Cross Asset Class 0.0% 10.5% 20.0% 0.0% 0.0% 0.0% 0.0% -- Absolute Return 0.0% 10.0% 10.0% 23.5% 20.0% 15.0% 20.0% +/- 10% Risk and Return Statistics Expected 3-Year Return 1.6% 5.4% 6.0% 6.2% 4.8% 4.6% 5.0% Expected 5-Year Return 2.1% 5.6% 6.2% 6.4% 5.3% 5.2% 5.6% Long-Term Equilibrium Return 2.8% 6.1% 6.8% 6.8% 5.8% 5.6% 6.0% Standard Deviation (Risk) 2.7% 12.1% 14.2% 13.0% 8.3% 8.3% 9.1% Expected Worst 3-Year Return 0.8% -7.2% -9.2% -10.0% -4.2% -4.3% -4.3% 2008 Historical Drawdown 4.3% -20.7% -32.8% -27.3% -16.7% -16.7% -17.8% Return/Risk (3-Year Options for TRIP Asset Allocation 8.0% Expected 3-Year Return 6.0% 4.0% Option 1 MinMaxDD Option 2 Recommended Option 3 GEP TRIP Current TRIP Long-Term Policy 2.0% STIP 0.0% 0.0% 4.0% 8.0% 12.0% 16.0% Risk (Standard Deviation) 34 Optimize Allocation Between Different Portfolios: STIP, TRIP, and GEP STIP Current TRIP Proposed TRIP GEP Key Portfolio Characteristics Expected Return 1.6% 5.4% 4.6% 6.2% Expected Risk 2.7% 12.1% 8.3% 13.0% Risk Tolerance Low High Medium High Time Horizon Short (Less than 3 years) Long (7+ years) Intermediate (3-5 years) Long (10+ years) Liquidity High Low Medium Low Composition of Pools Equity 0% 50% 35% 38.5% Fixed Income 100% 30% 50% 12.5% Liquid Alternatives 0% 20% 15% 28.5% Illiquid Alternatives 0% 0% 0% 20.5% Total 100% 100% 100% 100% 35 Recommended Asset Allocation Changes Optimization focused on drawdown over 5 year time horizon across broad asset classes (public equity, fixed income, and absolute return) Developed assumption with Consultant given current and expected environment Excluded illiquid assets Recommended changes are shown in the following table TRIP Current TRIP Long- Term Policy Recommended Reduce Equity, Increase Fixed Income and Absolute Return, and remove Cross Asset Class exposure Amendments to investment policy, benchmarks and guidelines Required Change in Policy Ranges Equity 50.0% 50.0% 35.0% -15.0% +/- 5% Fixed Income 29.5% 20.0% 50.0% +30.0% +/- 5% Cross Asset Class 10.5% 20.0% 0.0% -20.0% -- Absolute Return 10.0% 10.0% 15.0% +5.0% +/- 10% Risk and Return Statistics Expected 3-Year Return 5.4% 6.0% 4.6% Standard Deviation (Risk) 12.1% 14.2% 8.3% 36 Recommendations The following actions are recommended to the Committee: 1. Approve the proposed asset allocation changes of: a. Reduce Equity Allocation by -15% b. Increase Fixed Income Allocation by +30% c. Remove Cross Asset Class -20% d. Increase Absolute Return by +5% 2. Approve benchmark revisions a) Public Equity = MSCI ACWI Investable Market Index Tobacco Free b) Fixed Income = Barclays Capital US Aggregate Index 3. Approve investment policy changes 37 Recommended Investment Policy Changes Asset Category Current Target Current Benchmark New Target New Benchmark U.S. Equity 15.0% Russell 3000 Index (Tobacco Free) Non-U.S. Developed Equity 7.5 MSCI World ex U.S. Index (Net) (Tobacco Free) Emerging Market Equity 7.5 MSCI Emerging Market Index (Net) Opportunistic Equity 10.0 MSCI All Country World Index (Net) Global REITS 10.0 FTSE / EPRA / NAREIT Global REIT Index Total Equity 50.0% 35.0% U.S. Core Gov t. 2.5 Barclays U.S. Aggregate Government Index MSCI All Country IMI World Index (Net) (Tobacco Free) U.S. Core Credit 7.5 Barclays U.S. Aggregate Credit Index High Yield Debt 5.0 BofA / Merrill Lynch HY Cash Pay BB/B rated Index Emerging Market Debt 5.0 JP Morgan Emerging Markets Bond Index Global Diversified Total Fixed Income 20.0% 50.0% Barclays U.S. Aggregate Absolute Return 10.0 HFRX Absolute Return Index (50%) + HFRX Market Directional Index (50%) Cross Asset Class 20.0 Aggregate TRIP Policy Benchmark Total Liquid Alternatives 30.0% 15.0% Liquidity - TOTAL 100.0% Weighted Average of Underlying Benchmarks 100.0% HFRX Absolute Return Index (50%) + HFRX Market Directional Index
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