Overview of Financial Markets
Many financial markets moved quite violently during Fiscal Year 2016. However, all the drama produced investment returns that were unremarkable and, in fact, negative. The S&P 500 fell by 10% twice, once in August 2015 and again in early 2016, but recovered the losses in both instances to end the fiscal year roughly flat. Some refer to this as return-less risk. Global economic growth remained modest, corporate earnings declined, and U.S. interest rates continued their three-decade decline, while geopolitical concerns remained at the fore.
That’s two consecutive years of investors, including the Fund, accepting a variety of significant risks and receiving little return—with the prospect of more such years to come. Many anticipate that this low-rate, low-growth, low-return environment will persist. In such an environment, if one structures the same sort of investment portfolio that achieved some success in the past, and if one behaves in the same ways as in the past, one will be accepting far greater risks than in prior decades and likely accruing far lower returns. As described below, the Fund has been adapting.
Although the Fund’s cumulative returns have been strong over the most recent market cycle of about seven years, today’s exceptional investment environment poses considerable challenges. The U.S. stock market is at all-time highs, while interest rates globally are at all-time lows. This combination has led to higher prices of most securities and therefore may have borrowed from future returns, which may continue to be lower than those of the past.
As a result, Management currently views few asset classes and investment strategies to be attractively priced for buyers on a risk-return basis. Many capital markets forecasters project lower returns going forward—and we would agree. Institutions we respect share this view, including Cambridge Associates, the Fund’s investment consultant, which rates most of the dozens of asset and sub-asset classes as overvalued and nearly all of the rest to be fairly valued. Precious few register as undervalued.
Global high debt levels, muted economic growth, disinflationary trends, central bank-controlled interest rates, and high valuations do not tend to be a recipe for sustained, high market returns. The result: few compelling options for investors.
Against this challenging backdrop, unpredictable geopolitical events continue to spark investor concerns. Both emerging markets and, increasingly, developed markets have experienced political shocks this year, ranging from impeachment in Brazil to British voters’ desire to leave the European Union (so-called “Brexit”). Low income growth and wealth inequality are creating societal tensions that have boiled over into politics, fiscal policy and even monetary policy. In addition, the world has experienced many episodes of terrorism and increased military friction as China and Russia assert dominance over their spheres of influence. Such developments only add to the uncertainty about what the future holds for financial market returns.
During the Fund’s 94 years, broad exposure to stocks and bonds has been sufficient to fulfill the Fund’s mission. We do not believe this is so today. The following sections of this report describe the steps that we are taking on your behalf to fulfill the Fund’s mission in the face of this challenging environment.
As you will read in this report, your Fund’s Management is adapting and responding to the low-rate, low-return environment in a variety of important ways.
Most important, however, is what is not changing. The Fund is fortunate that, due to its liability structure, it is able to maintain a long-term perspective as it considers its investment options and stewards its assets. The Fund has the capacity to be patient and forward-looking. As such, when conditions warrant and certain types of assets look inexpensive, the Fund can choose to act in a contrarian fashion, buying the less-expensive assets and selling what is valued excessively.
We continue to maintain a diversified portfolio comprised of numerous asset classes, each of which can respond differently under various economic conditions.
What is changing at the Fund is the product of an ongoing effort to diversify the sources of risk we accept—in other words, to pursue not more risk, but different risks. In particular, we are increasingly pursuing return streams that are less correlated to economic growth or financial market valuations, which are some of the main factors that drive equity values. Public equities constitute approximately half of our capital and the vast majority of our risk and volatility. Examples of strategies that are at least modestly less correlated include:
Directional Alternatives Strategies, examples of which are strategies whose managers can add value to companies, such as certain private equity managers and activist investors, or hedge fund strategies that pursue attractive absolute returns with mitigated risk
Certain niche strategies in which returns depend primarily upon cash flows rather than valuation at the time of a future sale
In addition, we are taking steps to maintain and augment the Fund’s downside protection, including our holdings in:
Maintaining roughly 10% of the Fund in the recently created Rates portfolio, which holds only the safest securities, in particular U.S. Treasuries. These are more likely to preserve value if financial markets were to revalue lower and the rest of our portfolio were to decline in value accordingly.
Maintaining an allocation to Cash. Currently, cash has defensive properties similar to short-term U.S. Treasury securities, and it also provides the Fund with available capital to make new investments following a market decline.
We strive to earn market returns efficiently and to find strategies and managers within each asset class that we are confident can generate superior performance over a market cycle, although not necessarily in a given quarter or year.
Highlights of Fund Performance
The Fund takes a long-term perspective in its asset allocation and investment decisions as well as in evaluating performance, and we summarize our fiscal year results in each Annual Report. In FY’16, a year of muted financial returns in the investment markets, the Fund declined by ‑3.7% (net of all external and internal investment related fees and expenses). The Fund ended FY’16 with $5.9 billion of investment assets.
This is the first time in seven years that the Fund has fallen short of its benchmark over a one-year period. As we have cautioned, the investment strategies pursued by your Fund’s Management are not expected to provide positive returns or better returns than a given benchmark every year. Rather, these strategies are designed to provide the long-term returns necessary to support Fund benefits. Accordingly, we have not become overly excited when our one-year returns exceeded our Composite Benchmark, nor do we necessarily become highly concerned when the one-year returns fall short. While we pay close attention to interim results and consider making course corrections along the way, our ability to take a long term perspective is one of the Fund’s key investment advantages.
In FY’16, the Fund’s underweight positioning to Public Equity helped our relative returns. Disappointing performance by certain managers, especially those in U.S. Large Cap Equities, were the most important drag on the Fund’s relative returns. This asset class, which had helped the Fund outperform in recent prior years, represented nearly all of the Fund’s underperformance versus the Composite Benchmark.
While the Fund underperformed its benchmark in FY’16 by roughly 2%, absolute and relative returns over longer periods have been better; over three- and five-year periods, the Fund returned 5.1% and 5.4%, respectively. Both of these periods were roughly in line with the Composite Benchmark. Over the last seven years, which most closely approximates the most recent market cycle, the Fund has returned a healthy 8.7% per annum and exceeded its Composite Benchmark.
Managing the Portfolio’s Risks
Risk measurement, monitoring and management are critical aspects of investing. As mentioned earlier, the challenging investment environment has led your Fund’s Management to adjust our investment strategies. In some cases, these changes entail greater portfolio complexity.
To keep pace with the needs of a more complex portfolio, we have been upgrading our risk-related systems and processes. Our Director of Investment Risk is coordinating and upgrading our exposure analysis and other risk functions. Below are some of the many other steps we take to measure, monitor and manage risk in the portfolio:
We perform quantitative modeling to understand a variety of portfolio risks and sensitivities to possible economic scenarios.
We manage the Fund’s liquidity, based on a combination of historical analysis and forward-looking projections, in order to ensure an uninterrupted stream of benefit payments.
We regularly monitor our exposures and concentrations by various categories. Certain key items are monitored daily, while others are tracked weekly or monthly or, in the case of most private (illiquid) asset classes, quarterly.
Asset Class Exposures
As the largest single asset class, representing almost half of the Fund, Public Equities plays an important—even dominating—role in both the Fund’s return generation and volatility. Management seeks investment firms that perform deep diligence on their portfolios (and some that occasionally use activist strategies to enhance returns), while also paying close attention to how their companies would perform in an economic downturn. Management is consolidating the portfolio into the investment managers in which we have the greatest confidence. In general, we tend to prefer investing with bottom-up, valuation-sensitive equity managers. However, the Fund remains broadly diversified across geographies, sectors, investment styles, and other metrics.
The Rates portfolio is intended to provide liquidity and downside protection, with return generation being a lower priority. As such, this asset class is currently comprised solely of U.S. Government obligations. However, in some circumstances, it might hold other very low-risk assets.
The Credit portfolio consists of managers that pursue an array of strategies, including distressed investments (both broadly and in energy companies specifically), bank loans, direct lending funds, and funds that invest opportunistically throughout the credit universe. These funds seek to generate strong long-term returns and are impacted more by their security selection than by interest rate movements.
Broadly, Hedge Funds are intended to provide long-term returns that meet the Fund’s needs while also providing a measure of protection in the event of an equity market decline. The Fund targets managers in a variety of strategies, some of whom perform fundamental security selection (akin to the Public Equity portfolio—but with lower target volatility) while others pursue macro, arbitrage or other strategies that have had diversifying properties. These Hedge Fund strategies can be divided into “Directional Exposures” (moving with equity and credit markets) and “Diversifying Exposures” (largely not correlated with equity markets).
The Fund seeks to partner with a small group of exceptional Private Equity managers who have strong track records, proven operating abilities and histories of emphasizing downside protection. Most of our Private Equity managers seek to generate strong returns by acquiring private businesses and enhancing their value through growth and operational improvements. Our other Private Equity managers seek to invest in and help grow emerging companies.
The Fund has been pursuing real estate investments tactically, as we see reasons for caution throughout the marketplace. Recent investments have focused on sharpshooters with deep capabilities in a particular market or property type.
The Natural Resources portfolio seeks to generate strong long-term returns with substantial exposure to commodity prices, especially energy. Management has focused on private funds that invest primarily in companies that own and operate energy-producing assets, but also has a smaller amount of exposure to firms focusing on energy services. We continually review other strategies as well, including those focused on commodities other than energy.
Looking Forward: Asset Allocation
Asset allocation tends to be the primary driver of investment returns over longer periods of time, and diversification across asset classes is a key component of a successful investment program. Management and your Board of Trustees have constructed a Policy Allocation that reflects our preferred strategic asset allocation, with target allocations and ranges. We modify this periodically; as of July 1, 2015, we increased the allocation to certain types of Hedge Fund strategies, while decreasing allocations to Public Equities and Credit. These initiatives remain ongoing, and similar changes are expected when we next revisit the Policy Allocation.
The current Policy Allocation is presented in the chart above. The targeted asset allocation in the Fund’s Policy Allocation appears inside the box in the middle of each bar. The range of allowable exposures speaks to the Fund’s risk control, as it ensures we have minimum amounts of each type of asset while ensuring we don’t have too much of any. In short, it helps ensure a diversified portfolio. These limits are reflected in the end points of the bar depicting the range for each asset class.