eastern michigan university board of regents · • embrace illiquidity in opportunistic credit and...

Quarter Ending September 30, 2016Investment Performance Analysis

James E. Reichert, CFA, PartnerGary A. Wyniemko, CFA, Senior ConsultantChristopher Chow, CFA, Analyst

Eastern Michigan UniversityBoard of Regents

NEPC Update 2

Market Update 4

Market Focus: Inflation Expectations 21

Q3 Executive Summary 26

Total Fund Summary 33

Appendix 51

Page

Table of Contents

September 30, 2016

Eastern Michigan University - Board of Regents

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NEPC Update

2

NEPC InsightsRecent White Papers• “DC Governance: Slaying the Hydra” (August)• “Nonprofit Annual Audit Survival Guide” (August)• “Class is in Session: Lawsuits Against Higher Education

Retirement Plans” (September)• Market Chatter: “NEPC’s Summer Travel: Perspectives

on China” (September )• NEPC’s 11th Annual Defined Contribution Plan & Fee

Survey

Webinar• “2016 Defined Contribution Plan & Fee Survey Webinar”

(September); Panel reviewed key findings from our 11th annual NEPC 2016 Defined Contribution Plan & Fee Survey.

Video Series• “Five Questions with Jeff Roberts on Healthcare

Strategic Private Equity Investing” (July)• “Five Questions with Richard M. Charlton” (July) • “Discussing Pension Risk Transfers with Chris Levell

and Craig Svendsen” (August)

Third Quarter NEPC Update September 30, 2016

Upcoming EventsNEPC’s 22nd Annual Investment Conference will be held on May 9-10, 2017 at the InterContinental Hotel in Boston, MA.

ESG – Clearing Up The Confusion Webinar (Coming in December)

NEPC is hosting a webinar to continue the conversation around Environmental, Social and Governance integration (ESG). We aim to help clear up the confusion around what ESG represents and why it has become a growing topic of interest. NEPC will be joined by investment managers from different asset classes who will offer their insights into how they are implementing ESG into their investment portfolios.

NEPC Gives Back• NEPC employees went “sock-less” and

participated in the Sox for Socks drive to support the Boston Health Care for the Homeless Program, which provides socks for the homeless men and women of Boston.

• Eighteen NEPC employees volunteered to work with Habitat for Humanity Greater Boston, stepping up to help build new homes for low-income families in need of decent and affordable housing.

NEPC RecognitionsWe are pleased to announce that Chief Investment Officerpublished their fifth annual list of the world’s most influential investment consultants featuring NEPC’s Tim McCusker, FSA, CFA, CAIA, CIO, Partner, and Scott Perry, CAIA, Partner.

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Market Update

4

• US economic expansion can persist: Growth cycles don’t die of old age– Health of US consumers remain supportive for an extended growth cycle– US corporate earnings under pressure from profit margin declines and dollar strength– Continued growth supports positive returns in a low expected return environment

• Slow expectation of interest rate increases from the Federal Reserve– Risks are asymmetric for a negative Fed surprise with muted rate hike outlook– A surprise Fed rate increase poses risk to both US equities and interest rate exposure– US dollar strength is interconnected with pace of US Federal Reserve policy

• Central Banks continue to dictate the global investment outlook– Fed balancing current policy and the disruptive effects of a strong dollar on global markets– ECB and BoJ likely to maintain and adjust accommodative monetary policies– Easing in China is broadly stimulative in the near term but currency policy is unpredictable

• Improved emerging vs developed world economic growth differential– Large currency adjustments across most emerging countries have provided a foundation to

support improved capital market returns– Continued political and economic reform is needed to benefit economic growth profile– Chinese Yuan devaluation has been incremental; Rapid fall of Yuan remains a global tail-risk

Capital Market Observations

September 30, 2016


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• Trim US equity exposure as US markets have rebounded significantly– Remain disciplined and look for rebalancing opportunities should equity markets decline– Use tactical strategies to capture pockets of value in US high yield as spreads compress

• Maintain overweight exposure to non-US developed market equities– Central bank support and dollar strength provide a positive economic backdrop– Small-cap equity and global equity are preferred implementation approaches

• These strategies offer the best opportunity to exploit valuation discrepancies among stocks

• Emerging Markets offer the most attractive total return opportunity for investors in public markets– China uncertainty, dollar pressure and idiosyncratic country risks temper excitement– Overweight small-cap and consumer focused strategies relative to broad mandates

• Developed market duration exposure is generally unattractive– Preserve US duration exposure with a bias towards TIPS over core bonds– Rebalance long treasuries, long credit, and risk parity following recent gains– Look to eliminate WGBI focused global bond strategies with yields at historic lows

• Embrace illiquidity in opportunistic credit and private credit strategies – Stressed credit liquidity magnifies the scale of price movements in traditional credit assets– Credit markets ability to absorb an exodus from crowded positions is challenged

General Actions for Clients

September 30, 2016


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Year to Date Performance: All Assets Have Moved Higher

Source: BloombergAs of 09/30/2016

0%

5%

10%

15%

20%

25%

S&P 500 Russell 2000 MSCI EAFE MSCI EM Barclays Agg Barclays TIPS Barclays HY JPM GBI EMGlob Div

Barclays 20+STRIPS

YTD ReturnsTrailing 1 Year Return

September 30, 2016


7

Subdued Global Growth and China Remains the Growth Engine


$100

$0

$100

$200

$300

$400

$500

$600

$700

$800

US China Eurozone Japan UK Brazil Russia Canada Australia Korea

$Billion

sUSD

GDP Growth: $ Billions USD

2015 Actual2016 Projection

September 30, 2016


8

• Muted, but consistent, US economic growth gives the Fed flexibility to move slowly with policy tightening

• Markets discounting a more muted pace increases potential for a negative Fed surprise

Expectations of Federal Reserve Action Have Decreased Considerably From 2015

Source: Bloomberg

Market is discounting only 3Federal Reserve rate hikes overthe next 3 years

September 30, 2016


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

0 0.25 0.25 0.5 0.5 0.75 0.75 1

Prob

ability

(%)

Fed Funds Rate

December 2016 Implied Fed Funds Rate

6/30/20169/30/2016

Fed Funds Probabilities Offer a More Nuanced View but Fed Expectations Remain Dovish


Market is pricinga 40% chance ofno rate increase

0%5%

10%15%20%25%30%35%40%45%50%

0 0.25 0.25 0.5 0.5 0.75 0.75 1.0 1 1.25 1.25 1.5

Prob

ability

(%)

Fed Funds Rate

September 2017 Implied Fed Funds Rate

Market is pricing onlya 33% chance of 2 ormore rate increaseover next 12 months

September 30, 2016


10

S&P Earnings Weakness has been Overlooked as Expanding Valuations Drive Recent Returns

Source: Bloomberg, NEPC

September 30, 2016


11

Broad Outperformance of High Yield Increasingly Dependent on Lower Quality Sectors

Source: Bloomberg

0

500

1000

1500

2000

2500

3000

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

High Yield Credit Quality & OAS

BB/B Credit SpreadCCC Credit SpreadBB/B Long Term Spread MedianCCC Long Term Spread Median

September 30, 2016


12

Europe and Japan Equity Markets Carry Risks but Offer a Meaningful Return Opportunity

Source: Bloomberg

September 30, 2016


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Catalyst for MSCI EAFE Outperformance are Present but Risks Remain

6%

4%

2%

0%

2%

4%

6%

8%

10%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Euro Area Consumer Credit Growth (YoY)

Credit growth isnormalizing offcrisis lows

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

1.8%

0%

20%

40%

60%

80%

100%

120%

140%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

ShareBu

ybackYield

Cash/Boo

kVa

luePe

rSha

re

Japan Equity Market (TOPIX)

Cash/Book Value Per Share (LHS)Share Buyback Yield (RHS)

Availability of cashfor share buybacksat historic highs

September 30, 2016


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Investor Flows Materially Impact Short-Term Performance

Source: EPFRAs of 09/30/2016

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

Jan 15 Mar 15 May 15 Jul 15 Sep 15 Nov 15 Jan 16 Mar 16 May 16 Jul 16 Sep 16

USD

Millions

Cumulative Equity Fund Flows: Europe

$100,000

$80,000

$60,000

$40,000

$20,000

$0

$20,000

Jan 15 Mar 15 May 15 Jul 15 Sep 15 Nov 15 Jan 16 Mar 16 May 16 Jul 16 Sep 16

USD

Millions

Cumulative Fund Flows: Emerging Markets

EM Bonds

EM Equity

September 30, 2016


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Economical Stressed Countries Have Led the Emerging Markets Rally

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

Brazil7.3%

Russia3.7%

South Africa6.7%

Taiwan12.1%

South Korea14.6%

Hong Kong4.4%

China21.4%

India8.4%

Malaysia3.0%

Mexico4.1%

Country Index Weight

MSCI Emerging Market IndexFX ReturnLocal ReturnTotal Return

Source: Bloomberg (Top), JP Morgan (Bottom)Returns for 12/31/2015-09/30/2016

10%

0%

10%

20%

30%

40%

50%

60%

70%

Brazil10%

Russia5.6%

South Africa9.6%

Indonesia10%

Colombia7.5%

Turkey9.7%

Malaysia8.8%

Thailand7.6%

Poland10%

Mexico10%

Country Index Weight

JP Morgan GBI EM Index (EMD Local)FX ReturnLocal ReturnTotal Return

September 30, 2016


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EM Equities Remain a Compelling Return Opportunity but With Volatility


0%

5%

10%

15%

20%

25%

Financials Info Tech Cons DiscCons Staples Energy Telecom Materials Industrials Utilities Real EstateHealth Care

EM Sector Weights: Broad Market vs. Small CapMSCI EMMSCI EM Small Cap

50%

40%

30%

20%

10%

0%

10%

20%

30%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Relative Emerging Market Equity Valuations

MSCI EM PE Discount to MSCI World10 Yr Avg PE DiscountMSCI EM PB Discount to MSCI World10 Yr Avg PB Discount

September 30, 2016


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• Inflation sensitive assets that offer a positive yield are preferred– Commodity roll yield is negative, particularly in the energy sector

• Private market strategies are the more attractive total return opportunity but encourage patience

Distressed Energy Markets Rebounded Significantly in 2016

Negative roll yield offutures contracts iscostly for investors

September 30, 2016


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Look to Eliminate WGBI Focused Global Bond Strategies with Yields at Historic Lows

Yield and Expected ReturnCorrelation: 0.95

Current Yield:0.65%


September 30, 2016


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Preserve US Duration Exposure With a Bias Towards TIPS Over Core Bonds

Limited instances of Core CPIinflation levels exceeding TIPSinflation expectations. TIPSoutperformed Core Bonds by 9%cumulatively during this period

Source: Bloomberg

September 30, 2016


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Market Focus: Inflation Expectations

21

Labor Market Tightness is Beginning to Influence Wage Inflation


1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

3%

4%

5%

6%

7%

8%

9%

10%

11%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

U.S. Unemployment Rate (RHS)

U.S. Wage Growth (RHS)

September 30, 2016


22

Strength of US Dollar Exerts Deflationary Pressure on Economy

Source: Bloomberg

65

70

75

80

85

90

95

100

105

72%

73%

74%

75%

76%

77%

78%

79%

80%

2011 2012 2013 2014 2015 2016

U.S. Capacity Utilization (LHS)USD (RHS)U.S. Dollar Index (RHS)

September 30, 2016


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2.5%2.0%1.5%1.0%0.5%0.0%0.5%1.0%1.5%2.0%2.5%

2.5%2.0%1.5%1.0%0.5%0.0%0.5%1.0%1.5%2.0%2.5%

Jan 14 Apr 14 Jul 14 Oct 14 Jan 15 Apr 15 Jul 15 Oct 15 Jan 16 Apr 16 Jul 16

Services ex. EnergyGoods ex Food/EnergyEnergyFood

Negative Impact of High Energy Prices is Rolling Off and CPI is Likely to Revert Higher


30%

20%

10%

0%

10%

20%

30%

5%4%3%2%1%0%1%2%3%4%5%

2010 2011 2012 2013 2014 2015 2016 2017 2018

CPICPI EstimateEnergy (RHS)Energy Estimate (RHS)

Energy has lessened the drag

September 30, 2016


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• “It might be possible to reverse supply-side effects by temporarily running a ‘high-pressure economy’...” – Janet Yellen

– The Fed will likely remain slow to raise rates since economic activity has failed to return to pre-recession levels

– The current policy is based on a 2% inflation target, but the committee will let inflation run above the target to encourage economic activity, helping to reverse excess capacity remaining from the 2008 crisis

The Fed Will Let the Economy Run Hot

Source: Bloomberg, Fed

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%

1990 1993 1996 2000 2003 2006 2010 2013

Personal Consumption ExpenditureFed Inflation Target

September 30, 2016


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Q3 Executive Summary

26

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Composite Performance - The Composite returned 3.1% for the third quarter of 2016, while the Long Term Investment Pool returned 3.3%, underperforming the Policy and Allocation Indices by 0.1%. - The Total Composite ranked in the 4th percentile of the peer group. - The Long Term Pool ranked in the 35% of its peer group for the first three quarters of the year. Allocation Index - An overweight to Equity relative to Policy contributed positively during the third quarter, while an underweight to Hedge Funds detracted from performance. - Total Assets varied significantly through the quarter as a noticeable portion of the Long Term Pool was liquidated to support margin calls on the organizations interest rate swap. Active Management -Artisan outperformed their assigned benchmark by 530 basis points. The fund's holdings in technology, consumer discretionary and healthcare contributed to the outperformance. - Ashmore outperformed its benchmark by 290 basis points due to security selection, particularly within externally denominated debt, and due to an overweight to corporate debt versus the benchmark.

Intermediate Term Balanced Index comprised of 50.0% Barclays Intermediate U.S. GV/CR Index and 50.0% BofA ML 1-3 Year Treasury Index.Allocation Index: Used to measure the value add from active management. Calculated as the asset weight from the prior month end mulitiplied by the specified market index.

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Diligence Monitor

September 30, 2016


Manager Changes/ NEPC DueInvestment Options Announcements Diligence Committee

(Recent Quarter) Recommendations

State Street Global Advisors No ActionRussell 3000 IndexOther: SSgA new employee roles after acquisition of

GEAM

No ActionPIMCOAll Asset Strategy Loss of Personnel: PIMCO AUM/Personnel update

DoubleLine No ActionLow Duration Loss of Personnel: Death of Bonnie Baha

DoubleLine No ActionLow DurationOther: New Director of Global Developed Credit

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Diligence Monitor

September 30, 2016


Investment Option Commentary NEPC Rating

State Street Global Advisors Following State Street’s recent acquisition of GE Asset Management (GEAM), State

Street promoted a senior investment professional was joined by several leaders from the former GEAM team. State Street sees the acquired team as strong cultural fit. They feel that GEAM brings a robust, active fixed income team, as well as enhancements to State Street’s overall capabilities. State Street has renewed the lease on the Stamford, Connecticut office for two years and will not require anyone to relocate. There were 275 employees at GEAM, 175 of these were investment professionals, and all were given the opportunity to come over to State Street. Only a small percentage chose not to stay with the firm. NEPC recommends and is comfortable with this announcement.

Neutral

Russell 3000 Index

PIMCO PIMCO released the outcomes of its recent severance package offering. Out of 93 individual proposals made, 25 were accepted. Of the 25 acceptances, only one was by a portfolio manager and one other was a client facing person. The Portfolio Manager (PM) who accepted the offer worked on the insurance desk and will be replaced. Natural attrition for PIMCO is 10% historically. NEPC believes that this result is a positive outcome for PIMCO. In addition, since the announcement, the PM on the only pure equity strategy left at PIMCO has resigned. NEPC recommends .

Preferred

All Asset Strategy

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Diligence Monitor

September 30, 2016


Investment Option Commentary NEPC Rating

DoubleLine DoubleLine’s Head of Global Developed Credit, Bonnie Baha, passed away suddenly. Doubleline Capital has announced that current Portfolio Manager (PM) Robert Cohen will serve as the company’s new Director of Global Credit. Mr. Cohen joined the Global Development Credit team in 2012 where he served as a portfolio manager and sat on DoubleLine’s Fixed Income Allocation Committee. Mr. Cohen reported to Jeffrey Gundlach, current CEO and CIO at the firm. DoubleLine believes that Mr. Cohen will run the GDC team with the same philosophy, structure, and team approach as Bonnie Baha. Mr. Cohen will continue with his existing PM responsibilities and position on DoubleLine’s Fixed Income Asset Allocation Committee in his new role. NEPC recommends No Action.

Preferred

Low Duration

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Total Fund Summary

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Intermediate Term Balanced Index: 50.0% Barclays Intermediate U.S. GV/CR Index and 50.0% BofA ML 1-3 Year Treasury Index.

Allocation Index: Used to measure the value add from active management. Calculated as the asset weight from the prior month end mulitiplied by the specified market index.

Long-Term Balanced Index: (10% - Russell 3000)(5% - MSCI EAFE Small Cap)(5% - MSCI Emerging Markets)(15% - MSCI ACWI)(15% - Barclays Aggregate)(5% - 50%JPM EMBI GD/ 25% JPM ELMI+/ 25% JPM GBI EM GD)(5% - Barclays Multi-verse)(20% - 60% MSCI World (Net)/ 40% CITI WGBI)(10% - HFRI Fund of Funds Composite)(10% - PIMCO All Asset Index).

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Appendix

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Information Disclaimer

• Past performance is no guarantee of future results.

• The goal of this report is to provide a basis for substantiating asset allocation recommendations. The opinions presented herein represent the good faith views of NEPC as of the date of this report and are subject to change at any time.

• Information on market indices was provided by sources external to NEPC. While NEPC has exercised reasonable professional care in preparing this report, we cannot guarantee the accuracy of all source information contained within.

• All investments carry some level of risk. Diversification and other asset allocation techniques do not ensure profit or protect against losses.

• This report is provided as a management aid for the client’s internal use only. This report may contain confidential or proprietary information and may not be copied or redistributed to any party not legally entitled to receive it.

September 30, 2016


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It is important that investors understand the following characteristics of non-traditional investment strategies including hedge funds and private equity:

1. Performance can be volatile and investors could lose all or a substantial portion of their investment

2. Leverage and other speculative practices may increase the risk of loss3. Past performance may be revised due to the revaluation of investments 4. These investments can be illiquid, and investors may be subject to lock-ups

or lengthy redemption terms5. A secondary market may not be available for all funds, and any sales that

occur may take place at a discount to value6. These funds are not subject to the same regulatory requirements as

registered investment vehicles7. Managers may not be required to provide periodic pricing or valuation

information to investors8. These funds may have complex tax structures and delays in distributing

important tax information9. These funds often charge high fees10.Investment agreements often give the manager authority to trade in

securities, markets or currencies that are not within the manager’s realm of expertise or contemplated investment strategy

Alternative Investment DisclosuresEastern Michigan University - Board of Regents

September 30, 2016

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eastern michigan university board of regents · • embrace illiquidity in opportunistic credit and...

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