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Aon HewittRetirement and Investment
Investment advice and consulting services provided by Aon Hewitt
Investment Consulting, Inc., an Aon Company.
Nebraska Investment CouncilBlank Sheet Equity Review – Summary
of Activity to Date and Current Thinking
June 2017
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The Domestic / International Blank Sheet review started in June
2016– Managers were chosen from a combination of top managers in
Pension and Investments as well
as managers participating in the Global Equity Review– Joe &
Jeremiah contacted 23 managers and met with 21 managers. These 2
hour meetings took
place from June 30th through September 12th
During the manager meetings a few common themes kept coming up–
The Investment Staff met a couple of times during November and
early December to discuss
themes and develop questions for Aon. Joe & Jeremiah sent
Aon 15 questions regarding these themes along with 3-4 pages from
each manager’s presentation that best described their solution.
– In January 2017 the Investment Staff met to discuss Aon’s
responses. On March 2nd Aon presented their own blank sheet review,
taking into consideration the common themes that we identified. The
Investment Staff met again on March 7th to discuss Aon’s blank
sheet review.
Common themes:– Reduce / Eliminate Home Country Bias
• We had 9 managers come in and make this recommendation; this
was the most common theme we heard
– Use a Global Mandate / Passive International• There were 5
managers that made this recommendation
– Leave Currencies Unhedged• We had 3 managers make this
recommendation, but we originally told the managers to
ignore the issue of hedging since historically the portfolio has
been unhedged
NIC Investment Staff – Summary of Process
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While the original focus of this review was the optimal
implementation of the U.S. and Non-U.S. Equity components, we are
generally of the view that public equity sub-asset classes should
be viewed holistically
As such, this review focuses on the optimal implementation of
the total allocation to public equities
Overview
Long-Term Target AllocationU.S. Equity 29.0%
Non U.S. Equity 13.5
Global Equity 15.0
Total Public Equity 57.5%
Real Estate 7.5%
Private Equity 5.0
Fixed Income 30.0
Total Portfolio 100.0%
DB/CBB Plans
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Above (right) we illustrate what our “blank sheet” approach to
equities would like for NIC– Cap-weighted approach (i.e., no home
country bias)– Current ≈1/3 active / ≈2/3 passive split is
maintained; however, all active exposure is now obtained
via global equity mandates• The size of the allocation to active
global mandates increases by roughly 1.7X
– Active risk level (i.e., the degree to which the return of the
total equity allocation is expected to deviate from its benchmark)
increases slightly, but remains similar to existing structure
IronBridge is replaced with Dodge & Cox; global manager
relative weightings adjusted modestly
Current Equity Structure vs. Pro-Forma “Blank Sheet” Equity
Structure
MFS, 10%
Ironbridge Dodge & Cox,
7%
Arrowstreet, 11%
Wellington, 5%Passive Global Equity, 67%
DFA (U.S.), 5%
BlackRock Russell 1000 Index (U.S.),
45%
MFS (Global), 5%
Ironbridge (Global), 4%
Arrowstreet (Global), 8%
Wellington (Global), 3%
BlackRock ACW IMI (Global), 7%
BlackRock World ex‐U.S. IMI (Non‐
U.S.), 14%
Baillie Gifford (Non‐U.S.), 4%
Gryphon (Non‐U.S.), 6%
Current Structure “Blank Sheet”
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Current Structure vs. Pro-Forma “Blank Sheet” Equity Structure
(Cont’d)
Relative to the existing structure, we think the pro-forma
“Blank Sheet” equity structure has the following advantages:
1) Cap-weighting improves diversification, maximizing long-term
risk-adjusted returns of the equity allocation
2) Active management is deployed only in mandates where we think
the odds of success are greatest (i.e., global)
3) Reduction in number of active managers increases “active
share” (i.e., reduces the potential for closet indexation), and
should lead to reduction in investment management fees• Larger
mandates increase negotiating power
In order for the “Blank Sheet” structure to be considered
superior to the current equity structure, one needs to believe the
following:
1) Broader mandates (e.g., global) give a manager a better
chance for success than narrower, region specific mandates
2) A cap-weighted approach to the equity market has better
risk-adjusted return prospects than an approach that is biased
towards U.S. equities
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The table above illustrates the percentage of active managers
that have outperformed their respective benchmarks net of fees
across various categories over the last one, three, and five
years
– As shown, only a small percentage of active managers have had
success adding value in recent years
– International mandates appear most attractive (or “least
unattractive”), followed by global mandates and U.S. mandates
– We believe there is a fair amount of noise in that
International fund data, however • i.e., structural differences
between international managers and the benchmarks they are
being
measured against (USD hedging, exposure to U.S. domiciled
companies, lack of exposure to EM, etc.)
Our “house view” is that 1) equity markets are hard to beat, and
2) broader mandates like global give skilled active managers the
best chance to add value
Active Management – The Case for Global Mandates
Percentage of Funds Outperforming their Benchmarks – Periods
Ending 6/30/2016*
Trailing 1 Year Trailing 3 Years Trailing 5 Years5 Year Average
Value Added
Large-Cap U.S. Funds 15.4% 18.7% 8.1% -2.5%
Mid-Cap U.S. Funds 12.1% 16.2% 12.1% -2.5%
Small-Cap U.S. Funds 11.2% 5.9% 2.4% -3.9%
Global Funds 24.7% 23.0% 17.6% -1.9%
International Funds 45.1% 45.5% 39.6% -0.3%
*S&P Indices vs. Active (SPIVA) U.S. Scorecard – Mid-Year
2016
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Active Management – The Case for Global Mandates (Cont’d)
Arguments for global mandates include:– Markets around the world
have become more integrated
• Increasing cross-border M&A activity, expansion of
domestic corporations sales’ overseas, increasingly common
accounting standards, etc.
– Correlations between U.S. and Non-U.S. markets have risen–
Global mandates allow for wider opportunity sets and “best in
class” stock selection
NIC’s own experience with actively managed U.S., Non-U.S., and
Global Equities provides support to the notion that global mandates
offer the best active management prospects
Trailing 1 Year
Trailing 3 Years
Trailing 5 Years
Trailing 10 Years
Since Inception
Inception Date
Total U.S. Equity 13.3% 8.6% 14.8% 7.1% 9.6% 7/1/1983
Custom Benchmark 12.6 8.4 14.6 7.2 10.5
Total Non-U.S. Equity 2.6% -1.0% 5.8% 0.5% 5.2% 10/1/1991
Custom Benchmark 4.4 -1.4 5.3 1.3 5.6
Total Global Equity 7.7% 3.1% 9.9% 4.2% 6.5% 9/1/2005
Custom Benchmark 8.4 3.2 9.6 3.7 5.6
Cumulative Periods Ending 12/31/2016
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Home Country Bias
Most institutional investors forecast long-term returns for
non-U.S. markets to be at least as good as those that can be earned
in the U.S.
Finance theory suggests holding an equity portfolio in market
proportions is optimal But institutional investors have always
invested a substantially greater proportion of equity in their
home countries It has been described as one of the puzzles of
modern finance; possible explanations:
– Greater optimism regarding home market; greater perceived risk
in non-domestic markets– Greater fees and costs in non-domestic
markets– Less information/transparency in non-domestic markets–
Liabilities denominated in home currency– Sensitivity to peer
comparisons
AHIC Long-Term Return
Forecast
AHIC Forecasted
Volatility
Horizon Survey* Avg
Return Forecast
Horizon Survey* Avg
Volatility Forecast
U.S. Stocks (Large-Cap) 6.4% 17.0% 6.6% 16.9%
U.S. Stocks (Small Cap) 6.6 23.0 7.0 21.0
Non-U.S. Stocks (Developed) 7.3 20.0 7.1 19.5
Emerging Market Stocks 7.5 30.0 8.5 26.4*Horizon Actuarial
survey of 2016 capital market assumptions from 35 independent
investment advisorsExpected returns of the survey are annualized
over 10-years (geometric).
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Public Funds’ Movement Towards a Cap-Weighted Equity Allocation
Over the Past Decade
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*
Composition of Equity Allocation: Public Funds $1-$5
Billion*
59.1%
40.9%
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*Greenwich Associates –
Institutional Investors Market Trends 2007-2016
The Council currently targets a split of approximately 65% U.S.
Stocks / 35% Non-U.S. Stocks within the DB Plans’ equity
allocation
– This represents a home country bias of ≈10%-15%
In recent years, peer public funds have sought to reduce their
equity exposure’s home country bias
U.S. equities have produced stellar returns over the past
several years, dramatically outpacing their non-U.S.
counterparts
– Equity market valuation levels (please see next slide) suggest
now might not be a bad time to move closer to a cap-weighted
approach
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Equity Market Valuations Levels – U.S. vs. Non-U.S. Markets
Russell 1000 Forward P/E Ratio (Large-Cap U.S. Stocks)
Russell 2000 Forward P/E Ratio (Small-Cap U.S. Stocks)
MSCI EAFE Forward P/E Ratio (Developed Market International
Stocks) MSCI Emerging Markets Forward P/E Ratio
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Why Move to a Capitalization Weighted Portfolio?
A capitalization weighted portfolio approach places the global
market as the natural starting point It acknowledges that
deviations from market weights of regions are active investment
decisions Geographical constraints limit investors’ ability to
capture growth opportunities For passive investors, a
capitalization weighted portfolio captures the global investable
opportunity
set and provides for efficient market beta exposure For active
investors, a capitalization weighted portfolio provides the freedom
to select the best
stocks and leads to higher potential to generate alpha
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
omin
al
Geo
met
ric R
etur
n
Expected Risk (Volatility)U.S. Equity Non-U.S. Equity
Cap-Weighted
Current NIC Equity
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Reducing home country bias means increasing exposure to other
currencies– The Council’s liabilities are denominated in US
dollars; exposure to other currencies is an uncompensated risk
Exposure to other currencies could be hedged but:– There is a
cost associated with hedging– Currency fluctuations tend to wash
over time– Human nature often leads to sub-optimal decisions from a
timing perspective
A Few Comments on Currency
Why Hedge Currency? Why Not?
Returns are difficult to forecast Currency exposure is a
relatively small proportion of the overall portfolio
Risk is likely to be unrewarded Implementation is deemed too
costly and/or complex
Will likely reduce overall equity volatility Cash flow
volatility is undesirable
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