FROM: Lisa Sorani, Manager of HR Employee Services LS -

M E M O R A N D U M 

Date: April 29, 2013 

To: 

East Bay Municipal Utility District (EBMUD) 

From: Pension Consulting Alliance, Inc. (PCA) cc: Eric White – PCA 

Jeremy Thiessen – PCA 

RE: 

Barrow Hanley “Heightened Monitoring” Status Recommendation 

Summary 

PCA recommends that EBMUD place the Barrow, Hanley, Mewhinney & Strauss Large Cap 

Value (Barrow Hanley) account on heightened monitoring status to be closely monitored over 

the next 12 to 18 months. As of March 31, 2013, Barrow Hanley’s gross of fees trailing 12- 

month performance underperformed their benchmark, the Russell 1000 Value Index, by (5.6%), 

falling below EBMUD’s short-term 1 Manager Heightened Monitoring Criteria. 

Discussion 

EBMUD retained Barrow Hanley to manage approximately $109.3 million for the large cap value 

portion of its investment portfolio during the third quarter of 2005. EBMUD’s total exposure to the 

Barrow Hanley Large Cap Value account was approximately $152.4 million as of March 31, 2013. 

Over the past 1-year period Barrow Hanley has underperformed their benchmark, the Russell 

1000 Value Index, by (5.6%). Over the past 3- and 5-year periods Barrow Hanley has 

underperformed by (1.8%) and outperformed by 1.1% per annum, respectively. Since inception, 

Barrow Hanley has matched its benchmark with a 5.0% return. 

1 Short-term criteria: Underperformance greater than (3.5%) in a trailing 12-month period gross of fees.

Barrow Hanley Large Cap Value 

Heightened Monitoring Status Recommendation 

Product and Organization Review Summary 

Reason for Update 

Failed Performance Criteria 

Organizational Changes 

Scheduled Watch Update 

Product 

Key people changes 

Changes to team structure/individuals roles 

Product client gain/losses 

Changes to the investment process 

Personnel turnover 

Level of 

Concern^ 

None 

None 

None 

None 

None 

Areas of Potential Impact 

Investment 

process 

(client Investment Performance 

portfolio) Team Track Record 

Team/ 

Firm 

Culture 

Organization 

Ownership changes 

Key people changes 

Firm wide client gain/losses 

^None, low or high 

None 

None 

None 

Review and Recommendation History 

Date PCA Findings and Recommendation Board 

04/2013 

PCA recommends placing Barrow Hanley on Heightened Monitoring 

status due to performance. Next review in 12 to 18 months 

Pending 

Annualized Performance Results 

As of 03/31/2013 

Inception 

(12/31/05) 

Performance QTR YTD 1 Year 3 Years 5 Years 

Barrow Hanley 10.1 10.1 13.2 10.9 5.9 5.0 

Russell 1000 Value Index 12.3 12.3 18.8 12.7 4.8 5.0 

Difference -2.2 -2.2 -5.6 -1.8 1.1 0.0 

Peer Ranking^ 

Barrow Hanley 82 82 80 65 40 61 

Russell 1000 Value Index 28 28 8 39 60 63 

Source: MPI 

^Peer rankings are based on gross of fee performance. Rankings: 1 = best and 100= worst 

2

Recent Investment Performance 

Barrow Hanley exhibits a consistently higher quality portfolio (high returns on equity, low leverage, 

sustained earnings) than the benchmark. This quality bias leads to a relative performance pattern 

wherein Barrow Hanley performs well during periods of volatility and market decline but tends to 

lag in strong up markets. Over time, this quality bias should lead to outperformance as a number 

of studies have shown higher quality stocks outperform lower quality stocks over the long term. 

When looking at quarterly excess performance relative to the Russell 1000 Value Index (see graph 

below), it is evident the portfolio’s excess returns have proven to be volatile. Since inception, 

Barrow Hanley has produced positive excess results relative to the Index in 13 of the 30 quarters 

(43% of the time). Strong excess performance in periods of market decline has helped Barrow 

Hanley over longer time periods. 

5 

4 

3 

Quarterly Excess Performance 

(Since Inception – 03/31/2013) 

Barrow 

Excess 

2 

Excess Return, % 

1 

0 

-1 

-2 

-3 

-4 

Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Mar-13 

On a risk-adjusted basis, since inception returns ending March 31, 2013, fall below those of the 

strategy’s median peer fund (see following graph). Over this 91-month period, the strategy 

produced an average annual return of 5.0%, while incurring a 16.4% annualized standard 

deviation. These results produced a 0.27 Sharpe ratio (a measure of return per unit of risk). 

3

10 

Risk / Return Performance Comparison 

(Since Inception Ending 03/31/2013) 

Large Value Manager Universe 

Barrow 

Russell 1000 Value 

Total Annualized Return, % 

8 

6 

4 

2 

Annualized Return, % Annualized StdDev, % Sharpe Ratio 

Barrow 5.04 16.39 0.27 

Russell 1000 Value 5.02 17.21 0.27 

Large Value Manager Universe Median 5.62 16.36 0.31 

0 

0 5 10 15 20 25 30 35 

Total Annualized StdDev, % 

The following exhibit shows Barrow Hanley’s cumulative performance versus the Russell 1000 

Value Index since inception. Since inception, the cumulative performance of Barrow Hanley has 

been in-line with its benchmark despite relatively strong performance surrounding the credit crisis. 

Cumulative Performance 

Inception – 03/31/2013 

150 

140 

Barrow 

Russell 1000 Value 

130 

120 

Growth of $100 

110 

100 

90 

80 

70 

60 

Aug-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 M ar-13 

4

Additional Considerations 

Barrow Hanley is a 75% owned subsidiary of Old Mutual investment adviser located in Dallas, 

Texas. Employees own the remaining 25%. 

Capital Assets / Clients 

Firm-wide 

Large Cap Value Equity 

Assets 

Assets 

($ millions) Clients ($ millions) Clients 

2012-12 67,665 418 42,899 185 

2011-12 59,680 402 41,346 196 

2010-12 60,345 387 43,295 202 

2009-12 55,032 375 41,599 209 

Source: eVestment Alliance 

Barrow Hanley’s approach to the equity market is based on the underlying philosophy that 

markets are inefficient. These inefficiencies can best be exploited through adherence to a valueoriented 

investment process dedicated to the selection of securities on a bottom-up basis. The 

firm does not attempt to time the market or rotate in and out of broad market sectors, as it 

believes that it is difficult, if not impossible, to add incremental value on a consistent basis by 

market timing. They stay fully invested with a defensive, conservative orientation based on the 

belief that superior returns can be achieved while taking below average risks. The firm 

implements this strategy by constructing portfolios of individual stocks that reflect all three value 

characteristics; price/earnings and price/book ratios below the market and dividend yields above 

the market (S&P 500). 

Barrow Hanley’s history indicates that a strategy of emphasizing low price/book ratios and high 

dividend yields provides a measure of protection in down markets, as well as participation in 

improving economic cycles. 

The firm starts by looking at a stock’s price relative to its (1) current earnings level, (2) current 

tangible book value, and (3) stated dividend, identifying stocks with a low P/E, low price/book, and 

high yield. They then make five-year forecasts on ROE, book value, dividends and earnings per 

share. Each stock must be attractive on their Relative Return and Dividend Discount Models 

before it can be bought. Once purchased, securities are monitored through those two models. 

When a stock becomes fairly valued on either of the models, the liquidation process begins. The 

firm does not try to judge when the holding might reach a speculative level of overvaluation. 

5

M E M O R A N D U M 

Date: April 29, 2013 

To: 

East Bay Municipal Utility District (EBMUD) 

From: Pension Consulting Alliance, Inc. (PCA) cc: Eric White – PCA 

Jeremy Thiessen – PCA 

RE: 

INTECH Management Fee Recommendation 

Summary 

PCA has reached out to INTECH to discuss alternate fee arrangements for the large cap growth 

mandate they have with EBMUD. In response, INTECH has proposed a performance-based fee 

comprised of a low 5 basis point base fee with an incentive fee of 12.5% of excess performance. 

This compares favorably to their current 49.5 basis point flat fee. INTECH’s proposed fee schedule 

will more closely align INTECH’s compensation and their ability to add value. As such, PCA 

recommends that the Board accept the new management fee schedule proposal. 

Discussion 

In a recent meeting with INTECH, PCA requested that INTECH review their current management 

fee arrangement with EBMUD and potentially consider alternatives. PCA made this 

recommendation in light of the fact that INTECH has failed to add meaningful value over recent 

time periods. INTECH responded with an attractive performance-based option. The proposed 

annual management fee will consist of a 5 basis point base fee with an incentive fee of 12.5% of 

excess performance. 

The objective is for EBMUD to pay a lower base management fee and then only pay additional 

fees if INTECH outperforms the benchmark. A maximum fee cap is also incorporated in the 

proposal which would impose a ceiling on the fees paid if INTECH were to significantly outperform 

the benchmark. 

The cost of the proposed fee schedule would match current fees when INTECH outperforms the 

benchmark by 3%. This was chosen because 3% relative outperformance is INTECH’s self-stated 

goal. As such, the new fee arrangement is superior to the current fee arrangement in any time 

period wherein INTECH outperforms by less than 3%. Inversely, the new fee arrangement would 

be inferior and more costly if INTECH outperforms by more than 3%. Under the proposed fee 

arrangement outperformance will be measured over a rolling 36-month period.

For example, as of the most recent quarter end, INTECH has outperformed its benchmark by 1.2% 

over the past 36-month period. This level of outperformance would earn INTECH a total fee of 

approximately 20 basis points (5 bps base fee plus 15 bps incentive fee [1.2% outperformance 

times 12.5% incentive fee]): substantially less than the current flat base fee of 49.5 basis points. In 

dollar terms, this amounts to a savings of approximately $200,000 in this scenario (with the current 

fee structure, the annual fee is $327,000). For periods in which INTECH fails to outperform the 

benchmark, the total annual fee will be a mere 5 basis points, or $33,000. 

Attached is a document provided by INTECH illustrating the hypothetical fees given various levels 

of outperformance. 

2

INTECH Performance Fee Illustration * 

Fixed Fee Formula: 

0.495% on the 1st $100,000,000 Account market value (MV) = $66,000,000 

Base Fee $ = $33,000 

Avg. Fee % = 0.495% Performance Fee Terms: 

Avg. Fee $ = $326,700 Base Fee (BF) = 0.05% 

Participation Rate (PR) = 12.50% 

Maximum Fee (MF) = 0.90% 

Total Fee Calculations 

Gross Perf Total Excess TR 

Alpha Fee % Perf Fee $ Fee % Total Fee $ Net of 

[ α ] [ α * PR ] [ α * PR * MV ] [ Perf + Base ] [ Perf + Base ] All Fees 

Minimum Fee 0.00% 0.0000% $0 0.0500% $33,000 -0.05% 

0.25% 0.0313% $20,625 0.0813% $53,625 0.17% 

0.50% 0.0625% $41,250 0.1125% $74,250 0.39% 

0.75% 0.0938% $61,875 0.1438% $94,875 0.61% 

1.00% 0.1250% $82,500 0.1750% $115,500 0.83% 

1.25% 0.1563% $103,125 0.2063% $136,125 1.04% 

1.50% 0.1875% $123,750 0.2375% $156,750 1.26% 

1.75% 0.2188% $144,375 0.2688% $177,375 1.48% 

2.00% 0.2500% $165,000 0.3000% $198,000 1.70% 

2.25% 0.2813% $185,625 0.3313% $218,625 1.92% 

2.50% 0.3125% $206,250 0.3625% $239,250 2.14% 

2.75% 0.3438% $226,875 0.3938% $259,875 2.36% 

3.00% 0.3750% $247,500 0.4250% $280,500 2.58% 

3.25% 0.4063% $268,125 0.4563% $301,125 2.79% 

3.50% 0.4375% $288,750 0.4875% $321,750 3.01% 

Fixed Fee Equivalance 3.56% 0.4450% $293,700 0.4950% $326,700 3.07% 

3.75% 0.4688% $309,375 0.5188% $342,375 3.23% 

4.00% 0.5000% $330,000 0.5500% $363,000 3.45% 

4.25% 0.5313% $350,625 0.5813% $383,625 3.67% 

4.50% 0.5625% $371,250 0.6125% $404,250 3.89% 

4.75% 0.5938% $391,875 0.6438% $424,875 4.11% 

5.00% 0.6250% $412,500 0.6750% $445,500 4.33% 

5.25% 0.6563% $433,125 0.7063% $466,125 4.54% 

5.50% 0.6875% $453,750 0.7375% $486,750 4.76% 

5.75% 0.7188% $474,375 0.7688% $507,375 4.98% 

6.00% 0.7500% $495,000 0.8000% $528,000 5.20% 

6.25% 0.7813% $515,625 0.8313% $548,625 5.42% 

6.50% 0.8125% $536,250 0.8625% $569,250 5.64% 

6.75% 0.8438% $556,875 0.8938% $589,875 5.86% 

Maximum Fee 6.80% 0.8500% $561,000 0.9000% $594,000 5.90% 

* Example calculations provided for illustrative purposes only. Only the Base Fee will be charged for the initial 3 

quarters under the performance fee arrangement. For the 4th and subsequent quarters, both the Base Fee and 

Performance Fee will be charged. The performance fee will be based upon the account's excess performance from the 

inception of the performance fee until its 3rd anniversary, at which point a rolling 3-year return will be utilized. The 

performance excess for the account will be calculated relative to the Benchmark Index in US dollars, although significant 

investment restrictions may require that a custom benchmark be used to calculate the excess performance for 

performance fee purposes. A document further describing INTECH’s standard performance fee methodology 

accompanies this illustration.

Q1 - 2013 

Preliminary 

Recent Investment Performance 

Quarter 1 Year 3 Year 5 Year 10 Year 20 Year 

Total Portfolio 6.3 10.4 10.2 5.6 8.7 8.1 

Policy Benchmark 6.4 11.1 10.0 5.3 8.9 8.2 

Excess Return -0.1 -0.7 0.2 0.3 -0.2 -0.1 

*Gross of Fees 

Portfolio Valuation as of March 31, 2013 

(in millions $) 

March 31, Dec. 31, Quarterly Percentage March 31, Annual Percentage 

2013 2012 Change Change* 2012 Change Change* 

EBMUD $1,109.2 $1,045.7 $63.5 6.1% $1,011.1 $98.1 9.7% 

*Percentage change in value due to both investment results and cash flows. 

1

Q1 - 2013 

Actual vs. Target Allocations 

Preliminary 

As of March 31, 2013 

Actual vs. Target Allocation 

Segment Actual $(000) Actual % Target %* Variance 

Total Portfolio 1,109,153 100% 100% --- 

Domestic Equity 599,471 54.0% 50.0% 4.0% 

International Equity 204,568 18.4% 20.0% -1.6% 

Fixed Income 239,489 21.6% 25.0% -3.4% 

Real Estate** 52,818 4.8% 5.0% -0.2% 

Cash 12,807 1.2% 0.0% 1.2% 

*2006 asset allocation policy targets. 

**RREEF performance results and allocation are lagged one-quarter. 

Actual Asset Allocation Comparison 

March 31, 2013 

FI 

22% 

December 31, 2012 

FI 

23% 

Dom Eq 

54% 

Cash 

1% 

RE 

5% 

Dom Eq 

52% 

Cash 

1% 

RE 

5% 

Intl Eq 

18% 

Intl Eq 

19% 

2

Q1 - 2013 

Preliminary 

Periods ending March 31, 2013 

(Gross of Fees) 

Asset Class Quarter 1 Year 3 Year 5 Year 10 Year 20 Year 

Total Portfolio 6.3 10.4 10.2 5.6 8.7 8.1 

Policy Benchmark^ 6.4 11.1 10.0 5.3 8.9 8.2 

Domestic Equity 10.2 13.0 12.6 6.4 9.1 8.3 

Russell 3000 (blend)* 11.1 14.6 13.0 6.3 9.6 9.2 

International Equity 3.2 8.4 6.3 1.1 11.2 --- 

MSCI ACWI x U.S.(blend)** 3.3 8.9 4.9 0.1 10.8 --- 

Fixed Income 0.4 6.0 7.3 6.8 5.7 6.7 

BC Universal (blend)*** 0.1 4.7 6.0 5.9 5.2 6.2 

Real Estate 5.7 12.5 17.2 -0.6 --- --- 

50/50 NCREIF/FTSE NAREIT All Equity**** 5.8 14.7 15.1 3.5 --- --- 

Cash 0.1 0.4 0.4 1.1 2.4 --- 

Citigroup T-bills 0.0 0.1 0.1 0.3 1.7 --- 

^Total Portfolio Benchmark consists of 50% Russell 3000 (blend), 20% MSCI ACWIxU.S. (blend), 25% Barclay’s Capital Universal (blend), 2.5% NCREIF (lagged), 2.5% FTSE 

NAREIT All Equity REITs index as of 11/1/11 

*Russell 3000 as of 10/1/05. Prior: 30% S&P500, 10% S&P400, 10% Russell 2000 (4/1/05-9/30/05); 33% S&P500, 10% S&P400, 10% Russell 2000 (9/1/98-3/31/05); 30% S&P500, 

15% Wilshire 5000 (4/1/96-8/31/98) 

**MSCI ACWIxU.S. as of 1/1/07; MSCI EAFE ND thru 12/31/06 

***BC Universal as of 1/1/08; BC Aggregate thru 12/31/07 

****50% NCREIF (lagged), 50% FTSE NAREIT All Equity REITs Index as of 11/1/11; NCREIF (lagged) thru 10/31/11 

3

Q1 - 2013 

Manager Performance (Gross of Fees) 

Preliminary 

Domestic Equity – Periods ending March 31, 2013 

Manager 

Mkt Value 

($000) 

Asset Class 

Management 

Style 

Quarter 1 YR 3 YR 5 YR Estimated Annual 

Fee (bps) 1 

Current Monitoring 

Status 

Northern Trust Co. 266,346 Large Cap Core Passive 11.0 14.5 13.0 6.3 3 --- 

Russell 1000 Index --- --- --- 11.0 14.4 12.9 6.2 --- --- 

Intech 69,564 Large Cap Growth Active 8.7 10.8 14.3 7.1 50 --- 

T. Rowe Price 67,400 Large Cap Growth Active 7.9 8.4 13.2 8.1 49 --- 

Russell 1000 Growth Index --- --- --- 9.5 10.1 13.1 7.3 --- --- 

Barrow Hanley 152,416 Large Cap Value Active 10.1 13.2 10.9 5.9 32 --- 

Russell 1000 Value Index --- --- --- 12.3 18.8 12.7 4.8 --- --- 

Northern Trust Co. 18,612 Small Cap Growth Passive 13.2 14.9 15.0 --- 5 --- 

Russell 2000 Growth Index --- --- --- 13.2 14.5 14.7 --- --- --- 

Opus 25,133 Small Cap Value Active 11.5 13.6 12.1 8.1 67 2 Heightened 

Russell 2000 Value Index --- --- --- 11.6 18.1 12.1 7.3 --- --- 

International Equity – Periods ending March 31, 2013 


Mkt Value 

($000) 

Asset Class 

Management 

Style 

Quarter 1 YR 3 YR 5 YR Estimated Annual 

Fee (bps) 1 

Current Monitoring 

Status 

Franklin Templeton 3 100,102 ACWI x U.S. Active 3.3 12.1 5.7 0.3 58 --- 

Fisher Investments 104,466 ACWI x U.S. Active 3.1 5.1 6.6 1.8 66 --- 

MSCI ACWI x U.S. (blend)* --- --- --- 3.3 8.9 4.9 0.1 --- --- 

*As of January 1, 2007, the benchmark changed from MSCI EAFE to MSCI ACWI x U.S. 

1 Reviewed annually. Last reviewed June 30, 2012. 

2 The Estimated Annual Fee reported for Opus is based on the new management fee schedule approved by the Board at the November 2012 Board meeting. 

3 Franklin Templeton’s returns are reported net of fees. The Franklin Templeton institutional mutual fund account was liquidated in June 2011 and moved to a transition account which 

later funded the Franklin Templeton new separate account in the same month. The Q2-2011 return is an aggregate of the institutional mutual fund account, Franklin transition account, 

and new separate account. 

4

Q1 - 2013 

Preliminary 

Fixed Income – Periods ending March 31, 2013 


Mkt Value Asset Class Management Quarter 1 YR 3 YR 5 YR Estimated Annual Current Monitoring 

($000) 

Style 

Fee (bps) 4 

Status 

Western Asset Management 82,448 Core Plus Active 0.9 8.8 9.3 8.1 26 --- 

BC Universal (blend)* --- --- --- 0.1 4.7 6.0 5.9 --- --- 

CS McKee 157,041 Core Active 0.1 4.5 --- --- 20 --- 

BC Aggregate --- --- --- -0.1 3.8 --- --- --- --- 

*As of January 1, 2008, the benchmark changed from BC Aggregate to BC Universal. 

Real Estate – Periods ending March 31, 2013 


Mkt Value Asset Class Quarter 1 YR 3 YR 5 YR Estimated Annual Current Monitoring 

($000) 

Fee (bps) 4 

Status 

RREEF II* 21,075 Real Estate 3.4 12.4 15.6 -1.5 161 Heightened 

NCREIF* --- --- 2.5 10.5 12.6 2.1 --- --- 

Urdang 31,744 Real Estate 7.5 13.8 --- --- 27.5 bps + 15% on 

--- 

excess returns 

FTSE NAREIT All Equity REITs --- --- 9.1 18.7 --- --- --- --- 

*Results are lagged one quarter. 

4 Reviewed annually. Last reviewed June 30, 2012. 

5

EBMUD FIXED INCOME DISCUSSION 

East Bay Municipal i Utility District 

i t 

May 2013

AGENDA ITEMS 

Section 

Tab 

Current Interest Rate Environment 1 

Looking Forward 2 

Investment Options 3 

Conclusions 4 

Pension Consulting Alliance, Inc. ││ EBMUD Fixed Income Discussion │ 2

SECTION 1 

THE CURRENT INTEREST RATE ENVIRONMENT 

Pension Consulting Alliance, Inc. ││ EBMUD Fixed Income Discussion 

│ 3


• Approximately 32 years ago on September 30, 1981, the 10-year Treasury reached its 

100-year peak of 15.8% 

• Since then interest rates have steadily fallen 

• Interest rates are now near all time lows at 1.7% 

18 

16 

14 

12 

10 

8 

6 

4 

2 

0 

10-Year Treasury Yield 

Source: PCA, US Treasury 



• The gradual decline in interest rates over the past 30 years has acted as a wind at the back of 

fixed income returns 

• Over this period the BC Aggregate has averaged an annualized 8.75% return per annum 

12 Month Rolling Performance 

35 

31.87 

Mar-81 - Mar-13 

BC Aggregate Bond 

30 

28.72 Total 

25 

% 

Total Return, 

20 

17.24 

15 

13.05 

9.86 

10 

5.30 

5 

12.34 12.91 13.29 

11.40 

11.99 

12.53 

11.69 

10.79 

873 8.73 

6.49 

4.89 5.16 

4.99 4.91 

2.37 

1.87 

7.69 7.71 

6.59 7.67 

5.35 5.40 

5.12 

3.77 

1.15 2.26 3.13 

0 

Mar-81 Mar-86 Mar-91 Mar-96 Mar-01 Mar-06 Mar-11 Mar-13 

Source: PCA, MPI 



• The declining i interest t rate environment has been very positive for Plan Sponsors 

• As interest rates fell and pushed up Fixed Income returns, the performance sacrifice for 

holding Fixed Income instead of more risky Stocks was relatively small 

• Over the past 20 years, Fixed Income has returned 6.1% while stocks have earned 8.5% 

o 

This resulted in a relatively small 2.4% performance sacrifice for holding considerably safer Fixed Income rather than 

Stocks 

• Using a 70% Stock / 30% Fixed Income allocation earned 7.78% per year over that time 

period 

• However, using the same 70/30 mix with today’s low 2% yield on Fixed Income results in an 

annual return of only 6.55%! 

• This creates a challenging environment for Plan Sponsors as most plans have higher actuarial 

assumed investment return assumptions 



• However, the problem posed by the low current yield on Fixed Income is not the only problem 

facing Plan Sponsors 

• Plan Sponsors also face the possibility of capital loss as interest rates start to rise 

• Why is this? 

o 

There is an inverse relationship between bond prices and interest rates 



• Lets look at an example: 

o You buy a bond with 11 years to maturity that yields 2% trading at par ($100) 

o 

o 

o 

o 

After a year, interest rates have gone up to 5% and you want to sell your bond 

Will you get $100 when you go to sell the bond? => No 

Why not? The buyer could just as easily buy a new identical 10 year bond yielding 5% and make 

more money over the life of the investment 

So for the buyer to be willing to buy your bond, your bond must allow him to make an equivalent 

amount of money as the identical 5% bond 

o How does this happen? => The price of your bond must go down 

o 

o 

In order for the two bonds to have identical returns over the next 10 years your bond must be sold at 

=> $76.83! 

You have a capital loss of 23% because of the increase in interest rates 



• Luckily there is a simple measure that we can use to estimate the change in Bond prices for 

given changes in interest rates => Duration 

• Duration measures the change in the price of a Bond given small parallel shifts in interest 

rates 



• The current interest rate environment has created an extremely asymmetric risk reward profile 

o 

o 

The best outcome is getting your money back at maturity and earning a meager 2% interest along the 

way 

However, the potential downside during the tenure of the bond is enormous 

• The graph below shows the return distribution for a 10-year Treasury under different interest 

rate environments 

15% 

5% 

2% 

-5% 

% Change in 

Value 

-15% 

-25% 

-35% 

-45% 

‐7% 

‐15% 

‐22% 

‐28% 

‐34% 

‐39% 

-55% 

‐44% 

‐48% 

‐52% ‐55% 

-65% 

+0% +1% +2% +3% +4% +5% +6% +7% +8% +9% +10% 

Source: PCA, US Treasury 

% Change in Interest Rates 



• Historically there have been periods of moderate to severe losses from Fixed Income 

investments 

o Relatively small interest rate increases have led to significant capital losses 

Source: Welton Inv. Corp 



• Longest and most painful drawdown was in the period from 1954 to 1960 which featured a 

slow but steady rise in interest rates 

o 

During the period, interest rates only increased 1.8% but spanned 6 years of increasing rates resulting 

in a drawdown which continued over 8 years 

Source: Welton Inv. Corp 



• So why was the 1954 to 1960 drawdown so severe? Why was a 15.3% capital loss with a 8+ 

year drawdown period associated with an environment where interest rates went up slowly 

and by only 1.8%? 

• The answer is the low 2.85% starting interest rates of the period 

o 

o 

Return on Fixed Income is composed of two components: capital gain/loss and interest 

When interest rates are low there is less interest to offset a portfolio capital loss as well as less money 

to reinvest at the higher interest rates 

• From the previous slides we can see that the slow grind from a low interest rate can be a 

more bearish environment for Fixed Income than a more volatile period with higher rates (late 

1970s & early 1980s) 

• The key lesson to remember is that a slow rise in interest rates from a low starting rate can be 

very harmful for a Fixed Income portfolio 

o 

Potentially eliminating any return from a Fixed Income portfolio for quite a long period of time 


SECTION 2 

LOOKING FORWARD 

Source: Walt Disney 


│ 14

LOOKING FORWARD: INTRODUCTION 

r 

• With Fixed Income exhibiting such pronounced asymmetry between risk and reward we must 

look ahead to how the current interest rate environment might unfold 

• While accurately forecasting the future of the economy and financial markets is often an 

exercise in futility we can gain some insight into the broad themes that may play out 

• Unfortunately there are relatively few positive scenarios for investing in Fixed Income at the 

current level of interest rates 

o 

While there are many scenarios that can produce markedly negative outcomes 

• WARNING: The following slides regrettably must divert slightly into Monetary and Fiscal 

Policy to get a full picture of what may lie ahead 



r 

• As we’ve already discussed d interest t rates are near all time lows 

• This outcome is the direct effect of the US Central Bank’s (Fed) policies 

• To combat the economic crisis of 2008 the Fed embarked on an unprecedented endeavor to 

lower interest rates to boost economic activity 

o December 2008 Fed set the Federal Funds Rate to 0-0.25% 

o 

November 2008 Fed began Quantitative Easing (QE1) buying $600 billion in MBS 

o November 2010 Fed began QE2 buying $600 billion in Treasuries 

o September 2012 Fed began QE3 buying an unlimited quantity of Treasuries and MBS at a rate of $85 

billion a month 

• These actions have swollen the Fed’s balance sheet from less than $1 trillion before the 

financial crisis to approximately $3.3 trillion today 



r 

• The Fed has grown its balance sheet at a rate of 30% per year since the crisis 

Current: $3.3T 


LOOKING FORWARD: POSSIBLE OUTCOMES 

r 

• More recently the Fed has announced plans to keep interest t rates exceptionally low until at 

least 2015 and to continue to provide additional accommodation (QE) until economic growth 

accelerates 

• So what does this mean for Fixed Income investors? 

• Investors can expect low yields on Fixed Income investments for at least a couple years 

ahead. 

• This will continue to weigh on portfolio returns and continue to make it difficult for Plan 

Sponsors to reach their required investment return 


POSSIBLE OUTCOMES: ‘BASE CASE’ SCENARIO 

r 

• Ideally, and by far the most positive, scenario on how the interest t rate environment evolves 

includes a relatively quick pick-up in economic growth which pulls down the unemployment 

rate 

• This would allow the Fed to discontinue its bond buying program and to eventually start 

raising interest rates at a slow-to-moderate pace. In addition, the Fed would slowly shrink its 

balance sheet as securities mature 

• In this ideal scenario, investors could position their portfolios so that bond maturities and 

interest are reinvested at the slightly higher rates offsetting some of the capital loss 

• In this scenario, investors could hope to breakeven or experience a small loss over a 

moderate time period depending on how fast interest rates rise 

• We will consider this our “base case” and consider alternative scenarios with less optimistic 

outcomes 


POSSIBLE OUTCOMES: ALTERNATIVE SCENARIO 1 

r 

• Our first alternative ti scenario is one in which h growth does not accelerate as in the base case 

resulting in an environment of continued high unemployment 

• In this scenario, the Fed will likely keep interest rates low for a considerable period as well as 

continue to provide additional accommodation 

• This could cause two potentially problematic situations for investors/Plan Sponsors 

1. Prolonged period of low interest rates which places pressure on Plan Sponsors to meet their longterm 

assumed rate of return 

2. Alternatively, the continual printing of money may eventually spark inflation putting the Fed in an 

extremely difficult situation between supporting the economy through money printing or price stability 

through higher interest rates 



r 

• Our first alternative scenario characterized by slow growth and stubbornly high unemployment 

is lent credence by the thus far slow economic rebound after the financial crisis 



r 

• Thus far the Fed’s unprecedented d monetary policy has not sparked a large increase in the 

rate of inflation 

• Inflation has remained relatively muted with core inflation (ex volatile energy and food) 

remaining below 2% 

• Despite this, many economists are still worried that the seeds of future inflation are being 

sown today through the Fed’s easy money policy 

o 

o 

o 

They worry continuous printing of money will eventually lead to a marked decline in the dollar 

This would greatly increase the cost of imports but would also flow through to domestic goods due to 

the fact that a large percent of domestic goods use imports purchased internationally 

If inflation does start it would put the Fed in a particularly challenging position 

♦ 

♦ 

They could continue their accommodative process risking runaway inflation 

Or they could raise interest rates to slow inflation risking choking off the nescient recovery 



r 

• Regardless of whether or not the prolonged period of low interest t rates and money printing 

actually creates higher rates of inflation, this alternative scenario would be extremely 

challenging for investors/Plan Sponsors 

• A prolonged period of near zero interest rates will make it exceedingly difficult for Plan 

Sponsors to meet their required investment return 

• Further complicating the situation is the knowledge that the continual money printing can lead 

to inflation 

o 

Many Plan Sponsors would likely look to alter their asset allocation to hedge this risk 

• Under this scenario, an investment in Fixed Income would have a highly asymmetric risk 

return profile 

o 

o 

Investors would have to accept near zero rates of return 

While simultaneously, being exposed to the possibility that high inflation could severely damage their 

portfolio 



r 

• The next alternative ti scenario is similar il to the first but brings in the complicating role of fiscal 

policy and Government debt which will likely have a large impact on the future course of 

interest rates 

• In reality this second scenario is really a series of multiple sub-scenarios comprised of similar 

themes 

• Before we can jump into the analysis of what the impact of these different sub-scenarios scenarios will 

be on interest rates and Fixed Income returns we must set the stage 

o 

Please excuse the quick journey through Government finances 



r 

• Government fiscal realities and Government debt 

o Over the last 20 years, Government expenditures have grown at an annual rate of 4.6% 

o Over the past 10 years, Government expenditures have grown at an annual rate of 5.1% 

o While over the same time periods, Government revenue (Taxes) grew at annual rate of 3.9% and 

32% 3.2% respectively 

Government Expenditures 

Government Revenue 

4,000,000 

3,500,000 

3,000,000 

2,500,000 

2,000,000 

1,500,000 

1,000,000 

500,000 

0 

4,000,000 

3,500,000 

3,000,000 

2,500,000 

2,000,000 

1,500,000 

1,000,000 

500,000 

0 

1992 

1994 

1996 

1998 

2000 

2002 

2004 

2006 

2008 

2010 

2012 

1992 

1994 

1996 

1998 

2000 

2002 

2004 

2006 

2008 

2010 

2012 

Source: PCA, TreasuryDirect.gov 



r 


o 

o 

o 

o 

o 

The difference between Government expenditures (Spending) and Government revenue (Taxes) is the 

federal budget deficit 

The accumulation of deficits results in Government debt 

For perspective, the budget deficit in 2012 is equivalent to $9,398 per U.S. household 

Government debt has grown at a rate of 8.6% a year for the past 10 years 

For perspective, the Government debt amounts to approximately $150,000 per tax payer 

Deficit 

Total Debt 

1,600,000 

18,000,000 

1,400,000 

16,000,000 

1,200,000 

000 

1,000,000 

800,000 

600,000 

400,000 

200,000 

0 

14,000,000 

12,000,000 

10,000,000 

8,000,000 

6,000,000 

4,000,000 

-200,000 

2,000,000 

-400,000 

0 

1 992 

1 

994 

1 

996 

1 

998 

2000 

2002 

2004 

2006 

2008 

2010 

2012 

1 992 

1 

994 

1 

996 

1 

998 

2000 

2002 

2004 

2006 

2008 

2010 

2012 




r 


o As of 4/23/2013, Government debt totaled $16,794,349,827,897.30 

o 

Of which 71% was held by the Public and 29% consisted of intergovernmental holdings (Social 

Security Trust Fund) 

o 

Of the 71% held by the public 

♦ Foreign holders account for 47% with both China and Japan holding over $1T 

♦ The Fed holds approximately 15% 

♦ The other 38% are held by US investors and institutions 

o 

The composition of the holders of Government debt may impact the evolution of interest rates 

♦ 

♦ 

The Fed and some US holders may be willing to accept exceedingly unfavorable terms on the debt 

given their specific policy or requirement 

On the other hand, some foreign holders and other US holders may respond to unfavorable terms by 

selling their securities 



r 


o 

o 

Despite the large increase in debt over the past 20 years ($4T to $16T) the interest owed by the 

Government on that debt has essentially not grown 

The annual interest cost to the Government has grown by a mere 1% a year over the past 20 years 

o Over this period, the weighted average interest rate on all Government debt fell from a high of 7% to a 

recent low of 2% 

o Over the entire period, the average interest rate was 5.2% 

Interest Cost 

Average Interest Rate 

$500,000 

8.00% 

$450,000 

$400,000 000 

$350,000 

$300,000 

7.00% 

6.00% 

5.00% 

$250,000 

4.00% 

$200,000 

$150,000 

$100,000 

$50,000 

3.00% 

2.00% 

1.00% 

$- 

0.00% 

1 

992 

1 

994 

1 

996 

1 

998 

2000 

2002 

2004 

2006 

2008 

2010 

2012 

1 

1 

1 

1 

1 

1 

1 

992 

993 

994 

995 

996 

997 

998 

999 

1 

2000 

2001 

2002 

2003 

2004 

2005 

2006 

2007 

2008 

2009 

2010 

2011 

2012 




r 


o 

o 

The Government borrows on a relatively short time frame => ~50% 3 years or less 

♦ 

Short term nature means the Government must refinance its debts fairly regularly 

This will cause the average interest rate on Government debt to adjusts relatively quickly to changes 

in the interest t rates 

Maturity Profile of Publically Held Debt 

Source: Treasury.gov 



r 

• The background provided over the past few slides lays out the foundation for concern over the 

future course of interest rates 

• Currently the cost to the Government to finance its debt (its debt servicing cost) has been 

relatively muted and unchanged over the past 20 years 

• This has been a boon for the Government as it has not had to pay the price for increased 

borrowing 

o 

o 

Imagine a credit card on which h the interest t rate declined d as the balance grows 

No wonder why politicians have been so liberal with their largesse 

• We are likely approaching a tipping point where the cost from the balance of outstanding debt 

starts t to outweigh the fall in average interest t rate 

o The average interest rate could continue to decline over the next year or two 

o But it can not fall too considerably lower from the weighted average rate of 2% 

• The average interest rate on Government debt will adjust relatively quickly to changes in 

interest rates due to the short-term nature of Government borrowing 

• What happens when this tipping point is reached? 



r 

• The chart below shows the income statement of the US Government for 2012 

o 

With spending as the left column and revenue on the right 

What happens 

when this starts 

to grow? 

Source: PCA, US Government Printing Office 



r 

• So what happens when the cost of Government debt starts t to grow? 

• The obvious answers are: 

o 

o 

o 

The Government could raise revenue to cover the higher cost 

The Government could reduce spending on other goods/services to cover the higher cost 

♦ 

Debt crowding out effect 

The Government increases borrowing to cover the higher cost 

♦ 

Essentially paying for debt with more debt 

• The rate at which the cost to service Government debt rises and the method chosen to 

accommodate its rise will have large impacts on the future course of interest rates and the 

outcomes for Fixed Income holders 



r 

• Which h method chosen to accommodate the rise in the costs of servicing i the Government debt 

will have a meaningful impact on Fixed Income investors? 

• If the Government decides to raise revenue or cut spending to accommodate the rise in cost 

then there will likely be two competing forces on Fixed Income returns 

1. The spending cuts and higher taxes would likely lead to a slower economy, a slower economy usually 

pushes down interest rates which would temporarily boost Fixed Income returns 

2. On the other hand, higher taxes and reduced spending would likely force the Fed to remain 

accommodative for longer which would lower the long run return for Fixed Income investors 

• This process is compounded if the Government doesn’t have a balanced budget as the debt 

would continue to grow leading to an ever-increasing crowding out by debt 

• Taken to the limit, you can see how such a scenario would lead to an economy in a death 

spiral as austerity to cover the debt service slowly chokes off the economy 



r 

• If instead of deciding to raise revenue or cut expenses, the Government could decide to 

finance the cost by issuing more debt 

• This situation would compound much quicker than the previous one in which the Government 

enacted austerity to accommodate the debt service costs 

• Taken to the limit, it is easy to see how quickly this process can lead to a debt spiral 

Gov’t Debt 

I 

nterest 

Interest t 

Deficit 



r 

• A combination of the two approaches can be witnessed in many Southern European countries 

• Greece, an extreme example, exhibited a typical debt spiral in which debt reaches a certain 

tipping point after which debt begets more debt 

o 

o 

o 

o 

In such a situation, debt servicing costs are financed by additional debt leading to higher debt 

servicing cost 

At some point this process becomes non-linear and the debt servicing cost explodes 

Along this process investors start viewing the debt more skeptically, raising the interest that must be 

paid on the debt => exacerbating the process 

This process can happen relatively slowly or rapidly (as it did in Greece) 

• On the other hand, Spain and Italy have chosen a path of austerity 

o 

o 

Deciding to cut spending and increase taxes to avoid increased borrowing 

However, this has had a huge impact on their economies as GDP has continued to fall and 

unemployment has continued to climb 



r 

• While the US is in a far better situation than the countries in Southern Europe, some insights 

can be learned as the US enters a phase of increasing debt service cost 

• The dynamics of interest rates in Southern Europe and the outcomes on Fixed Income 

investments will provide valuable insights into the dynamics that could play out (likely with 

reduced severity) in the US 

• The chart below highlights just how quickly debt service costs can increase 

Debt = 

$16.8T 

Average 

Interest Rate 

Interest Cost 

($ Mil) 

% of Today’s 

Revenues 

Current 2.24% 376,498 15% 

3.00% 504,362 21% 

4.00% 672,483 28% 

20 Yr Avg 5.23% 879,302 36% 

6.00% 1,008,724 41% 



r 

• While the US will likely l not face the same severity of issues as Southern Europe, the US does 

face considerable challenges ahead 

• The economy continues to grow at an moribund pace of less than 2% 

• The US has had four consecutive Trillion dollar plus deficits 

o 

While the deficit should fall under a Trillion dollars in 2013 it will remain in the high hundreds of Billions 

range 

• Unemployment has shown little improvement 

o 

While the official unemployment rate has declined recently, labor force participation rate has continued 

to plunge 

• Entitlement programs have created a huge unfunded liability estimated by economists to be 

anywhere e from $50T to well over $100T 



r 

• The non-partisan Congressional Budget Office sees continued growth in Government Debt as 

entitlement programs expand as the population ages 



r 

• The outcome for Fixed Income investors in this alternative ti scenario greatly depends d on the 

actions of the Government and the Fed 

• If the Government decides to accommodate the increase in debt service cost through 

austerity then investors may be in for a prolonged period of ultra-low interest rates 

o 

As mentioned, such an outcome would put extreme pressure on Plan Sponsors 

• If the Government chooses to accommodate the higher debt service cost with additional 

borrowings then investors face a more perilous situation 

o 

o 

o 

This method of accommodation creates a more unstable situation in which debt service costs grow 

more quickly 

In this scenario, investors’ risk tolerance plays an important role 

If investors become more adverse to holding the debt they may begin to sell their holdings or at least 

slow or stop their purchase of additional securities 

♦ This would drive up interest rates, possible quickly and in a disorderly fashion 

• In such a scenario, investors would face capital losses as interest rates rise 

o 

Such losses could be extremely high if the situation unfolds disorderly 



r 

• Most observers comment that t the probability bilit of such a scenario playing out in the US is 

exceedingly unlikely 

o 

o 

One of the main reason people point to this unlikelihood is that the US controls its monetary supply 

In essence, if such a scenario began to play out the Fed could simply print additional money and 

purchase Government debt on the open market similarly il l to what they are doing with Quantitative 

Easing 

• However, such a scenario could lead to “Fed Capture” 

o 

o 

o 

o 

Fed Capture results when fiscal policy and the corresponding impact on the interest rate environment 

work together to force the Fed to act in a specific manner 

In such a scenario, monetary policy and the Fed essentially loses its independence 

Once this happens, the Fed’s mandate for price stability is sacrificed for interest rate stability and 

Government debt stability 

Historically, Central Bank Capture often proceeds bouts of inflation and currency decline and/or 

collapse 

♦ Central Bank Capture is a hallmark in studies of country default 

♦ Most countries prefer to default through currency devaluation and inflation versus reneging on debt 

♦ Reinhart and Rogoff point out in their book “This Time is Different” that inflation crises and exchange rate crises 

have traveled hand in hand in the overwhelming majority of [default] episodes across time and country 



r 

• While it is easy to see how such a situation ti can get out of hand in severe cases, Fixed Income 

investors are still exposed to negative outcomes in more moderate situations 

o 

o 

o 

Any form of Fed Capture would be highly detrimental to investors even if it does not lead to a spiral of 

hyperinflation 

Fixed Income investors rely on the price stability provided d by the Fed as part of its mandate 

Without price stability Fixed Income investors cannot make a sound judgment on the merits of a 

particular investment 

♦ Does the Bond provide adequate value greater than the foregone consumption today? 

♦ 

If the investor can’t quantify their prospective purchasing power in future periods then it is impossible to estimate 

the value of an investment in the current period 

♦ Today’s low interest rate environment compounds the problem by reducing the margin of safety 

• In such a scenario, Fixed Income investors today can face multiple paths to sub-optimal 

outcomes 

o 

o 

Any swings in interest rates could cause material capital losses in today’s low rate environment 

Plan Sponsors, especially those with COLA agreements, are dangerously vulnerable to inflation 

increases 

♦ 

The current 10-Year Treasury has a small negative real yield; if inflation increases, losses of real purchasing 

power would be substantial 


LOOKING FORWARD: CONCLUSIONS 

r 

• Conclusions 

o 

o 

o 

o 

o 

It is important to reiterate that while the alternative scenarios presented are quite worrisome especially 

when taken to the limit case, these are not the most likely future path for interest rates 

Investors will want to plan for the likely l evolution of the current interest t rate environment to be 

relatively close to the base case 

However, it is important to see the possible alternative ways that the current environment could unfold 

over time 

The goal is for Plan Sponsors to identify the possible negative outcomes 

Think about situations in terms of what are the: 

♦ 

♦ 

♦ 

Known-Knows: We know interest rates are at historic lows; interest will likely increase some point in the future; 

Fixed Income investors face capital losses in an increasing interest rate environment; Fixed Income will provide 

significantly lower returns going forward than they have in the past 

Known-Unknowns: What we don’t know is for how long interest rates will stay low; how fast they will increase; 

if inflation will rise; how the Government will react to increasing debt service costs; if the Fed will favor economic 

growth over price stability; if the Fed will favor price stability over interest rate stability 

Unknown-Unknowns: By definition we don’t know all the factors that may impact Fixed Income investors, in 

this case you have to use your imagination for thinking of scenarios that are seemingly improbable; for example, 

China deciding to let their currency free float which would no longer bind them to purchasing US Treasuries 


SECTION 3 

INVESTMENT OPTIONS 


│ 43

INVESTMENT OPTIONS 

r 

• In light of the preceding discussion i it is beneficial i to look at what other Plan Sponsors are 

doing in light of the current environment and what investment options can be put in place to 

mitigate some of the potential hazards of the current environment 

• Plan Sponsors have taken varied responses to the current environment 

o 

o 

o 

o 

Many Plan Sponsors are taking the long-term view, leaving their portfolios unaltered 

Others are implementing various tweaks to their asset allocation or to their fixed income composition 

Many Plan Sponsors are reducing their exposure to fixed income – namely foundations & 

endowments 

♦ 

Princeton chose to move from Fixed Income into Cash 

Many Plan Sponsors are investing in High Yield debt, Bank Loans, and Opportunistic Credit 

• The main problem is how to implement these changes without increasing other risk within the 

portfolio 


INVESTMENT OPTION 1 

r 

• Option 1: Do Nothing 

• By not altering either the strategic asset allocation or the composition of the Fixed Income 

portfolio the Plan Sponsor is sticking to the assumption that over time markets will normalize 

and a strong initial strategic asset allocation will meet the required return assumption 

• Benefits 

o 

o 

Known exposures – no exposure to new asset class (sub-asset class) 

Core Fixed Income would still do great in a deflationary environment (i.e., if risk-off occurs in some 

dramatic fashion) 

• Drawbacks 

o Will not adapt to changing rate environment 

o Fixed Income returns are currently significantly lower than historical averages 



r 

• Option 2: Reallocate Away from Fixed Income 

• By moving a portion of the Fixed Income portfolio into other asset classes a Plan Sponsor can 

mitigate the negative impacts on Fixed Income investments 

o 

o 

However, doing so will expose the overall Plan portfolio to new risks or increase the risks already in 

the portfolio (if reallocating within current asset allocation) 

If the Plan reallocates to Cash rather than Fixed Income the Plan maintains the liquidity and stable 

value properties of Fixed Income with less exposure to a rising interest rate environment 

• Benefits 

o 

Reduces the potential headwinds facing Fixed Income 

• Drawbacks 

o 

o 

o 

Increases other risks in the portfolio 

Likely increase the overall portfolio risk level – can be mitigated through other portfolio reallocations 

While reallocating to Cash would lessen the exposure to rising interest rates, it would still produce 

minute returns if interest rates are held low for a long time 



r 

• Option 3: Reduce the Duration of the Fixed Income Portfolio (w/ current managers) 

• The duration of the overall Fixed Income portfolio can be reduced by either directing the 

investment mangers to lower their portfolio duration to a predetermined level or by hiring a 

derivatives overlay manager to reduce the duration through derivative contracts 

• Benefits 

o 

Reduces the duration risk 

o Maintains current investment managers 

• Drawbacks 

o Alters investment managers mandate – may not agree to changes 

o Only hedges against increases in interest rates – still exposed to potential long period of low rates 

o Overlay manager could be prohibitively expensive if hedging over long time periods 



r 

• Option 4: Alter Fixed Income Portfolio 

• By altering the composition of the Fixed Income portfolio a Plan Sponsor can move to address 

some of the challenges facing a traditional core Fixed Income manager in the current 

environment 

• We will look at 3 alternative methods for altering the composition of the Fixed Income portfolio 


INVESTMENT OPTION 4-A 

r 

• Option 4 – A: Short-Term Lower-Quality 

• A portfolio composed of lower-quality investments that are short-term in nature can potentially 

mitigate some of the headwinds of the current interest rate environment. The lower-quality 

aspect allows the portfolio to earn a relatively high yield (4-6%) whereas the short-term nature 

limits the exposure to Duration risk (as well as default risk) 

• PCA has worked with a large Public Plan to implement a portfolio composed of 1/3 short-term term 

High Yield bonds, 1/3 Bank Loans, and 1/3 other short-term/floating rate instruments 

o 

o 

o 

Short-term High Yield benefits from the fact that securities with higher yields have less Duration risk; 

also, since they mature relatively soon there is less time for the business to deteriorate causing a 

default scenario. 

Bank loans have two great advantages: they have floating coupons and they are senior in the capital 

structure – since 1997 the S&P/LSTA Bank Loan Index has only lost money in one year (2008) 

The other category allows the investment manager to find value in other market segments depending 

on the manager’s expertise 


INVESTMENT OPTION 4-A 

r 

• Option 4 – A: Short-Term Lower-Quality (Continued) 

• Benefits 

o 

o 

o 

o 

Increases the yield on the Fixed Income portfolio 

Short-term and floating rate nature provides protection in a rising rate environment 

Likely increases returns in low interest rate environment 

Short-term and senior nature of investments limits default risk 

• Drawbacks 

o Increases the credit risk of the overall Fixed Income portfolio 

o Exhibits increased “equity like” risk exposure in periods of market turmoil 

o High Yield and Bank Loans are expensive relative to history 

♦ Many investors have already moved into the space seeking yield 


INVESTMENT OPTION 4-B 

r 

• Option 4 – B: Private Credit 

• Private Credit are investments in credit-related assets that are not publically traded 

o 

This can include loans to middle market firms, distressed debt, mezzanine loans, etc. 

• Due to the investments being private there is considerable illiquidity for the assets 

o 

This has benefits and drawbacks 

♦ 

The major drawback is that t the funds that t do these type of investments t have private structures t (PE) 

♦ The rationale for this is the money has to be invested in a illiquid security or workout situation which dictates 

reduced access to the capital by Plan Sponsors 

♦ Fund-of-funds exist allowing for greater diversification 

• Relative to publically traded debt securities, private credit remains relatively cheap 

o 

Main reason for this is the illiquidity premium 

♦ 

♦ 

Many Plan Sponsors experienced predicaments during the credit crisis due to large illiquid investments; this 

greatly reduced their appetite for illiquid investments 

As a net inflow plan, EBMUD should not have any major liquidity needs for many years ahead 


INVESTMENT OPTION 4-B 

r 

• Option 4 – B: Private Credit (Continued) 

• Benefits 

o 

Limited exposure to interest rates – return generated through Credit not Duration 

o High expected return (8-10%) 

o Relatively inexpensive compared to publically traded High Yield debt 

o Significantly better risk return profiles than publically traded High Yield debt 

♦ 

Superior position in capital structure, stronger credit covenants, ability to do workouts 

• Drawbacks 

o Illiquidity – funds often have 4-8 year lock-ups 

o Pi Private fund structure 

t 

o High management fees – base and incentive 

o Much higher risk investment than traditional core fixed income 


INVESTMENT OPTION 4-C 

r 

• Option 4 – C: Barbell llApproach 

• This option simply includes an allocation to either option A or B paired with a high-quality 

short-term mandate 

• By having both features, the overall credit quality of the bond portfolio does not change as 

materially – less effect on overall bond portfolio 

• The goal is to increase the return during the period of low interest rates through the “risk” 

portion of the barbell yet maintain credit quality through the “safe” side of the barbell 

• Since both portions of the barbell are short-term in nature the portfolio is less exposed to 

interest rate increases 


INVESTMENT OPTION 4-C 

r 

• Option 4 – C: Barbell llApproach (continued) 

• Benefits 

o 

o 

o 

Less reduction in credit quality compared to option A or B 

Reduced exposure to rising interest rates 

Higher return than traditional fixed income 

• Drawbacks 

o 

o 

Reduced return potential due to safe side of the barbell 

High Yield and Bank Loans are relatively expensive 


CONCLUSIONS 

r 

• Interest t rates are near all time lows as a result of unprecedented d actions taken by the Fed 

• Plan Sponsors face an extremely challenging situation 

o 

o 

o 

o 

o 

Low Bond yields make it exceedingly difficult to meet their actuarial return assumptions without 

t 

significantly altering the composition of their portfolio 

Compounding the problem is the fact that traditional Fixed Income benchmarks are highly weighted in 

Government backed debt – proportion is growing *** 

The base case for the evolution of the interest rate environment is not overwhelmingly positive - we 

can see from 1954 that small increases in interest rates over long time periods can be exceedingly 

detrimental to Fixed Income portfolios 

Despite the lackluster base case, alternative ti scenarios exist with far greater downside for Fixed 

Income investors 

While it is exceedingly unlikely that the U.S. would experience any of the more severe outcomes 

outlined, it is important to note that it is a continuum of outcomes and that very poor outcomes can 

occur for Fixed Income investors even at relatively modest potential scenarios *** 


CONCLUSIONS 

r 

• There are a few approaches Plan Sponsors can pursue to lessen the impact on the Plan from 

the current interest rate environment and the headwinds Fixed Income investors face 

• There is no right answer as to how best to handle the situation 

o 

o 

As usual there is simply a series of tradeoffs that as fiduciaries of the Plan you must feel comfortable 

with 

These tradeoffs include: 

♦ 

♦ 

♦ 

♦ 

♦ 

Willingness to change the risk profile of the complete Plan to avoid falling short of your required rate 

Exploring new asset classes for their hedging abilities 

Sacrificing return for safety 

Sacrificing credit quality for greater yield 

Accepting illiquidity for higher returns 


Disclosures 

Pension Consulting Alliance, Inc. (PCA) prepared this document solely for informational purposes. To the extent that market conditions change subsequent to the date of this 

report, PCA retains the right to change, at any time and without notice, the opinions, forecasts and statements of financial market trends contained herein, but undertake no 

obligation or responsibility to do so. 

Neither PCA nor PCA’s officers, employees or agents, make any representation or warranty, express or implied, in relation to the accuracy or completeness of the information 

contained in this document or any oral information provided in connection herewith, or any data subsequently generated herefrom, and accept noresponsibility, obligation or 

liability (whether direct or indirect, in contract, tort or otherwise) in relation to any of such information. PCA and PCA’s officers, employees and agents expressly disclaim any and all 

liability that may be based on this document and any errors therein or omissions therefrom. Neither PCA nor any of PCA’s officers, employees or agents, make any representation 

or warranty, express or implied, that any transaction has been or may be effected on the terms or in the manner stated in this document, or as to the achievement or 

reasonableness of future projections, management targets, estimates, prospects or returns, if any. Any views or terms contained herein are preliminary only, and are based on 

financial, economic, market and other conditions prevailing as of the date of this document and are therefore subject to change. Past performance does not guarantee or predict 

future performance. 

PCA prepared p this document and the analyses contained in it based, in part, on certain assumptions and information obtained from sources affiliated with the client, including, 

without limitation, investment advisors, investment managers, consultants, client staff, outside counsel and third-party providers. PCA’s use of such assumptions and information 

does not imply that PCA independently verified or necessarily agrees with any of such assumptions or information. PCA assumed and relied upon the accuracy and completeness 

of such assumptions and information for purposes of this document. This information is provided on an “as is” basis and the user of this information assumes the entire risk of any 

use made of this information. 

All trademarks or product names mentioned herein are the property of their respective owners. Indices are unmanaged and one cannot invest directly in an index. The index data 

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Considering a Real Return Class 

East Bay Municipal Utility District 

1 

May 2013 

1


RATIONALE 

• Under current policy, plan sponsor portfolios often exhibit 70+% equity exposure 

• Institutional real estate portfolios have become more appreciation-oriented and may not diversify against equity risk 

• Other alternative investment portfolios (e.g., hedge funds) may exhibit higher-than-expected equity betas 

• A prudently structured Real Return portfolio should capturing a stable incremental return over 

inflation while diversifying equity risk 

• A Real Return class should be designed to produce relatively stable returns regardless of 

market environment and recover principal losses relatively rapidly 

2

Defining Inflation 

• Inflation is the general rise in the price level for goods and services over a period of time 

• When the general price level rises, each unit of currency buys fewer goods and services 

• Inflation also reflects an erosion in the purchasing power of money – a loss of real value in the internal medium of 

exchange and unit of account in the economy 

• Two measures of Inflation: Headline and Core CPI 

• Headline CPI: Broad measure of prices for goods and services purchased by a typical consumer 

• Core CPI: Headline CPI with volatile Food and Energy removed 

• Inflation's effects on an economy are various and can be simultaneously positive and negative 

• Positive: 

• Erodes value of fixed rate debt 

• Negative: 

• Decreases the real value of money 

• Erodes and discourages savings 

• Creates uncertainty 

• Leads to higher interest rates 

3

Inflation’s Impact on Traditional Asset Classes 

• Equities and bonds do best under low and stable inflationary environments 

• Bonds suffer the most from inflation 

• Equities initially do poorly during the onset of inflation but generally do better over time as inflation expectations are 

built into product pricing. 

Source: Morgan Stanley 

4

Expert Views 

5

Expert Views: Inflation Doves 

• Inflation Doves: Experts who do not believe inflation poses a real or immediate threat 

• Inflation is not an imminent problem 

• If it does occur it will be in the distant future 

• We have the policy tools to deal with it 

• Inflation cannot increase without a stronger job market and economic recovery 

• Policy makers should be doing more to stimulate the economy 

• Inflation is a distant problem 

6


• Ben Bernanke – Chairman of the Federal Reserve 

• Long term inflation expectations have remained stable and well anchored 

• Demand is slack and core inflation below-target 

• Any increase in inflation from higher commodity prices will be transitory 

• Fed will be able to maintain inflation at or below target as long as inflation expectations remain stable 

• Reasoning 

• High unemployment – slack in labor markets inhibits greater inflation 

• Output gap – below average economic recovery 

• Lack of lending from banks 

• Falling home prices – about 40% of CPI is housing related 

• Debt deleveraging 

7


The Evidence 

Source: Federal Reserve Bank of Philadelphia Survey of Professional Economists 

Surveys of Professional Economists: 

• Consistently shown inflation expectations have remained anchored near long term averages 

• PCA’s 10 year forecast is for 3.0% annual headline inflation 

8


The Evidence 

• Breakeven Inflation Rate: 

• Measures investors expectation of inflation based on relative investments in nominal and inflation adjusted Treasuries 

9

Expert Views: Inflation Hawks 

• Inflation Hawk: Experts who believe inflation poses a real and immediate danger 

• Inflation is the ultimate consequence of the Federal Reserve’s monetary policy of greatly increasing 

the money supply 

• Increases in the money supply are created by the Fed printing money and buying bonds (QE1 & QE2) 

• The Fed should pull back on the extremely aggressive monetary policy – Raise rates 

• The Fed is being forced to monetize the debt due to extreme budget deficits 

10 

10


• Bill Gross – Founder and co-CIO of PIMCO 

• Policy makers are robbing investors through the combination of ultra-low interest rates and inflation 

• Policy makers are attempting to reduce debt loads by monetizing the debt 

• Put his money where is mouth is – sold Treasuries from the PIMCO Total Return Fund he manages 

• Reasoning 

• Federal Reserve is printing money at an unprecedented pace 

• Record government deficits will lead to some form of default 

• Countries who control their own monetary policy default through currency devaluation and inflating away debt – 

Not reneging on debt 

• Policymakers overestimated the extent to which high unemployment will keep inflation from 

accelerating – U.K. has 8% unemployment and 5% increasing inflation 

• Businesses thus far have absorbed input price increases 

• When will businesses start passing on increased costs? 

• PPI (measure of business inflation) increased by 4.8% in 2011 

11 

11


The Evidence 

• The Federal Reserve has undergone an unprecedented policy of lowing interest rates by increasing 

the Money Supply 

12 

12


The Evidence 

• As of 4/23/2013, Government debt totaled $16,794,349,827,897.30 

• Government debt has grown at a rate of 8.6% a year for the past 10 years 

• Deficits are currently running at over a trillion dollars a year 

• Likely to stay exceedingly high for the foreseeable future 

Deficit 

Total Debt 

1,600,000 

18,000,000 

1,400,000 

16,000,000 

1,200,000 

1,000,000 

800,000 

600,000 

400,000 

200,000 

0 

14,000,000 

12,000,000 

10,000,000 

8,000,000 

6,000,000 

4,000,000 

-200,000 

2,000,000 

-400,000 

0 

1992 

1994 

1996 

1998 

2000 

2002 

2004 

2006 

2008 

2010 

2012 

1992 

1994 

1996 

1998 

2000 

2002 

2004 

2006 

2008 

2010 

2012 

Source: US Treasury 

13 

13


The Evidence 

• Gold Prices have skyrocketed on inflation fears 

14 

14

Expert Views: Summary 

• Experts are bitterly divided on the future of inflation 

• Dovish Economists (usually more left leaning) see little near term threat from inflation 

• See Output Gap (slow economy) as impediment to inflation 

• Hawkish Economists (usually more right leaning) predicted moderate to massive inflation due to the easy 

monetary policy and the trillions of dollars of spending by the current administration 

• “Inflation is always and everywhere a monetary phenomenon” – Milton Friedman 

• Many great investors seem to believe inflation will be the victor and are buying gold and commodities as 

well as other asset classes that do well in an inflationary environment 

• Selling fixed income securities 

15 

15

Institutional Investor Response 

16 

16

Institutional Investor Response 

• Most Institutional investors believe that inflation will pose some sort of threat at some point in the future 

• Many public pensions are putting the “tools” in place to deal with perceived risks such as inflation 

• The key to this approach is the have these “tools” ready and to “dial” them up or down in response to signs 

of these risks 

• Numerous public pensions have implemented a “Real Return” class as one of these tools 

• A prudently structured Real Return portfolio should diversify equity risk and provide inflation hedging 

• Designed to produce relatively stable returns and principal protection regardless of market 

environment and recover principal losses relatively rapidly 

17 

17


RATIONALE – THE OPPORTUNITY SET IS LARGE 

Combined Size of Potential Real Return Investment Markets 

(estimates for 6/30/2009) 

Abs Ret/ 

Hedge Fds 

$1.6T 

Global 

TIPS 

$1.4T 

Commodities 

$3.7T 

Infrastrucure 

$1.6T 

Timber 

$500B 

Very new segment with significant potential 

Volatile segment 

Proven asset class with verifiable track record 

Wide range of strategies within segment 

• Real Return-oriented investments represent over $8 trillion in opportunity 

• Other segments include Agriculture and Oil & Gas; LIBOR+ mandates may also be appropriate 

Sources: RREEF Real Estate Research, AllianceBernstein, Forest Investment Associates, Mercer, BIS 

18 

18

Modeling the Real Return Class 

• Different plan sponsors may arrive at different structural definitions for the Real Return Class: 

• TIPS 

• Timber 

PLAN SPONSOR ABC 

• Core real estate 

• Hedge Funds 

• Infrastructure 

• Oil & Gas projects 

• Commodities 

PLAN SPONSOR XYZ 

• Agriculture 

• Once a set of components are determined as viable, appropriate assumptions must be established 

19 

19

Current Trends Concerning a Real Return Class 

• Several variations of this class are taking shape: 

• Real Return (New Jersey, Arizona, PSERS) 

• Tangible Asset (WSIB) 

• Real Asset (ABP) 

• Real Return (Kansas PERS) 

• Inflation-linked (CalPERS, OTPP) 

• Single-segment (such as commodities, infrastructure, timber as single strategic classes) 

• Key tradeoff: flexibility in structuring vs. complexity and perception of utilizing ad hoc 

approaches 

20 

20


• Different plan sponsor blueprints for the class reflect different preferences and skill sets: 

Source: PCA 

Examples of Approved Plan Sponsor “Blueprints” 

CalPERS 

Inflation- 

Linked 

OTPP 

Inflation- 

Linked 

WSIB 

Tangible 

Assets 

KPERS 

Real 

Return 

Hawaii 

Real 

Return 

Asset Class 

Subcomponents 

TIPS 20% 0% 0% 50% 50% 

TIMBER 20% 20% 30% 25% 50% 

INFRASTRCTR 30% 60% 50% 0% 0% 

COMMODITIES 30% 10% 0% 0% 0% 

OIL&GAS 0% 0% 10% 0% 0% 

AGRICULTURE 0% 10% 10% 0% 0% 

HEDGE FOF 0% 0% 0% 25% 0% 

TOTAL 100% 100% 100% 100% 100% 

• Wide variation of structures, reflecting unique plan sponsor characteristics 

• Typically, market-driven opportunities will cause actual fundings to deviate significantly from 

proposed structure for modeling purposes 

• Policies and guidelines for this class typically allow for ample investment latitude 

21 

21


• Significant discussion should take place to outline an appropriate Real Return investment policy 

• What underlying segments should be included? 

• How much exposure does the plan sponsor already have to the underlying segments? 

• What would be the resource requirements associated with investing in new segments? 

• Review of assumptions of underlying components 

• Recognition that any model for a Real Return class is likely, at best, to be indicative and not overly precise 

• Implementation of any one of several structures may take an extended period of time 

• Many of the underlying segments do not lend themselves favorably to mean-variance optimization 

• There is limited history, at best 

• Several segments/classes may not be marked-to-market 

• Stress testing of assumptions and disclosure of modeling difficulty is a critical step to developing an initial 

awareness of the challenges of investing in certain underlying segments 

22 

22

Implementing a Real Return Class 

• Investing in a Real Return Class would likely exhibit some level of private investment-type characteristics 

• The funding level for the Real Return Class would be determined through the asset-liability process 

• An important implementation step would be to review and enhance policies and guidelines that would 

dictate the long-term structuring of the Real Return Class portfolio 

23 

23

Recommendations 

• Include the modeled Real Return class in the A/L study to determine its attractiveness versus 

other classes 

• Depending on the policy portfolio finally selected by the Board, the Real Return class may or 

may not receive an allocation 

24 

24

Appendix 

25 

25

Modeling a Real Return Class 

• Modeling process for underlying components: 

• Gather actual historical time series (varies significantly by component) 

• Where historical data is lacking, first model existing time series using multiple regression with other wellknown 

asset classes as explanatory variables 

• Use derived multiple regression model to simulate needed time series history 

• Verify that summary statistics of modeled results are consistent with those of other asset class expectations 

• Disclose and discuss modeled results 

• Include final modeled time series in aggregate Real Return Class 

26 

26

Modeling a Real Return Class 

SUMMARY OF ASSET COMPONENTS 

Commodities 

• Based on GSCI Total Return Index since 1970 

• Modeled to set roll return to zero and spot index return equal to CPI (roll+spot=excess return over cash) 

TIPS 

• BC TIPS Index 1997-2009 

• Simulated modeled returns 1970-1996 by Bridgewater 

Absolute Return 

• HFR Total Hedge Fund Index since 1993 

• Simulated modeled returns 1970 – 1992 

Oil & Gas 

• Amex Oil Index 1984 – 2007 

• Simulated modeled returns 1970 – 1983 

• De-levered using D/E ratio of 40%, source: UBS 

27 

27

A Brief Description of Global Inflation Linked Bonds 

REAL RETURN - TIPS 

1,600 

Global Index-Linked Bond Issuance 

1,400 

1,200 

1,000 

$ Trillion 

800 

600 

400 

200 

0 

2004 2006 2008 2010 

U.S. U.K. France Japan Germany Other Euro/CDA 

Source: Barclays 

28 

28

A Brief Description of Global Inflation Linked Bonds 

REAL RETURN - TIPS 

• Objective 

• Produce inflation-protected income/returns over extended periods 

• TIPS can help plan sponsors secure more steady real returns over time 

• Key Market Trends/Issues 

• Returns on TIPS have proven cyclical as a result of supply/demand factors as well as expectations for economic growth 

• The bulk of global TIPS issuance has come from sovereign governments 

• The market of TIPS has grown significantly in recent years 

• Compared to other major classes, TIPS have exhibited better inflation-protection characteristics 

• In the 2008 crisis, TIPS became attractively priced relative to U.S. Treasuries for lack of liquidity reasons 

• Investment Management Trends/Issues 

• Institutional TIPS management totals approximately $125 billion 

• Several plan sponsors have dedicated TIPS asset class portfolios, while others consider TIPS a Real Return component 

• Track records of active TIPS managers is mixed and relatively sparse 

29 

29

A Brief Description of Absolute Return/Hedge FOFs 

REAL RETURN – ABSOLUTE RETURN 

• Hedge funds have exhibited significant growth 

• Estimates vary significantly 

• Projected to be more than 9,400 managers 

• Estimated to be over $2.0 trillion in capital, before leverage 

• Pace of commitments to hedge funds continues to grow but stabilizing 

Source: HFR 

30 

30



CHARACTERISTICS AND ATTRIBUTES 

• Market dominated by Opportunistic (Long/Short) 

• Long/short strategies combine both long as well as 

short equity positions. The short positions have three 

purposes: 

• Generate alpha 

• Hedge market risk 

• Earn interest on the short as the manager collects 

the short rebate 

BREAKOUT OF HEDGE FUND INDUSTRY 

by Major Strategy Type By Assets 

(as of 12/31/2011) 

Opportunistic 

67% 

Event 

Driven 

13% 

Relative 

Value 

19% 

Source: HFR 

31 

31



Strategies 

Relative Value 

Convertible Arbitrage 

Fixed Income Arbitrage 

Equity Market Neutral 

Event Driven 

Risk Arbitrage 

Distressed Securities 

Opportunistic 

Macro 

Short Sellers 

Long Region, Industry, 

or Style 

Emerging Markets 

Long/Short Equity 

Definition 

Hedge Funds - Characteristics and Terms 

Invests in the convertible securities of a company. A typical investment is to be long the convertible bond and short the 

common stock of the same company. Positions are designed to generate profits from the fixed income security as well as the 

short sale of the stock, while protecting the principal from market moves. 

Fixed income arbitrage managers seek to exploit pricing anomalies within and across global fixed income markets and their 

derivatives, using leverage to enhance returns. In most cases, fixed income arbitrageurs take offsetting long and short 

positions in similar fixed income securities that are mathematically, fundamentally or historically interrelated. The relationship 

can be temporarily distorted by market events, investor preferences, exogenous shocks to supply or demand, or structural 

features of the fixed income market. 

Equity market-neutral is designed to produce consistent returns with very low volatility and correlation in a variety of market 

environments. The investment strategy is designed to exploit equity market inefficiencies and usually involves being 

simultaneously long and short matched equity portfolios of the same size within a country. Market neutral portfolios are 

designed to be either beta or currency-neutral or both. Equity market-neutral is best defined as either statistical arbitrage or 

equity long/short with zero exposure to the market. 

Risk arbitrage (also known as merger arbitrage) specialists invest simultaneously in long and short positions in both companies 

involved in a merger or acquisition. In stock swap mergers, risk arbitrageurs are typically long the stock of the company being 

acquired and short the stock of the acquiring company. In the case of a cash tender offer, the risk arbitrageur is seeking to 

capture the difference between the tender price and the price at which the target company’s stock is trading. 

Distressed securities funds invest in the debt or equity of companies experiencing financial or operational difficulties or trade 

claims of companies that are in financial distress, typically in bankruptcy. These securities generally trade at substantial 

discounts to par value. Hedge fund managers can invest in a range of instruments from secured debt to common stock. The 

strategy exploits the fact that many investors are unable to hold below investment grade securities. 

Macro hedge funds pursue a base strategy such as equity long/short or futures trend following to which large scale and highly 

leveraged directional bets in other markets are added a few times each year. They move from opportunity to opportunity, from 

trend to trend, from strategy to strategy. 

The short selling discipline has an equity as well as fixed income component. Short sellers seek to profit from a decline in the 

value of stocks. In addition, the short seller earns interest on the cash proceeds from the short sale of stock. 

Traditional equity fund structured like a hedge fund; ie, uses leverage and permits managers to collect an incentive fee. Focus 

of the fund could be a specific geographic region (i.e., Japan) , industry (i.e., technology) or style (i.e., growth) 

Emerging market hedge funds focus on equity or fixed income investing in emerging markets as opposed to developed 

markets. This style is usually more volatile not only because emerging markets are more volatile than developed markets, but 

because most emerging markets allow for only limited short selling and do not offer a viable futures contract to control risk. The 

lack of opportunities to control risk suggests that hedge funds in emerging markets have a strong long bias. 

Long/short strategies combine both long as well as short equity positions. The short positions have three purposes, which can 

vary over time or by manager. First, the short positions are intended to generate alpha. This is one of the main differences 

when compared with traditional long-only managers. Stock selection skill can result in doubling the alpha. A long/short equity 

manager can add value by buying winners as well as selling losers. Second, the short positions can serve the purpose of 

hedging market risk. Third, the manager earns interest on the short as he collects the short rebate. 

32 

32



• Objective 

• Hedge funds can play a variety of roles within an institutional portfolio 

• Primary objective has been to produce a stable return through a variety of market environments 


• Hedge funds represent significant marginal capital in the markets leveraged (i.e., magnified) by an order of magnitude 

• During the crisis, many have argued that forced selling by hedge funds (and others) added significant volatility to the 

investment markets 

• Hedge fund capital declined significantly as investors sought to liquidate their position, lack of transparency and fraud 

issues have not helped the case for hedge funds 

• Significant assets have been pulled from hedge funds and many hedge funds have closed as a result of being more 

exposed to macro factors than otherwise assumed 

• The crisis also revealed that certain hedge fund strategies are more “beta-oriented” than “alpha-oriented,” causing 

investors to revisit the rationales for hedge fund investing 


• While an expensive solution, hedge fund of funds still retain significant market power 

• There is significant uncertainty relating to future regulation possibilities for hedge funds 

33 

33

A Brief Description of Commodities 

REAL RETURN – COMMODITIES 

• “Commodities:” Natural resources and/or foodstuffs that are in continual demand around the globe 

• Oil & gas 

• Livestock 

• Major agricultural crops 

• Industrial and precious metals 

• Natural suppliers and users of commodities 

• Farming/Agriculture/Livestock 

• Mining/Resource Extraction 

• Drillers/Refiners 

Consumers 

Manufacturers 

Industry/Consumers 

• Prices of commodities fluctuate depending on supply/demand considerations 

Source: HFR 

34 

34


REAL RETURN – COMMODITY BASKETS and COMPONENTS 

Energy 

Livestock 

Agriculture 

Industrial Metals 

Precious Metals 

Crude Oil 

Brent Crude Oil 

Heating Oil 

Unleaded Gas 

Natural Gas 

Live Cattle 

Lean hogs 

Feeder cattle 

Corn 

Soybeans 

Wheat 

Soybean oil 

Coffee 

Cocoa 

Sugar 

Cotton 

Aluminum 

Zinc 

Nickel 

Lead 

Copper 

Gold 

Silver 

Platinum 

35


REAL RETURN – COMMODITIES 

• Objective 

• Commodities are often seen as “insurance” against financial crises and/or surprises in inflation 

• Commodity returns can move in near-opposite direction of other financial assets, providing potential diversification 

benefits 


• While the correlation between commodities and other financial assets have been negative, certain commodities have 

moved more in tandem with financial assets during the last 12-24 months (e.g., gold correlated closely with public equity) 

• During the latter part of the 2008 crisis, certain commodities provided ample protection as investors retreated to safety 

• Commodities are the most volatile of all investments, with precious metals and energy-based commodities often making 

significant pricing adjustments 

• Most commodity investments rely heavily on supply/demand factors, rather than the projection of operating cash flows 

• Institutional investors are considering several alternatives to adopting strictly passive exposure: e.g., active management, 

alternative benchmarks, custom benchmarks, long/short strategies 

• Commodities, while volatile, are typically highly liquid 


• There are numerous potential methods for entering commodities: separate accounts, structured vehicles, ETFs, pooled 

funds, etc. 

36

A Brief Description of Oil & Gas 

REAL RETURN – Oil & Gas 

• The prospects for energy are supply/demand driven 

• Key continuing premise is Emerging Asia’s insatiable appetite for energy and other commodities as its 

middle class expands over the next several decades 

• One key consideration: technological and productivity development 

Source: HFR 

37



• Near-term prospects: 

• Colder than average winter…. 

• …while aggregate demand and production is picking up in the US and 

elsewhere as move out of recession continues… 

• …and supplies are expected to peak in early-2011 

38



• Objective 

• Oil & Gas projects allow investors to capture high levels of cash flow while gaining some positive exposure to inflation 

trends 

• Income would exhibit some degree of inflation-linkage 


• Many investors have gained exposure to energy indirectly, via broader commodity-oriented and/or infrastructure mandates 

• The energy sector is a large component of the economy with several types of entry points: private investments, Master 

Limited Partnerships (MLPs), sector-focused long equity portfolios, various long-short strategies 

• While there has been significant positioning with respect to developing dedicated infrastructure investments, dedicated 

energy-oriented portfolios have not received significant interest 

• MLP sector is developing significant scale – now over $100 billion in equity issuance; most MLPs have an energy 

orientation 

• Similar to REITs, MLPs pass a large proportion of their income directly to investors, allowing for high cash-on-cash yields 

• MLP market consists of numerous alternatives, with varying degrees of operating risk and liquidity 


• While early in its stages, a few investors are considering MLP-type investments 

39

EAST BAY MUNICIPAL UTILITY DISTRICT 

DATE: May 16, 2013 

MEMO TO: Members of the Retirement Board 

FROM: 

Lisa Sorani, Manager of Employee Services 

SUBJECT: PEPRA Update & Ordinance Updating Section 21 of Retirement Ordinance 

PEPRA 

As required by the California Public Employees’ Pension Reform Act of 2013, staff has 

implemented the provisions of the 2013 Plan that required 2013 members to contribute 50% of 

normal cost on January 1, 2013 or upon expiration of the MOU’s for represented members. As of 

April 22, 2013, all 2013 plan members are contributing 7.75%, which is 50% of normal cost. 

RETIRMENT ORDINANCE, SECTION 21 AMENDED 

Section 21 of the Retirement Ordinance provides for an optional modification of a member’s 

retirement allowance to provide an actuarially equivalent allowance for a surviving beneficiary. 

The actuarial rate of return and mortality tables are used to calculate the optional beneficiary 

allowance. The Retirement Board adopted the Plan actuary’s recommendations to update the 

mortality tables to reflect future mortality improvements (longer life expectancy) for plan 

participants, and two changes to actuarial rate of return since 2008 due to economic downturn. 

The Retirement Board adopted the actuary’s recommendation for the following Rate of Return 

reductions: 

September 16, 2010: Rate of Return reduced from 8.25% to 8.0% (eff. 7/1/11) 

November 15, 2012: Rate of Return reduced from 8.0% to 7.75% (eff. 7/1/13) 

The amendments to the Retirement Ordinance (Section 21) ensure Ordinance language is 

consistent with actuarial changes adopted by this Retirement Board in 2010 and 2012. 

The ordinance was introduced and had the first reading by the EBMUD Board of Directors on 

April 23, 2013. The second reading and passage of the Ordinance amendments took place 

during the Board of Directors meeting on May 14, 2013. In accordance with the Municipal 

Utility District Act, the amendments will now be published in the newspaper for two successive 

weeks. The adoption of the Ordinance amendments will then take effect 30 days after their 

passage on June 14, 2013. 

LS:ls

FROM: Lisa Sorani, Manager of HR Employee Services LS -

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