Michael Kimmel, Executive Director
We hope you are having a restful, meaningful and enjoyable summer.
We at the RPB are deeply committed to our core mission of providing a retirement plan and other products that enable you, our participants and your employers, to pursue a shared goal of financial security. One of the many ways we help to accomplish this is through ongoing communications and investment education. We hope this update provides a brief yet informative communication about the RPB’s Funds, how they are structured and how the global economy and capital markets impact our decision-making. Please let us know whether this update is useful and how we can better address your questions. We will use your feedback to improve upon what we do in the future. At the end of this update you will find a link to a short survey.
Investment Philosophy and Diversification
The Reform Pension Board’s investment philosophy is to be a strategic, diversified, long-term investor. Accordingly, the Board’s fundamental viewpoint is that investment decisions should be based on expected long-term performance and not driven by short-term market conditions.
Click here to see the 2015 Plan Year-end performance results.
Through our Investment Committee, in partnership with our investment consultant, Summit Strategies Group, we attempt to plan for the unknown and construct portfolios that preserve capital and provide growth while still trying to minimize volatility, or risk. This is one of the fundamental reasons why we maintain a diversified portfolio with different types of investments across the globe. The basic premise behind diversification is to invest in different types of assets that tend to not move in the same direction at the same time. Different sectors of the market move in and out of favor among investors, and it is a noisy and often unpredictable process.
In the 1990’s, for example, U.S. large cap stocks were riding the first internet tech boom and emerging markets could do nothing right. This abruptly reversed in the next decade as the S&P 500 Index, the most widely followed measure of U.S. large cap equity performance, suffered a decade of almost zero return while massive investments were attracted to emerging markets equities. (Click here to see a chart of the annual performance of different asset classes over the past two decades, which illustrates this fluctuation.) You will note that in 2014, the S&P 500 Index returned 13.7%, better than any other asset class. Year-end 2014 headlines trumpeted this performance leading some investors to ask why they should be invested in anything else. However, you will also note that the S&P 500 doesn’t always win, but in fact, takes first place just three times in the last twenty years. This variability of returns demonstrates the need to be diversified.
Diversification and periodic rebalancing based on valuations and market fundamentals are time-tested ways to achieve the RPB’s fundamental long-term investment goal of good long-term returns with a reasonable amount of volatility. The RPB measures itself against global equities (MSCI All-Cap World Index) and fixed income (Barclays Capital Global Aggregate), not just the U.S. market. (Click here for a chart that compares each of the RPB’s Funds’ historical risk/return profile to global benchmarks.) This chart illustrates the hypothetical trailing ten year risk and return profile of each fund using current policy weightings. In each case, the fund’s current asset allocation has produced a higher return with less risk than the fund’s benchmark.
To keep risk on target and to enhance returns, one must be willing to pare back winners when they become overvalued and to take the more difficult step of adding to short-run underperformers when they become fundamentally cheap. This is something the RPB and institutional investors do every month. In practical terms, balancing return and risk over time means that in most instances over time, we might not beat the highs of a given market cycle, but we should also not be as low as the lows of any given market cycle. And because we are long-term strategic investors, we must look beyond a quarter, a year or even two years. We must understand how the global economy works and how it impacts our investments over time.
The Year in Review
The RPB’s 2015 Plan Year that ended on June 30, 2015 is a great example of how economic conditions have dramatically impacted the capital markets. We saw the U.S. economy continue to stabilize with the job market showing vast improvement. Economic growth around the rest of the world was somewhat lackluster, although there were more positive signs during the second quarter of calendar year 2015 despite the uncertainty surrounding Greece and their issues with the European Union. How this and other factors translated into equity market performance can be seen below:
You can see how quickly markets can change over the course of twelve months. For the 2015 Plan Year, equity markets were mixed. In the first half, U.S. equity markets (S&P 500 Index) outpaced international stocks (MSCI EAFE & Emerging Markets) due primarily to slow economic growth outside the U.S. and a rapidly appreciating U.S. dollar, which decreases the return earned by U.S. investors in international markets. This trend partially reversed during the second half of the year, with international equities outpacing U.S. equities even with the impact of currencies. In fact, international developed and emerging market equities were among the best performing asset classes in local currency during this period. In addition, the international fixed income markets were impacted in a very similar way by currencies. It is important to note that over the long term, history has shown that the impact of changes in the value of currencies has been minimal to the international investor.
While we invest for the long term, we also do not sit idly by and passively watch the markets. With the global economy continuing to strengthen, we’ve maintained our allocation to both domestic and international developed equity markets in the Capital Appreciation Fund. However, we also have made decisions this past plan year to address changing market conditions as this current market cycle continues to mature. We decided to fully divest of our investment in emerging markets debt, as the asset class no longer fit with our portfolio construction approach and due to deteriorating fundamentals. In addition, we shifted a portion of the allocation of our dividend-focused manager to our emerging markets equity manager based on the prospect of higher growth and more favorable relative valuations.
In the Income Focused Fund, we reduced our exposure to developed international fixed income with a comparable increase in domestic fixed income due to the long-term prospects of those markets. We recently increased our exposure to commodities despite the precipitous drop in oil prices this past year. This drop has made the asset class more attractive given the expectation of future global economic growth that should drive demand for oil and other commodities. Lastly, in early 2014 we made an allocation to an asset class called “unconstrained bonds” to hopefully help mitigate some of the risk of the anticipated rise in interest rates. With current interest rates remaining very low yet anticipated to rise, we needed an approach that provided for additional flexibility. Interest rates did not rise initially, but in fact continued to fall. However, since the beginning of calendar year 2015, they have begun to rise with expectations that this increase will continue with a strengthening economy and with the Federal Reserve expected to begin raising rates sometime before the end of calendar year 2015.
In the Appreciation and Income Fund, you may recall our recent decision to shift the allocation from a 50% Capital Appreciation Fund / 50% Income Focused Fund split to a 60% Capital Appreciation Fund / 40% Income Focused Fund split. We made this change because our forward-looking return assumptions for capital markets, particularly income focused markets, are lower than before because of rising interest rates as explained above. Therefore, to try to achieve the Fund’s investment objective established in 2013, we decided to increase the representation in the Fund from Capital Appreciation.
No changes have been made to the Capital Preservation Fund. It continues to preserve capital, albeit at low returns due to the very low interest rate environment we have experienced over the past two years.
We continue to maintain a globally diversified portfolio that is both strategically allocated for the long term and is responsive to conditions on the ground. Over the long term, with the guidance and support of our Investment Committee and investment consultant, we remain steadfast in our commitment to scrutinize and select relationships with talented managers who are experienced at navigating these markets and to allocate assets for your benefit.
Enjoy the rest of your summer, and be on the lookout for additional updates, commentaries and educational opportunities in the future.
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