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Staff Report Investment Division SAN DIEGO CITY EMPLOYEES’ RETIREMENT SYSTEM STAFF REPORT INVESTMENT DIVISION DATE : December 5, 2007 TO : SDCERS' Board of Administration via Investment Committee FROM : Doug McCalla, Chief Investment Officer SUBJECT : Recommended Changes to the Specific Investment Guidelines for Met West’s Core-Plus Fixed Income Portfolio Summary of Recommended Changes to Met West’s Specific Investment Guidelines Staff and representatives of Met West, one of our core-plus fixed income managers, have been in discussions concerning the broadening of the specific investment guidelines for the SDCERS portfolio managed by Met West. The goal of this review process was to identify and provide access to investment opportunities expected to result in improved risk-adjusted performance. Attached is a memo from Met West that includes a draft of the proposed specific investment guidelines, along with a table that highlights the differences between the propose and current guidelines. The two major changes incorporated into the draft specific investment guidelines include: 1) Increase the maximum exposure to non-investment grade, higher yielding investments from 10% to 20% of the portfolio; and, 2) Authorize the use of the Metropolitan West High Yield Fund to affect higher yielding exposures in the portfolio in a more diversified and risk controlled manner. Use of this fund as an additional investment structure managed by Met West would not result in any additional net fees to SDCERS. 3) Reduce the portfolio’s minimum average credit quality rating from AA to A. Other less substantive changes include: lowering the allowed quality rating on short-term commercial paper and asset-backed securities to A2/P2; authorizing investment in private placement 144a type securities; and, further defining the ever evolving types of fixed income instruments that may be included in the portfolio. The proposal to lower the minimum credit rating on short-term commercial paper and asset-backed securities from A1/P1 to A2/P2 would not be consistent with the current SDCERS Investment Policy Statement (IPS) minimum credit quality limitation rating of A1/P2 on short-term paper. The other proposed changes are consistent with the IPS and are similar to guideline revisions previously done with PIMCO, our other core plus fixed income manager. Therefore, staff would recommend adopting Met West’s proposed changes, with the exception on lowering the minimum credit quality of short-term commercial and asset backed paper to A2/P2. Recommended Changes to Met West’s Specific Investment Guidelines December 5, 2007 Page 2 of 2 History of Previous Core Plus Fixed Income Investment Guideline Modifications Met West was hired in June of 2001 to provide additional process diversification to our other core plus fixed income manager, PIMCO. Over the course of years, there have been a number of approved modifications to our core plus bond managers’ specific investment guidelines in response to changes in the financial markets, available investment instruments and the evolution of the managers’ total return investment processes. Examples of these evolutionary adjustments to our fixed income managers’ investment process are as follows: In September of 1994, PIMCO’s specific investment guidelines were modified to allow a risk-controlled (at least 75% currency hedged) exposure to non-U.S. fixed income investments of up to 15% of the portfolio. This was the first non-U.S. investment exposure implemented by SDCERS. In February of 1995, PIMCO was authorized an alternative means of implementing non-U.S. exposure by buying shares in an institutional PIMCO international fund (fee neutral to SDCERS). In June of 2001, when Met West was hired and the size of the PIMCO portfolio was reduced by 50%, PIMCO’s tactical discretion for non-U.S. bond exposure was adjusted from a maximum of 15% to a maximum of 20% of the portfolio. In July of 2003, PIMCO’s emerging market investment guidelines were updated and additional institutional mutual funds were authorized as alternatives for implementing exposures (fee neutral to SDCERS). Representatives from Met West are scheduled to present and discuss these proposed changes at the Investment Committee meeting. Staff recommends the approval of the proposed modifications to the specific investment guidelines for Met West, with the exception on lowering the minimum credit quality rating on short-term commercial and asset backed paper of A2/P2. These recommended modifications have been reviewed by our consultants from Callan Associates, who have indicated they are comfortable with the proposed changes (see attached memo). Attachment: 1) Met West Letter of November 15, 2007 with Draft Specific Investment Guidelines and Comparative Table of Current versus Proposed Guidelines. 2) Callan Associates Memo of November 30, 2007. Doug McCalla – Chief Investment Officer TO: Dawne Clark, CFA – Assistant Chief Investment Officer San Diego City Employees’ Retirement System FROM: Patrick Moore – Managing Director DATE: November 15, 2007 RE: MWAM Investment Guideline Update Periodically, MWAM undertakes a review of our client guidelines to ensure that we are effectively drawing on the fixed income market to avail portfolios to the most optimal reward-risk opportunities. Historically, the San Diego CERS investment policy pursuant the Core Plus strategy has been near-completely consistent with MWAM’s specified full-discretion guidelines. Enclosed please find two sets of documents to review in consideration of an update to the guidelines. The first document – Sample Investment Policy and Restriction Guidelines – represents a complete set of guideline specifications to govern the management of the portfolio. The second document represents a tabular comparison of the current San Diego CERS guidelines with the specifications of MWAM’s suggested full-discretion guidelines. In comparing the existing and proposed set of guidelines, we observe two substantive differences, which are related. The first is that our full discretion guidelines would call for up to 20% in high yield investment (though 10% based on SDCERS risk preference is completely suitable) and the second is that the full discretion guidelines would allow MWAM to effect the high yield latitude through a commingled or mutual fund, in this case, the Metropolitan West High Yield Fund (MWHIX). This well-diversified fund holds approximately 100 positions, from among three “tiers” of high yield exposure, including the securities of (1) longstanding and stable “BB” issuers accustomed to operating leveraged balance sheets, (2) companies downgraded from the ranks of investment grade issuers, and (3) stressed or distressed companies whose debt trades on a dollar, rather than a spread, basis. Naturally, the benefit of utilizing the Fund to gain the San Diego CERS high yield exposure is not only the diversification noted above, but also the relative liquidity that is characteristic of mutual fund investments. The utilization of the Fund for this exposure would require the completion of the attached Authorization, which grants consent to MWAM to employ the High Yield Fund on a discretionary basis (up to the 10% or 20% authorized by the updated investment guidelines). Moreover, Exhibit A of the Authorization details the procedure by which investment management fees incurred by San Diego CERS will be offset by the Advisory Fees paid through its participation in the High Yield Fund. In other words, use of the High Yield Fund will be fee neutral to San Diego CERS. We have also enclosed supporting information with regard to the High Yield Fund, including current Prospectus, Statement of Additional Information (SAI), and Fund Fact Sheet. If we provide additional information or answer any questions regarding the proposed guideline update or utilization of the High Yield Fund, please feel free to contact us. SAMPLE INVESTMENT POLICY AND RESTRICTION GUIDELINES FOR SAN DIEGO CITY EMPLOYEES’ RETIREMENT SYSTEM CORE PLUS FIXED INCOME PORTFOLIO I. Type of Fund: Public Pension II. Type of Portfolio Management: Total Return Bond Management III. Performance Objectives/Benchmarks: Lehman Bros. Aggregate Index IV. Fixed Income Duration Guidelines: Average Portfolio Duration: Benchmark +/- One Year Individual security maturities and durations are the discretion of the manager. V. Permissible Assets (U.S. Dollar-Denominated Only) – Subject to Concentration Guidelines specified in Section VII A. Fixed Income Securities 1. U.S. Government and Agency Securities, including but not limited to: a. U.S. Treasury Notes and Bonds b. U.S. Treasury Inflation-Protected Securities (TIPS) c. STRIPS (Zero Coupon Issues) d. Agency Debentures i) Government-Guaranteed ii) Government-Sponsored Enterprises (GSEs) 2. Corporate Securities, including but not limited to: a. Debentures b. Medium-Term Notes c. Capital Securities d. Trust Preferred Securities e. Yankee Bonds f. Eurodollar Securities g. Floating Rate Notes and Perpetual Floaters h. Structured Notes (with fixed income characteristics) i. Private Placements i) Bank Loans ii) 144(a) Securities 3. Structured Securities, including but not limited to: a. Agency and Non-Agency Mortgage-Backed Securities (MBS) Sample Investment Policy and Restriction Guidelines for November 2007 San Diego City Employees’ Retirement System Page 2 of 3 Core Plus Fixed Income Portfolio i) Pass-Through Securities ii) Collateralized Mortgage Obligations iii) Stripped MBS - Interest Only Strips (IOs) - Principal Only Strips (POs) iv) Floating Rate Notes v) Inverse
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