Investment Section Comprehensive Annual Financial Report 2018 / 73 Investment Section CHIEF INVESTMENT OFFICER’S REPORT INVESTMENT OVERVIEW by offering a reliable income stream through the yield com- ponent. This yield also provides some protection against a The Maryland State Retirement and Pension System returned deflationary environment, characterized by falling interest 8.06 percent (time-weighted) net of fees in fiscal year 2018. rates. This asset class includes long-term U.S. Treasury After the payment of benefits, the market value of assets bonds, Treasury inflation protected securities, corporate increased by approximately $2.9 billion, from $49.1 billion bonds and securitized debt. on June 30, 2017 to $52.0 billion on June 30, 2018. The fund exceeded its actuarial return target of 7.5 percent, and The purpose of the Credit asset class is to take advantage also outperformed its policy benchmark of 7.60 percent. of the potential higher returns offered by below invest- ment-grade bonds. The return objective is similar to public While all major asset classes achieved positive returns, the equity, with a lower risk profile. This category includes performance was not evenly distributed. Private equity and high yield bonds, bank loans, emerging markets debt, public equity provided the best returns for the year, pro- distressed debt, mezzanine debt, and other credit-focused ducing 19.6 percent and 10.7 percent, respectively. At the investments. other end of the spectrum, nominal bonds and emerging markets debt struggled, generating returns of 0.1 percent Real Assets includes real estate, natural resources and infra- and -2.0 percent, respectively. structure. A significant portion of the assets in this category provides an income stream. Due to the tangible, or real, The Board’s asset allocation policy is designed to achieve element of this asset class, it is expected to provide some the actuarial rate of return over long periods of time by level of protection against an inflationary environment, as assembling a diversified portfolio of asset classes, each of well as additional diversification to the total portfolio. which may have a large or small, positive or negative return in any given year. By assembling assets that exhibit unique The objective of the Absolute Return asset class is to risk and return characteristics in different market environ- achieve a return that falls between the expectations for ments, the Board expects more stable investment returns public equity and bonds, with low correlation to other over time than a less diversified portfolio. This lower risk asset classes. The risk profile of this asset class is expected portfolio should result in a larger asset pool for the System’s to be significantly lower than public equity, which should beneficiaries than a more volatile portfolio with the same provide protection during periods of stock market decline. average return. Understanding the Board’s principals of Strategies included in this asset class are hedge funds, asset allocation is important in evaluating the performance multi-asset mandates, insurance-related products, and other in any one-year period. While the realized return of 8.06 strategies with similar expected risk and return profiles. percent for fiscal year 2018 is above the Board’s long-term expectation for the portfolio, it is well within its expected ranges for annual variations. INVESTMENT POLICY AND OBJECTIVES The System’s asset allocation is organized into five broad The Board of Trustees is charged with the responsibility of categories: Growth/Equity, Rate Sensitive, Credit, Real managing the assets of the System. In doing so, the Board is Assets, and Absolute Return. During the fiscal year, the required to exercise its fiduciary duties solely in the interest asset allocation remained largely unchanged from the prior of the participants with the care, skill, and diligence that a year, with only minor adjustments being made to improve prudent person would exercise under similar circumstanc- the efficiency of the portfolio. es. This standard of care encourages diversifying invest- ments across various asset classes. The Growth/Equity portfolio is comprised of public equity and private equity. Within public equity, there are dedicat- Investment objectives are designed to support the ful- ed allocations to U.S., international developed, and emerg- fillment of the Board’s mission to optimize risk-adjusted ing markets. The objective of this asset class is to generate returns to ensure that sufficient assets are available to pay high returns associated with the economic growth underly- benefits to members and beneficiaries when due. As a ing global economies. long-term investor, the Board understands that short-term market returns will fluctuate. The Rate Sensitive category consists of exposure to core, or investment-grade, bonds. This asset class is designed to These investment objectives are implemented in accor- provide protection against downturns in the equity market dance with investment policies developed by the Board. 74 Maryland State Retirement and Pension System Investment Section Chief Investment Officer’s Report The “prudent person standard”, as outlined in both the The Board is also responsible for establishing the asset allo- Maryland Annotated Code and the Board’s investment cation policy for the System. It does this by weighing three policies, allows the Board to set investment policies and liability-oriented objectives when making asset allocation delegate authority to investment professionals employing determinations. These objectives include: active and passive strategies. Firms retained generally have a demonstrated performance record and a clearly defined 1. achieving and maintaining a fully funded pension and consistently applied investment process. plan; 2. minimizing contribution volatility year to year; and The Board manages the assets for the System with the goal 3. realizing surplus assets. of achieving an annualized investment return that over a long-term time frame: (1) meets or exceeds the investment Asset allocation policy targets are determined by recogniz- policy benchmark for the System; (2) in nominal terms, ing that liabilities (future benefit payments to the partici- equals or exceeds the actuarial investment return assump- pants and beneficiaries of the System) must be paid in full tion adopted by the Board; and (3) in real terms, exceeds and on time. The mix of asset classes is chosen to provide the U.S. inflation rate by at least 3 percent. A more detailed sufficient growth to meet the long-term return objective discussion of each of these goals follows below. of the System, while providing sufficient diversification to moderate the volatility of that return. For example, a portfo- 1. Meeting or exceeding the Investment Pol- lio of equities will likely provide the required return over a icy Benchmark for the System. The Invest- long time horizon, but will subject the market value of the ment Policy Benchmark is calculated by using portfolio to unacceptable levels of volatility such that the a weighted average of the Board-established goals of minimizing contribution volatility and realizing sur- benchmarks for each asset class. This bench- plus assets would be difficult to achieve. Combining other mark enables the comparison of the actual per- asset classes with equities will provide differentiated return formance of the System to a proxy portfolio, sources, reduce the volatility of returns and help realize and provides a measure of the contribution of those liability-oriented objectives. policy implementation and active management to overall fund returns. The Board’s long-term asset class targets and ranges as of June 30, 2018 are shown below. 2. In nominal terms, equaling or exceeding the actuarial investment return assump- LONG-TERM tion of the System. The Board adopts the ASSET CLASS POLICY TARGET RANGE actuarial rate of interest, which was set at 7.5 Growth Equity 50% +/-7% percent for fiscal year 2018. The actuarial U.S Equity 16% investment return assumption functions as an International Developed Equity 10% estimate of the long-term rate of growth of the Emerging Markets Equity 11% assets for the System. In adopting an actuarial Private Equity 13% return assumption, the Board anticipates that Rate Sensitive 19% +/- 5% the investment portfolio will achieve higher or Long-term Government Bonds 10% lower returns each year but will trend toward MBS/Corporate Bonds 5% 7.5 percent over time. TIPS 4% Credit 9% +/- 4% 3. In real terms, exceeding the U.S. inflation High Yield Bonds/Bank Loans 7% rate by at least 3 percent. The inflation Emerging Market Debt 2% related objective compares the investment Real Assets 14% +/- 4% performance against a rate of inflation mea- Real Estate 10% sured by the Consumer Price Index (CPI) plus Natural Resources/Infrastructure 4% 3 percent. The inflation measure provides a Absolute Return 8% +/- 4% link to the liabilities of the System, which have Total Assets 100% an embedded sensitivity to changes in the inflation rate. For private market investments in the real assets and pri- vate equity asset classes, additional risk reduction may be Comprehensive Annual Financial Report 2018 75 Investment Section Chief Investment Officer’s Report achieved through temporal diversification, making invest- INVESTMENT PERFORMANCE ments over time to take advantage of varying opportuni- ties. To reflect the desirability of investing over time in Investment performance is calculated using time-weighted accordance with a prudent pacing schedule, transitional rates of total return. Total return includes interest and allocations are implemented. Assets not yet deployed to dividends, as well as capital appreciation. private equity are assigned to the public equity transitional target. Assets not yet deployed to real estate are assigned The investment program realized a return of 8.1 percent to the rate sensitive transitional target. for fiscal year 2018. Annualized returns for the 3-, 5-, 10-, 20- and 25-year periods ending June 30, 2018 were 6.3 percent, 7.2 percent, 5.6 percent, 5.3 percent and 6.7 percent, respectively.