BOARD OF TRUSTEES MUNICIPAL EMPLOYEES PENSION PLAN May 9, 2006 The Municipal Employees Pension Plan Board of Trustees meeting was called to order at 3:10 p.m. by Mr. Robert Eisler, Jr., Chair. The following members were present, constituting a quorum: Ms. Marga Spangler; Mrs. Kristy Stallings; Ms. Renee Charpie; and Mr. Roger Peterson. Also present were: Mr. Mike Santos, Senior Assistant City Attorney; Mr. Mike Russo, Manager of Retirement Plans; and Mrs. Kathleen Imair, Recording Secretary. _____________________________________________________________________________________ QUARTERLY UPDATE Alliance Benefit Group - Mr. Grant Arends Mr. Grant Arends, Alliance Benefit Group, explained that there have been no real changes from an overall market perspective. What has occurred in the last three months in the market mirrors what has occurred over the last 12 months. They have been in a market that has been dominated by two things: Small Cap stocks and Oil stocks. He referred to the Market Overview section of the Investment Policy Analysis stating it shows that the market has been dominated by small cap stocks versus large cap stocks, but it has been predicted that the market will turn more favorable of large cap stocks. As of March 31, 2006, that change has not occurred. He referred to the remainder of the quarter noting the Russell 2000 was up 13.9 percent; NASDAQ was up 6.1 percent; Russell Mid Cap Index was up 7.6 percent; Russell 3000 was up 5.3 percent; Russell 1000 was up 4.5 percent; and the S&P 500 was up 4.2 percent. The second factor the market has been dominated by is oil. Gas prices have been rising and energy stocks have been leading with what has been happening in the market. Mr. Arends stated that this same action occurred last year, but not enough time has elapsed to show a trend. Since March 31, 2006, there has been much more of a large cap market than a small cap market, especially within the last three to four weeks. The DOW Jones was up 3.78 percent for that same period of time. The NASDAQ was up 0.12 percent, but the Russell Index was not up as much as the DOW Jones during that same period. He referred to the current Price to Index ratios stating the average large cap company in the S&P 500 has a P/E ratio of about 16 percent, which is priced very competitively versus the average small cap stock in the Russell Index, which has a P/E ratio of 42. The average market cycle runs about 28 months. Value stocks have outperformed growth stocks every year since 2000. Small cap stocks have outperformed growth stocks during that same period of time. He noted that they were at a 70-month plus market cycle with value and small cap stocks. Typically when the economy reaches the mature stage of economic growth, large cap stocks become more favorable versus small cap stocks. It has been predicted the economy is entering a mature stage, but they are still seeing robust economic growth with the jobs that have been added and the productivity of the economy.
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Mr. Arends referred to the second tab, Plan Summary, noting under page 1-3 that the ending market value was shown at $32 million versus $24 million to $27 million that they had since the plan’s inception. He noted that the City’s plan had almost $900,000 of gains in investment returns in the first quarter alone. He referred to Page 3-3 noting that American Century Ultra is the City’s third largest holding in their plan. The largest holding is the ICMA Plus Fund at $6.3 million. The second largest holding is their international fund, Europacific Growth, which makes the plan unique. The largest domestic stock holding is American Century Ultra with $3.1 million in the fund. American Century Ultra has not been performing to peer group levels, which had been an issue that came up for discussion in 2005. Prior to that time, they were extremely satisfied with American Century Ultra. Chair Robert Eisler stated that the American Century Ultra Fund was one of the first funds put in the plan. Prior to the Ultra fund they had strictly fixed income in the plan. Mr. Arends stated the American Century Ultra Fund was one of the plan’s largest domestic holdings that has had recent performance issues. A representative from American Century was present to speak to those issues. He pointed out that although their performance has not been that great, this has not been a long-term issue. The American Century representatives will discuss questions he presented to them regarding Ultra’s performance relative to peers; their outlook going forward, as far as how the portfolio is positioned; and why the City should keep the fund in the plan. American Century Ultra - Mr. Kevin Lewis, Client Portfolio Manager. Ms. Denise Tompkins, American Century Ultra, stated that she has been with American Century for the last 15 years. She noted that Mr. Kevin Lewis, Client Portfolio Manager, who has been with the company for 11 years would provide a presentation of American Century Ultra and address questions. Mr. Kevin Lewis, Client Portfolio Manager, provided a report referring to Page 2 and noted that American Century Ultra is a large cap growth oriented fund that invests in companies with sustainable above average growth. He referred to their track record explaining that they have had long term success with this fund. Over the last seven years, they have outperformed the benchmark five of those seven years. They have outperformed their peers in four of those seven years. Going back ten years, they have outperformed their peers 90 percent of the time. Mr. Lewis referred to their one-year performance stating it had a lot to do with the complexion of the economy and the stock market. The stock market has been reaching new highs. The DOW Jones is composed mainly of cyclical companies, which are companies that respond very favorably when the economy is doing well. In June 2005, they harvested their profits out of the cyclical portion of the market and reinvested in the types of companies that are more consistent, long-term growers. The market has not yet rewarded them on those investments. Large cap stocks and growth stocks are currently out of favor, but they have good odds. He felt their positioning was in line with where the next leg of the market cycle should be. He felt they were positioned prudently and uniquely, because most of their competitors are not positioned as they are.
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Mr. Lewis referred to Page 3 stating it outlined the product objectives of Ultra. The objective is to outperform the Russell 1000 Growth benchmark and large cap growth peers over time. He noted that Ultra builds a portfolio with diversified exposure to large cap growth companies. The diversified approach is then taken when managing the portfolio meaning risk is spread over a wider base of companies. Another objective is to add value through active management and security selection. The way they seek to outperform the benchmark is through a “bottom up approach.” This bottom-up stock selection chooses companies one by one and ensures they are on track to meet their objectives. Through that process they talk to companies to find out what their business trends are, competitive advantage, and what their competitors are doing. They usually spend a lot of time formulating their opinions, not only by reading research, but doing their own research by talking directly to the companies. Mr. Lewis explained that they invest in companies that have higher growth rates than the general company out there. An example would be Starbucks. This is a company that has consistently generated an earnings growth of about 25 percent. They have a lot of opportunities, and people enjoy their products and will pay for that product. Starbucks has a real niche in the marketplace, but over time they will come in and out of favor. Over a long period of time, Starbucks will compound profits at a high rate, and that means the stock price will tend to follow suit. Those are the types of companies Ultra tries to identify and invest in. They not only look at high growth companies, but they want to know what their edge is when they talk to management face to face. Mr. Lewis referred to Page 4 noting that it outlines the calendar year returns for Ultra versus their benchmark, the Russell 1000 Growth Index. The Morningstar Large Cap Growth Rank is also outlined on that page. Over the last seven years, Ultra has outperformed the market in five of those seven years. They have also outperformed the Morningstar peer group and have been ranked in the 50th percentile or higher four out of those seven years. Ultra has been able to outperform in the negative years, which he felt was important for long-term investors. In 2000, 2001 and 2002, the markets were declining and Ultra could not avoid that loss, but they could not lose as much on the downside, which they were able to achieve in the City’s portfolio. Mr. Lewis referred to Page 5 and explained that extending their performance record back to 1995 against their peers, Morningstar peers and large cap growth peers, Ultra has outperformed the average Morningstar large growth manager in 69 percent to 88 percent of rolling five-year periods and rolling ten-year time periods from December 1995 through December 2005. He felt the numbers listed in the report demonstrate that they have a legacy and heritage of success in the portfolio. Mr. Lewis felt they were in the worst part of the market as a large growth manager. Although Ultra is a large growth manager, it does not mean they cannot buy other types of stocks. Ultra usually stays true with large stocks and growth stocks. Ultra’s competitors use more mid-cap stock and value stock exposure than Ultra. Having large cap and growth stocks in the Ultra Fund worked against them last year. Mr. Roger Peterson referred to Page 6 of the report and asked if Ultra’s funds were listed in the Growth column, which shows 3.09 percent. Mr. Lewis stated that number showed how the index performed, but not Ultra.
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Mr. Lewis referred to Page 7, noting that these were the numbers the Board may have received in their report. He explained that they have had two bad years, 2003 and 2005, included in the total seven years. The economy was recovering in 2003, and very low quality companies performed well. Those are not the types of companies they typically include in the portfolio. In 2005, Ultra was up only 7.68 percent lagging their peers, and their benchmark was up 13. Mr. Lewis referred to Page 8, which outlines Ultra’s performance over the last year. This page explains where they made good and bad decisions versus the benchmark. He referred to the dark green colored bars on the page, which shows the areas of the market or areas of the benchmark where Ultra lagged. A few of those green bars stand out to Ultra, which explain what is going on in the market. The Materials, Industrials, and Energy bars represent cyclical earners, which mean their profits are cyclical in nature. When the economy is strong, their profits will rise. When the economy weakens, their profits will fall, as well as their stock prices. Mr. Lewis referred to the Consumer Discretionary sector, which shows they have been overweighted in those stocks. The earning trends are usually very consistent in those stocks, such as Wal-Mart, Target and Home Depot. There is very little deviation between the up and down of the growth rate, and it is very consistent. For example, Target had a growth rate of about 17 to 18 percent, which is very consistent. Mr. Peterson asked for clarification of a chart on Page 8. Mr. Lewis referred to the healthcare section on that chart stating it was their single worst performing group in the portfolio over the last one-year period versus the benchmark. Mr. Peterson asked about the light green colored areas of the chart. Mr. Lewis stated that the light green areas represent the absolute return. They had made money in health care stocks last year, but lagged the index’s holdings of healthcare stocks. In other words, if the index had two stocks that were up about 20 percent and their portfolio included one of those two stocks that was up 15 percent, they would have positive returns in health care stocks, but that 15 percent return would have lagged the index’s 20 percent return. The dark green bar shows how their holdings compared to the index’s holdings. Mrs. Kristy Stallings referred to the example Mr. Lewis provided with the two stocks and asked if that meant that the stocks in the portfolio of this fund happened to be stocks that were not very good. Mr. Lewis agreed and noted that it does not necessarily mean they lost money, it only means those stocks did not rise as much as expected. Mr. Lewis stated that the light green bars indicate areas in the market where they made money, and the dark green bars shows where they did not make as much money as the index could have provided. Mrs. Stallings asked if that was a function of the cycles experienced by those companies their fund has holdings in. Mr. Lewis agreed. Mrs. Stallings asked why there would be a cycle that would affect only one healthcare company, but not another. Mr. Lewis stated that it could be a function of the weighting. He noted that they were underweighted in a group of stocks, such as iron, steel and copper stocks. That idea alone produced a penalty, because those are cyclical stocks, which have done very well. Steel stocks on average were up 40 to 50 percent last year. Mrs. Stallings referred to what Mr. Lewis commented on earlier regarding some of what happened in the last year that was a result of having to reposition some stocks
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and asked if they had gotten out of certain funds a little too early, but still held the position that they should get into stocks that would perform better over longer periods of time. Mr. Lewis agreed. Mr. Lewis referred to Page 10, which shows the Energy Sector chart. The dark green line shows the profit cycle of energy stocks. In 1980, that line rose, plateaued and came back down. The blue line shows where those stocks outperformed the market, peaked and then fell. There is a definite correlation between when the profits of the green line rise and the outperformance of the blue line occur. Energy stocks are very cyclical, which dates back to the 1920s. He pointed out that they do not sell stocks when profits peak. Mr. Lewis referred to a section of the report dated July 2005 stating they entered 2004 overweighted in energy stocks over what the index held. In June of 2005, they were also overweighted in a number of cyclical categories, such as energy stocks. As they talked to those companies, they predicted 2006 to be the peak year for energy profits, which has occurred. Mr. Lewis referred to Page 11, which outlines Secular versus Cyclical earnings growth pointing out the green line shows the profits of Starbucks. That rate of growth is about 25 percent. Starbucks has had five periods where it has underperformed the market significantly, which is represented by the orange lines on the chart. The blue line represents the stock performance that underperformed moving away from the profits line. Despite those five periods of underperformance, Starbucks still outperformed the market by over 400 percent. When profits are harvested away from the cyclicals and they invest in companies like Starbucks, Wal-Mart, or Target, those companies tend to be more steady growers. Mr. Lewis pointed out that large cap stocks and growth stocks have underperformed by the largest lag in almost three decades. These stocks have gotten cheap, and the catalyst tends to be the transition of when large stocks and growth stocks start outperforming that tends to occur around the time interest rates begin to rise. The Federal Reserve has raised interest rates 15 times this year. According to academic research and Wallstreet research regarding this issue, the tipping point tends to center around interest rate policy. Eventually interest rates will rise high enough to where they will begin to dampen the economy, which will cause people to start moving more into the growth companies and the larger companies, because they tend to be more stable consistent growers. With regards to repositioning of the portfolio, Mr. Lewis stated that they positioned themselves for the next leg of the market cycle. He referred to Page 17, which shows an enlarged Morningstar style box. The growth exposure of the portfolio is larger than almost 80 percent of their peers in that section. Mr. Lewis referred to Page 18, noting that Ultra’s growth factors are in the green bar versus the average category, and they rank higher on every growth metric in terms of their growth for the portfolio. American Century Ultra is more growth oriented than most of its peers, its benchmark and the broad market. Mrs. Stallings asked for further clarification of growth in terms of the companies in the portfolio and the growth they have experienced or predicted to experience. Mr. Lewis stated that the growth represented in the report is the growth they are predicted to
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experience. He noted that the long-term earnings growth factor is the long-term expected profit growth. Their portfolio has on average about 15-percent in growth and their competitors have 14 percent growth, and the benchmark is at 13 percent. He referred to the historic earnings growth factor, which is 23 percent for their portfolio and 22 percent for peers. Their portfolio has, on average, had about 15 percent revenue in sales. Mrs. Stallings asked about the way these percentages or factors were determined. Mr. Lewis stated that the percentages and factors were entirely determined by Morningstar, which is a third party analysis. They submit their holdings to Morningstar as do competitors to determine the weighted average. Mrs. Stallings asked if the shift that was discussed was a result of some changes in management. Mr. Lewis stated that they have had a very steady team that always tries to find a better way to implement the process. The tools they have to work with today are more advanced. He noted that the process they have always implemented caused the shift, which was the same process that led them to five years of outperformance. Mrs. Stallings asked if their group had always used whatever tools they had available to try and eliminate a stock or investment they thought would fall to the bottom and to get into investments they predicted would rise. Mr. Lewis stated they have always followed that process, but the timing was not precise. Mr. Lewis referred to Page 19, which explains that Ultra invests in large companies with sustainable growth. Their record of success versus their peers has been positive. The reason performance has not been very good recently is due to the repositioning of the portfolio by getting away from cyclical investments and getting into more steady growing investments. Ultra felt it was time to harvest their profits and move them into what the next prudent cycle would be. He felt they were uniquely positioned for that rebound versus their peers, because a lot of other managers are not prepared to recapture the large cap stocks. He felt that they remain a viable large cap growth choice due to their long record, and Ultra is poised to likely benefit from a large cap, growth oriented rotation. Ms. Marga Spangler asked what Ultra’s time tolerance was if the performance does not go where they predict it to go. Mr. Lewis stated that they have an investment oversight committee that meets monthly, which reviews portfolios including the performance, implementations of the decisions and when they have established certain benchmarks. The team gets called in to question what has happened and what is going on. In addition to that, they are always looking at better tools or ways to help implement what they are trying to do. There is intense scrutiny as to the results, and American Century is not willing to tolerate long-term underperformance. Mr. Arends asked how big the fund was. Mr. Lewis stated that the fund was $20 billion, which is the largest fund. Mr. Arends asked about the next largest fund. Mr. Lewis stated that the next largest fund was $10 or $12 billion. Mr. Arends asked about the turnover ratio. Mr. Lewis stated the turnover ratio was at 30 percent, which is due to the fact they are long-term investors and believe in allocating money to the management teams who have done a good job. Mr. Peterson referred to Page 21, which shows the top ten holdings versus the Russell 1000 Growth and asked which chart represented their holdings. Mr. Lewis explained that both charts show their holdings. In an absolute sense, they own 3.67 percent of Wal-Mart in the portfolio, but that is not a big position relative to what the index holds. Wal-Mart is about the ninth largest overweight stock in their portfolio. The
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biggest weighting difference versus the index is Teva Pharmaceutical Industries, in which there is 2.92 percent in the portfolio and the index had 0 percent. Senior Assistant City Attorney Mike Santos referred to their analysis of Starbucks as a niche company. There was comfort in keeping these types of companies long-term, but on the other hand they describe why they are behind their peers at this time, because they harvested some of their cyclical companies too soon or too late compared to their peers. He asked if Ultra was harvesting the comparable companies. Mr. Lewis referred to the first quarter stating their peers continued to be overweighted in the same cyclical stocks. He noted that their peers were staying with those winners, but American Century was moving on. Mr. Lewis referred to the energy weighting noting the index holds 3 percent and Ultra was equal to that index, but they only own one-third of what the top performers own in energy stocks. Mr. Santos stated that although energy stocks represent a cyclical area, he asked if those were the only stocks missing from the profile. Mr. Lewis stated that they entered 2005 with an overweight position having 8 percent in energy stocks, which was reduced, because they felt the profit cycle was rolling over. These companies were priced as the next new thing in the market. Mr. Arends stated that there were so many large cap funds that hold a significant amount of their portfolio. Ultra also participated in this strategy at one time, but it has been predicted that the market would go to a large cap market and they needed to position themselves accordingly. Mrs. Stallings referred to Page 12 and asked if they should watch for when the lines on the chart start heading toward the growth period again. Mr. Lewis agreed. Mrs. Stallings asked if Ultra’s strategy works if they would go back into the exceeding category. Mr. Lewis agreed and noted that the charts on Page 12 show that the markets moved from a growth market to a value market, which is the longest period of three decades that growth has lagged value stocks. Mr. Peterson asked what their prediction was as to when this cycle would change. Mr. Lewis felt it was difficult to predict what pushes a cycle into that category. He presented a couple of charts that show the current cycle has lasted the longest in three decades. At some point, interest rate will rise, which will have a dampening effect on the economy. Mrs. Stallings referred to the analytical tools mentioned and asked if Ultra used tools they develop internally that are proprietary. Mr. Lewis stated that they spend over $10 million a year in their technology budgets, which is a proprietary tool. Mrs. Stallings asked if they were trying to figure out ways to increase the artificial intelligence capability they have to analyze data. Mr. Lewis stated they started programming a computer that was one of the first quantitative methods, but since then they have been refining and trying to anticipate improvement. In trying to find the same characteristics, they want companies with an improving profit, which is what they call the Stowers Acceleration methodology. Mr. Peterson asked if Ultra was getting more requests to provide this type of information than in the past. Mr. Lewis agreed and stated that people were looking at
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the numbers and realizing there is a short-term performance problem, and they want a more full explanation of what is going on. Ms. Renee Charpie referred to the issue raised about the rise in interest rates stating they start to affect the growth stocks and small cap stocks. She noted that the interest rates were still extremely low, and she felt they could stay low for a while even though they are beginning to rise. She felt they were experiencing the 1970s type of move with international growth that is taking place, and they are seeing demand as they have never seen before. Mr. Lewis felt Ms. Charpie was referring to the 19731974 market cycle. Ms. Charpie clarified that it was the late 1976-1980 cycle. Mr. Lewis stated that from 1973 to 1974 was an inflationary cycle, as was 1976 to 1980. These cycles will last anywhere from 18 to 24 months. Energy prices began to rise in late 2004. Classic economics has a notion called demand destruction, meaning that as these prices move higher, people start substituting. They are currently seeing a lot of substitution effects already occurring with energy. There is a lot of talk in the media about getting ethanol to the market, the government is saying more investigation of price gouging is needed, and motorists are switching their driving habits. Demand destruction begins to happen when people begin to change their driving habits when gas prices rise to $3 per gallon. The ridership will move to the City buses. The same thing is true of commodity prices. The Federal Reserve is very aware and concerned about commodity prices working their way into the inflation numbers. Once that happens, they will take interest rates up until they can shut inflation down, because they do not want that to happen. He felt they were rapidly coming to the point of where interest rates create demand destruction due to inflation, or because more capacity is created to satisfy this demand. Mr. Lewis felt there will be a limited upside and a more probable downside to buying a high energy expenditure in the City’s portfolio today versus 18 months ago. Because they were overweighted in energy stocks 18 months ago, he favored that decision, but they are now more neutrally weighted in energy stocks. However, their competitors are still at a higher weighting in energy stocks. He noted that retail stocks were up 7 percent for April, but they have now fallen behind. He felt that was an opportune segment of the market to be exposed to by talking to those companies and looking at their outlooks and where their three-year profits are compared to current prices. Mr. Lewis felt it was important to realize that things will turn around and that they should be looking at their long-term record and at where they are positioned. He felt Ultra remained as a viable large cap growth option for the City’s portfolio. Chair Eisler felt American Century Ultra’s presentation was excellent, but felt the Board still had to look at other fund options in the same category that are consistently doing better. In the long-term, he felt Ultra had performed the best until recently. They have not performed as well as other funds in the same category for about the last six years. Mr. Arends stated that Ultra has outperformed its peers three out of the last five years. He pointed out that Ultra has experienced low performance times like this before, but seemed to be a very resilient fund, because it has always come back. When the Ultra fund was put into the portfolio, it was a small cap fund, but is now a large cap growth fund. The thing he liked about the way the City’s large cap growth category is covered currently is the fact they have two different large cap growth funds that are very different from one another. Ultra takes some risks, but not as much as Fidelity
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Growth, which holds over $2 million. Fidelity Growth has a lot of money in oil stocks and mid to small cap stocks, which is why their performance has been stellar recently. Mr. Arends stated that they provided the Board with a search for large cap growth managers, which is included in the packet information. There is no fund included in that list that has performed worse than Ultra. Funds are listed on that information that they think are quality large cap growth offerings. Mr. Peterson asked what type of feedback staff received from MEPP members about the Ultra fund. Mr. Russo explained that staff used to send out a survey asking MEPP members which funds they liked and disliked, and comments came back that always said that they wanted to maintain the Ultra fund, but those comments are no longer being made. He pointed out that the MEPP statements were recently sent out and only three funds lost money in April, which included the Ultra fund. They were down 1 percent compared to their average large cap growth fund, which was up .28 percent. Over the ten year period, Ultra’s average rate of return ending April 30th was 6.4 percent compared to their peers of 6.38 percent. Comparing Ultra to Fidelity Growth over that same ten-year period, Fidelity had 9.99 percent. Mr. Arends pointed out that the Ultra fund was in the 32nd percentile over the last five years, and they have outperformed their peers three out of the last five years. In 2003, Ultra was up 26 percent and their peers were up 28 percent. He was not heavily concerned about the numbers for 2003. Chair Eisler felt since the Ultra fund was running very close to what their peers were doing, that they could add an index fund to the portfolio. Mr. Arends felt they could add the Russell large cap growth index into the plan, which would be a complement to Fidelity Growth due to how different it is. He felt that was a viable option. Chair Eisler felt they should look for funds that are consistently performing in the top 6th percentile if possible. Mr. Santos asked Mr. Arends if he was comfortable with keeping the Ultra fund in the portfolio. Mr. Arends felt the comments made by Mr. Lewis about the market cycle being in a position to change have been shown by history that it has to change. He explained that if they only had the Ultra Fund in their plan for large cap growth without having Fidelity Growth and having a complement to that fund, he would be more concerned about keeping the Ultra fund in the plan. He felt they should keep the Ultra fund in the portfolio for the next 12 months and then bring Mr. Lewis in for a review of how the fund performed and what he was predicting for the fund. He did not feel Ultra was a bad manager, but there were better managers. He noted that Ultra was not in the disarray that Janus was in with the upheaval of their management and other problems they were experiencing. He was disappointed with some of the performance, but they are not in a crisis. Mrs. Stallings referred to the annual performance data and agreed with Chair Eisler’s comments. If Ultra is performing similar to their peers, she asked how that would be different than an index fund. Mr. Arends noted that in 2003 Ultra had 26 percent versus their peers at 28.9 percent. Mrs. Stallings referred to the annual performance data and asked if years of success meant the fund was outperforming. Mr. Arends stated that meant the fund was outperforming its peer group. Mrs. Stallings pointed out that although American Century had five successful years out of ten, the Fidelity Fund and the mid cap index also had successful years. She was not opposed to
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considering other funds for their large cap growth category, but she was not overly anxious to remove the Ultra fund given the information that was presented. Chair Eisler felt it was the Board’s responsibility to review how the funds are performing. When they look at the performance versus their peers, they must consider if there are other funds that exceed that performance more consistently. He felt consistent performance was a very important component. Mr. Peterson moved to table the discussion of this issue until the November MEPP Board meeting and instruct Mr. Arends to discuss this item as a separate agenda item as to where they stand versus their peers. Ms. Spangler seconded the motion, which carried by a vote of 5 to 0. Mrs. Stallings suggested Mr. Arends comment on the funds that have performed well compared to Ultra. Mr. Arends referred to the funding examples stating two of those funds, Contra and Fidelity Growth, have already closed to new investors since that report had been done. Mrs. Stallings noted that Fidelity Growth had two bad years since 2001. American Century has had two bad years, but over a ten-year period each fund has had five bad years out of ten. She asked when the Fidelity Growth Fund was added to the portfolio. Mr. Russo stated that fund was added January 1, 2004. Mr. Arends added that time was the perfect time to add the Fidelity Growth Fund, because that fund was very depressed before that time. If they entered a bear market, that fund would be the worst fund in the portfolio. Ms. Charpie asked if the suggested funds listed in the report were the best available funds comparable to the Ultra fund. Mr. Arends stated that they were large cap growth managers that they consider for all their clients. He noted that they have a set of due diligence screens they apply to those funds, and those suggested funds have passed their screens. They also have quantitative screens that are used. Their investment committee puts those funds in the large cap growth area from a qualitative standpoint. Ms. Charpie asked which two funds on the list were not options the Board could consider. Mr. Arends stated that the two Fidelity funds were not options to consider, because they are both closed to new investors. Mrs. Stallings asked if any of the funds on the list have had a similar track record to the Ultra fund over the last five or ten years. Mr. Arends stated that the American Funds group is large and very conservative managed funds. He did not expect American Century and American Funds Amcap to have a huge stake in energy stocks, and they would be more hesitant on cyclicals than other managers. If the plan was not a participant directed plan and if the decision was more invisible to the participant, Mr. Arends stated they would be more aggressive in replacing the American Century Ultra Fund. They are much more cautious on fund replacements on these types of plans. Mrs. Stallings felt comfortable waiting to see how the Ultra fund performed in six months. She felt watching and monitoring the funds was their responsibility to the participants. She was convinced by the information the American Century Ultra representative provided. Although time will tell, she felt that Ultra has a group of
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people that have been around for a long time and they were aware of the issues going on. Ms. Charpie stated that although their management staff had been in place six years, she felt Ultra’s performance was not equal to their peers by dropping down to the 36th percentile. However, she did not feel there was anything to be extremely worried about. Mr. Arends noted when a fund is managed by a team, they must look at it more closely. Mr. Peterson felt if the Ultra fund continued to remain in the negative range six months from now, then they should seriously consider removing it. Mr. Arends added that in the six-month time frame, the three and five year numbers from Ultra will still not look very good, because it takes a while for those numbers to turn after having that type of past history. He felt they should focus on the short-terms numbers in the next six months. Ms. Charpie asked if there was something in the plan that would only allow them to have two large cap funds. Mr. Arends stated that no such requirement existed. Ms. Charpie felt they should think about adding another fund in the large cap category if they decide to keep American Century and watch that fund over the long term, which would give the participants another option over and above those two funds. Mr. Russo stated that a decision must be made regarding how those model portfolios are constructed and the break out. Currently, all the funds are represented in most of the portfolios except for the Dodge and Cox fund. If a third large cap growth fund is added, they must decide how to split up the large cap growth in that portfolio. Mr. Arends stated that it was not overly common to have three funds in one category. Companies only steer away from that option in the participant directed plans, because they would enter a new cycle. He noted that studies have come out that have shown for every option added to the portfolio, employees are offered great returns that go up in a plan until they reach ten funds. Once they go above ten funds, rate returns on participant directed plans go down, because there will be too many choices for investments that could end up in bad investment decisions. He felt the models would serve as a good tool to fix that issue, but there should be no cost ramification if that is considered. Mr. Arends stated that the fund he favored the most on the list is the T. Rowe Price Fund, which is a good money manager, especially with participant directed retirement plans where an equal emphasis is put on risk versus return. He noted that a participant in a participant directed plan looks at returns on an absolute basis. Participant directed plan risk is a huge component on fund selection. If the Board had the Fidelity Growth Fund as their only large cap profile in their plan, he would be concerned. Mr. Arends referred to the large market cap stating that Washington Mutual and Scudder funds were likely not bad funds, but they are funds that have had some bad experience, because what they are currently buying is out of favor. He stated that they wanted to review the Board’s portfolio and try to structure the large cap growth value category like their large cap growth category, which has two funds that are completely different from one another. He noted that the Scudder and Washington
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Mutual funds will be merged into one fund effective July 1, 2006. Washington Mutual will be the name of the fund. Both funds are very similar in performance. The Scudder Fund has had more manager and firm upheaval, whereas the American Funds have expertise in large cap and value funds. They have had some short-term issues with Washington Mutual since it has a median market cap of about $55 billion versus its peers of $31 billion. They have put another fund beside it that has a median market cap of $12 billion, which is the Excelsior Value Fund, and that will be offered July 1, 2006. This fund is in the top 10 percent against its peers for the quarter. The City’s MEPP plan will have two large cap value funds that perform differently from one another. When the Ultra fund recovers, they expect Washington Mutual to perform better than Excelsior Value. He noted that they were not recommending any changes in large cap value, and they were comfortable with the decisions that were made at the last meeting regarding large cap value. Mr. Arends stated that Mr. Bryan Westmeyer would address the small cap value side. Mr. Bryan Westmeyer, Alliance Benefit Group, stated that the FPA Capital Fund was added as a comparable fund against the Janus small cap value fund, which replaced the Invesco Small Company Growth Fund. There are no concerns about the FPA Fund, but they had a slight downturn this past year. Since the time FPA has been included in the City’s plan, it has been performing along with its peers in the small value category over the last two and a half years. Both Janus small cap value and FPA Capital try to look at small companies that are at all time lows in terms of their stock price, but have rich cash flow. If a stock does not meet those criteria, they do not buy the stock. Going back to 2004, the decision was made to remain patient with the Janus small cap value fund with the exception of this quarter. Both funds have higher cash holdings than the average small value category. Small value funds on average hold between 3 and 4 percent in cash. Janus holds about 15.8 percent cash, and FPA Capital holds about 18 percent cash. Since the time those funds have been in the City’s plan, they have had four to five times more cash. Janus has been in the plan since May 2000, and FPA Capital has been in the plan since January 2004. Both funds have performed slightly below their peer average. That performance shows they are very good stock managers. If they can remain patient with Janus, he recommended they continue with that fund. Mr. Arends added that both funds were very conservatively managed funds. He noted that the P/E ratios for small cap funds are at 42 percent, and they are realizing they do not need to buy. They then decide to hold a higher position in cash. These funds are not going to perform as well, and the conservative nature of both these funds is not going to perform as well in an ultra bull small cap market, because they are a deep value conservative manager. Mr. Westmeyer stated that since Mr. Bob Rodriguez has run the fund, there have been 247, 12-month rolling periods, and he has only shown a loss in 29 of those rolling periods. Two-thirds of the time during those 247, 12-month rolling period that he has outperformed his peers. This fund protects on the down side, but both funds are closed. Mr. Arends noted that in the last ten years FPA has had three years where it has shown a loss, and its largest loss is 3.86 percent in a 12-month period.
Board of Trustees Municipal Employees Pension Plan Page 13 CENTRALIZED CUSTODY
May 9, 2006
Mr. Russo stated that at the February MEPP Board meeting, the Board elected to change out a couple of funds. They decided to remove the Scudder Value Fund and replace it with the Excelsior Value Fund. In the three-month period since that board meeting, staff has tried to establish an account with Excelsior, but they have run into some obstacles. Mr. Russo provided a history stating that in 1997, staff dealt with three fund families, ICMA, Janus and Twentieth Century. Since that time, they have expanded the lineup that has been offered, and they now have 14 funds and 13 fund families. The frustrating part of that arrangement is that there is no consistency in their procedures among those fund families. Examples of inconsistency involve their weekly purchases. Every payday there are three funds that they must fax letters of instruction to, because they will not accept phone calls. Seven funds require phone calls, and the purchases are handled by ACH debit. Four funds require phone calls to be made, instructions to be e-mailed to them, and a wire be sent to them. When staff was trying to establish an account with Excelsior Value they ran across a problem where a letter of instruction signed by all five Board members for every purchase they make or every sale made would be required. Instead of following that process, Excelsior would be willing to have the Board sign a Certificate of Incumbency, which would allow staff to make a phone call to conduct transactions. Mr. Santos explained that the Certificate of Incumbency is a document that would be signed by all Board members that designates a person to make investment transactions by telephone calls. The Certificate of Incumbency would allow Excelsior to accept the investment directions by the designated person. He felt this was an unacceptable process, because he did not believe staff members should be moving funds around. The Law Department also did not feel it was proper to require all five Board members’ signatures on every transaction. Mr. Arends referred to the centralized custody idea and suggested removing the revenue sharing component and consider the value of centralized custody, because this concept would only allow the custodian to have relationships with all the funds. Mrs. Stallings moved that the Board immediately move forward on implementing centralized custody and to schedule a special meeting to proceed if needed, as well as an RFP process. Although the RFP process is their normal procedure with this type of issue, Mr. Santos noted that U.S. Bank may have unique qualifications that would warrant waiving the RFP process. Mr. Russo noted that the two other Boards he works with, the Police Retirement Plan and the Fire Retirement Plan, have had long standing relationships with U.S. Bank as their custodian for their money mangers and other assets, and he felt comfortable using U.S. Bank. He had previously contacted American Century to find out if they provided this type of service, but they no longer are in that business. After he contacted U.S. Bank, they agreed to provide this service for a fee, which he felt was reasonable. Mrs. Stallings asked if that contract would have to be approved by the City Council. Mr. Santos agreed.
Board of Trustees Municipal Employees Pension Plan Page 14
May 9, 2006
Mr. Russo stated that the total fee they calculated would be about $13,750 per year based on today’s value. That would be about 4 basis points on the first $40 million and 2 basis points thereafter. Mr. Arends felt those numbers were competitive. He felt the appropriate solution was to centralize custody with an entity. Comparably, he pointed out that Schwab would charge 5 basis points and Fidelity would charge 6 basis points. Mr. Peterson asked if there was a local bank that would be used for the centralized custodian. Mr. Russo stated there was a U.S. Bank located at Shawnee Mission Parkway and Antioch. He offered to provide a fee schedule from U.S. Bank. Mr. Arends asked if the funds would be reregistered. Mr. Russo stated that the funds would be reregistered in the name of U.S. Bank. He noted that U.S. Bank was very familiar with this procedure, and it is something they do all the time. Mr. Santos suggested that a separate motion be made to waive the normal RFP process and select U.S. Bank as the centralized custodian. Mrs. Stallings moved to waive the RFP process and select U.S. Bank as their centralized custodian. Mr. Peterson seconded the motion, which carried by a vote of 5 to 0. Mrs. Stallings moved to authorize staff to immediately proceed with centralized custody with U.S. Bank at the rate of 4 basis points for the first $40 million and 2 basis points thereafter. Ms. Charpie seconded the motion, which carried by a vote of 5 to 0. Since the RFP process is being waived, Mr. Santos felt it was the Board’s fiduciary responsibility to have staff bring the final contract and documents to the Board so that they understand the related security issues. Those documents should be ready for review in about two weeks. A special meeting will be required to handle that final procedure. Mr. Peterson moved that at such time as staff has completed or nearly completed the contract with U.S. Bank, that a Special Board meeting be appropriately scheduled so they can act on this issue. Mrs. Stallings seconded the motion, which carried by a vote of 5 to 0. APPROVAL OF MINUTES – February 14, 2006 Chair Eisler presented the February 14, 2006, Municipal Employee Pension Plan minutes for approval. He referred to Page 11 of the minutes where it states “Scudder has a median market value of $54,261 billion” and suggested changing the comma to a period. Mr. Arends suggested an amendment be made to the minutes to state $54 billion. Mr. Peterson moved to approve the February 14, 2006, MEPP minutes including the suggested amendment. Mrs. Stallings seconded the motion, which carried by a vote of 5 to 0.
Board of Trustees Municipal Employees Pension Plan Page 15 APPROVAL OF WITHDRAWLS Chair Eisler presented five withdrawals for approval.
May 9, 2006
Mrs. Stallings moved to approve the five withdrawals as presented. Ms. Spangler seconded the motion, which carried by a vote of 5 to 0. SUMMARY OF PARTICIPANT EVALUATIONS No discussion was held regarding this item, but the information was included in the packet materials for review. Mr. Peterson moved to adjourn the meeting at 5:05 p.m. Ms. Spangler seconded the motion, which carried by a unanimous vote. Minutes transcribed by Kathleen Imair.
________________________________ Robert E. Eisler, Jr., Chair