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					                    Fiscal 2007
                   INVESTMENT PLAN




                       June 16, 2006




60-118, 6/06/210
                                                   Table of Contents

     I. Purpose................................................................................................................................1

    II. Investment Plan Overview ................................................................................................3
        • Forecast in Brief...............................................................................................................3
        • Economic Overview.........................................................................................................3
        • Total Fund Outlook ..........................................................................................................5
        • Investment Plan Themes ..................................................................................................6
        • Outlook for the Amortization Period ...............................................................................6

  III. Asset Allocation/Risk Budget ............................................................................................7
       • Asset Class Summaries ....................................................................................................7
       • Asset Allocation ...............................................................................................................8
       • Risk Budget......................................................................................................................9

   IV. Fiscal 2007 Economic Outlook........................................................................................13
       • Overview ........................................................................................................................13
       • U.S. Economic Growth and Inflation Outlook...............................................................15
       • U.S. Economic Forecast.................................................................................................23
       • International Economic Growth and Inflation Outlook .................................................24
       • International Forecasts ...................................................................................................27

    V. Fixed-Income Investments ..............................................................................................29
       • Outlook ..........................................................................................................................29
       • Strategy ..........................................................................................................................31

  VI. Domestic Equities Investments .......................................................................................35
      • Outlook ..........................................................................................................................35
      • Strategy .........................................................................................................................38

 VII. International Investments ...............................................................................................39
      • Outlook ..........................................................................................................................39
      • Strategy ..........................................................................................................................44

VIII. Real Estate Investments ..................................................................................................45
      • Outlook ..........................................................................................................................45
      • Strategy ..........................................................................................................................49

  IX. Alternative Investments...................................................................................................53
                                                      Addendum
                                                       June 16, 2006

    Between the writing of the Fiscal 2007 Investment Plan and its adoption by the State Teachers
Retirement Board on June 16, 2006, the return outlook for STRS Ohio’s major asset classes changed
due to the significant volatility in the markets. This change in outlook is reflected in the chart below,
which replaces the current chart on Page 5. STRS Ohio now projects total fund returns for fiscal 2007
to be “above normal,” exceeding 8.0%.




                                                 ANTICIPATED MARKET RETURNS
                                                       Board Policy
                                                     Expected Average      Annualized Return*
                                                      Annual Returns    Expectation for Fiscal 2007
    Liquidity Reserves                                    4.2%                Above Normal
    Fixed Income                                          5.5%                Above Normal
    Domestic Equities                                     8.0%                Above Normal
    International                                         8.0%                Above Normal
    Real Estate                                           6.7%                Above Normal
    Alternative Investments                               10.7%               Below Normal
    Total Fund                                            7.42%               Above Normal

*Based upon market levels as of June 12, 2006.
                                                                           Fiscal 2007 Investment Plan
                                                                                                         1



I. Purpose
    The Investment Plan provides strategy for fiscal 2007 based on the Retirement Board’s long-term
objectives and the forecasted climate. Because the staff forecast is based on estimates of a future
economic climate, modifications to the plan may be necessary. Modifications will be communicated
to the Retirement Board in bimonthly reviews of the plan as needed. In implementing the plan, the
staff will ensure that all potential Ohio investments in each asset class receive a thorough analysis
according to policy.
    Fiscal 2007 Investment Plan
2
                                                                             Fiscal 2007 Investment Plan
                                                                                                           3



II. Investment Plan Overview
                                         FORECAST IN BRIEF

                                                    Fiscal 2007              Fiscal 2006
                                                 Projected Ranges             Forecast
        Real Gross Domestic Product                2.25%–3.75%                  3.5%
        Real Personal Consumption                  2.00%–3.50%                  3.2%
        Real Business Fixed Investment            2.50%–12.50%                  8.4%
        Housing Starts (millions)                    1.70–1.90                  2.04
        Real Net Exports (billions)                ($700)–($640)              ($653.7)
        Consumer Price Index                       1.50%–3.00%                  3.7%
        S&P 500 Earnings                             $80–$85                    $78
                                                     3%–9%                      8%

                                                    Fiscal 2007
                                                 Projected Ranges            May 2006
        Federal Funds Rate                         4.25%–5.75%                 5.00%
        10-Year Treasury Note                      4.00%–5.50%                 5.03%




ECONOMIC OVERVIEW
    It has been many years since the U.S. economy and major foreign economies were growing at
solid rates together. In fiscal 2006, the United States’ role as the locomotive for the global economy
changed and leadership began to spread to other countries. That movement of growth from the United
States to other countries should continue into, at least, the early stages of fiscal 2007. Most foreign
economies will grow faster than their longer-term potential at the start of fiscal 2007 before moderat-
ing toward their longer-term potential growth as the year progresses. Meanwhile, the United States’
economy will likely grow slightly less than its longer-term potential as it continues to move through
a mid-cycle slowdown. While the Federal Reserve has worked diligently to normalize U.S. monetary
policy since mid-2004, other central banks are about to shift their monetary policies as well. After 16
consecutive 25-basis point rate increases, the Federal Reserve is near the end of its monetary tighten-
ing campaign and will probably pause through the early stages of fiscal 2007 to view the economic
impact of past rate increases. Monetary policy has edged into a slightly restrictive region after many
years of stimulus to ward off deflation threats coming out of the last recession. Though headline infla-
tion measures around the world will continue to be driven by energy price swings in fiscal 2007, core
inflation measures will likely remain well contained.
    The main alternative to our baseline forecast highlighted below is that growth in the United States
remains moderately above the economy’s longer-term potential with inflation expectations moving
higher, though core inflation rates remain in a 1% to 2% band. Though some economic sectors (e.g.,
housing) would likely continue to soften, consumer and business spending would remain strong be-
cause underlying economic fundamentals are solid. The secondary alternative consists of slower than
the slightly-below trend growth expected in our baseline forecast. It would be caused by ever-soaring
energy costs that weigh heavily on domestic activity and drive total inflation higher than anticipated.
    Fiscal 2007 Investment Plan
4



       Another devastating hurricane season or geopolitical risks, such as terrorist attacks on the United States
       or a significant escalation of tensions in the Middle East, could also drive a slower growth/higher
       headline inflation outcome. Under either alternative, core inflation measures should remain contained
       due to continuing solid productivity and global competition. Because we place high confidence in our
       baseline forecast, we would put only moderate confidence in the primary alternative or the secondary
       alternative occurring.
          Here are the highlights of the STRS Ohio baseline forecast:
          •   Real gross domestic product (GDP) should grow at a slightly less-than-trend 3% year-
              over-year rate in fiscal 2007 after a solid 3.5% growth rate in fiscal 2006. We expect both
              final sales (real GDP less inventory change) and domestic final sales (final sales less net exports)
              to grow slightly less than the roughly 3.25% longer-term potential as well. Economic activity
              is expected to be healthy in Asia (including Japan), the Eurozone and Latin America.
          •   Personal spending in the United States is expected to slow below potential as mortgage
              equity withdrawal dries up and energy prices remain high. Between 150,000 and 200,000
              jobs should continue to be created each month. Spending on durable goods will continue to be
              disappointing, while nondurables and services spending should moderate to a below-potential
              rate in the higher interest rate environment.
          •   Growth in capital equipment investment should remain fairly steady as companies con-
              tinue to look for ways to improve productivity. Businesses will likely keep tight controls on
              inventory investment, maintaining roughly a level amount of change from quarter to quarter.
              Meanwhile, residential investment will likely detract from economic activity as homeowners
              adjust to a higher interest rate world. Housing affordability plummeted in 2005, largely due
              to soaring home prices and gradually higher interest rates. In fiscal 2007, home price growth
              should continue to decelerate.
          •   Trade conditions in the United States should finally stabilize in fiscal 2007 after further
              deterioration in fiscal 2006. The dollar is expected to gradually weaken in an orderly manner
              once U.S. interest rates stop rising and foreign central banks begin moving their rates higher.
              The United States is running a huge current account deficit and with improving foreign econo-
              mies, the dollar can now begin to adjust to a changing global economy. A softer dollar should
              modestly improve the U.S. relative trade position.
          •   The baseline forecast expects inflation to ease in fiscal 2007. Energy costs could remain
              elevated during the fiscal year, but are not likely to increase dramatically from current levels.
              Growth in core inflation measures (which exclude food and energy costs) should remain within
              an acceptable band of 1% to 2%. Though businesses will face marginally higher labor costs,
              productivity gains will continue to be their focus and unit labor costs should remain relatively
              low. Consumer prices should grow by 2.1% during fiscal 2007 — down from 3.7% in fiscal
              2006. Broader inflation measures, like the GDP price index, should grow by 1.9% in fiscal
              2007 — down from 3.3% in fiscal 2006.
          •   The Federal Reserve is at or near the end of its interest rate increases and will likely pause
              through at least the early stages of fiscal 2007. Entering fiscal 2005, Federal Reserve officials
              knew they were running a highly stimulative monetary policy to combat deflationary threats.
              After raising the federal funds rate to 5% in May (from 1% at its low through mid-2004), the
              need to continue tightening monetary policy is ending. The Federal Reserve has accomplished
              its task of returning interest rates to a more normal level and even pushed short-term rates into
              a slightly restrictive area. In most countries, underlying inflation is expected to remain well
              contained. Nevertheless, many central banks will be gradually raising their short-term interest
              rates to more normal levels. However, the pace at which they normalize will likely be slower
              than many anticipate as their currencies appreciate against the dollar.
                                                                             Fiscal 2007 Investment Plan
                                                                                                           5



    •     The STRS Ohio forecast shows more modest growth in consumer prices and the GDP
          price index than the consensus economic view, but slightly higher growth in real GDP.
          The Blue Chip Economic Indicators consensus outlook for fiscal 2007 calls for 2.9% year-
          over-year growth in real GDP versus the STRS Ohio forecast of 3%. The consensus view has
          consumer prices growing 2.4% and the GDP price index advancing 2.2% over the same period.
          The STRS Ohio forecast shows CPI growth of 2.1% and GDP price index growth of 1.9%.


TOTAL FUND OUTLOOK
    During fiscal 2007, STRS Ohio investment assets are projected to grow to about $70 billion at
market value, from an estimated $66 billion in June 2006. This approximate $3.0 billion increase
consists of income and market appreciation minus net contributions. Since net contributions, which
are contributions less benefits and operating expenses, continue to be negative (minus $1.6 billion
annually), the growth in assets comes totally from investment returns. The projected market return in
this 12-month period is approximately 7.0%, which is consistent with the return outlook in the table
below. Caution is required when estimating future market values of assets because of the potential for
market fluctuations over short time periods.
    The chart below illustrates the expected annual market return for each asset category for fiscal
2007 relative to the Retirement Board’s policy expected average annual returns. As detailed in various
sections of this plan, we project this period to be slightly below normal (+7.0%) for the STRS Ohio
total fund return based upon market levels in mid-May 2006. Domestic and international equities are
expected to have below normal benchmark returns after the recent robust years. Liquidity reserves and
fixed income are projected to have above normal benchmark returns after lackluster results the previ-
ous two years. The real estate benchmark should have at least one more banner year in fiscal 2007.
Assuming the individual asset projections are on target, the total fund could achieve a +7.0% return.
    Predicting an individual year’s total fund return can be hazardous and it has a large confidence
interval around it. Using one standard deviation of returns on the total fund (+11.6%), the actual re-
turn could be from – 4.2% to +19%. However, the equity markets, which provided excellent returns
recently, are unlikely to be extremely positive or negative in fiscal 2007. Thus, the total fund return
should be “just okay” in fiscal 2007, led by better results in fixed income and continued excellent
results in real estate.


                                             ANTICIPATED MARKET RETURNS
                                                   Board Policy
                                                 Expected Average      Annualized Return*
                                                  Annual Returns    Expectation for Fiscal 2007
   Liquidity Reserves                                 4.2%                Above Normal
   Fixed Income                                       5.5%                Above Normal
   Domestic Equities                                  8.0%                Below Normal
   International                                      8.0%                Below Normal
   Real Estate                                        6.7%                Above Normal
   Alternative Investments                            10.7%               Below Normal
   Total Fund                                         7.42%           Slightly Below Normal

*Based upon market levels in mid-May 2006.
    Fiscal 2007 Investment Plan
6



       INVESTMENT PLAN THEMES
         As we begin our planning for the Investment Plan each year, we examine whether there are any
       major investment themes or goals to consider. For fiscal 2007, these include:
          •   Evaluate a global equity program with the intention of funding a global equity portfolio
              (domestic and international combined) during fiscal 2007.
          •   Continue to refine the implementation of Investment Risk Management for the portfolio, includ-
              ing reporting risk levels used to achieve desired alphas at performance presentations.
          •   Reformat the Statement of Fund Governance and the Statement of Investment Objectives and
              Policy.
          •   Determine the value-added of implementing a “long/short” domestic equity portfolio.
          •   Evaluate the addition of a global real estate public securities program and any related bench-
              mark adjustments.
          •   Evaluate the timber component of the real estate composite benchmark.
          •   Implement recommendations from the Independent Fiduciary Services (IFS) audit as appropri-
              ate. A final IFS report is expected to be completed in June 2006.


       OUTLOOK FOR THE AMORTIZATION PERIOD
           With the excellent return being achieved in fiscal 2006, the period to amortize the unfunded
       actuarial accrued liability should improve to 50 years from 55.5 years as of June 30, 2006, despite
       the estimated unfavorable experience ($1 billion) with the other economic and demographic assump-
       tions. While the projected market return for fiscal 2007 is only 7%, the four-year smoothed market-
       related return used by the actuary would be approximately 11%. This favorable actuarial return would
       enable the funding period to improve to 43–44 years as of June 30, 2007, despite an additional estimated
       $1 billion in actuarial losses projected for fiscal 2007.
                                                                                 Fiscal 2007 Investment Plan
                                                                                                                7



III. Asset Allocation/Risk Budget
ASSET CLASS SUMMARIES
Liquidity Reserves
    For the past several years, returns on liquidity reserves have been very low due to the Federal
Reserve maintaining a low level of short-term interest rates. However, with the federal funds rate now
at 5% (up from 1% two years ago), returns on cash assets in fiscal 2007 are now projected to be above
their average expected return of 4.2%. We plan to maintain some cash reserves to take advantage of
the likely volatility in the other asset classes while earning a very good risk-adjusted return.

Fixed Income
    For the past year, returns on the fixed-income benchmark have been poor as long-term interest
rates have risen approximately 120 basis points. We had been anticipating this rise in rates and kept
the weighting and volatility low. Now we believe the increase in long-term rates is nearly over and
could decline as economic activity is moderate, inflation appears benign and the Federal Reserve
is likely pausing. With a yield of nearly 6% on the fixed-income benchmark, returns will be above
normal if rates remain the same. Therefore, we plan to overweight fixed-income investments while
maintaining an above-neutral duration as long as long-term interest rates remain in the upper half of
our projected range.

Domestic Equities
   The U.S. stock market has provided good returns in each of the past three fiscal years (2004–2006).
STRS Ohio began reducing its overweight in domestic equities as the market continued to rise in fiscal
2006. While adequate economic growth, moderate inflation and good corporate profits provide a solid
underpinning to the stock market, valuations are not cheap. We forecast a modest year for the domestic
equity benchmark with returns likely to be below 8%. We plan to remain underweight in domestic
equities until we can envision returns exceeding 8% –10% over the next 12 months.

International Equities
   International benchmark returns have been phenomenal (25% per year) over the past three fiscal
years (2004–2006). The emerging market segment return has actually been substantially higher than
the developed market return. Our overweight in international, especially in emerging markets, has
been very beneficial. For fiscal 2007, we anticipate total international will have a return below 8%
with emerging markets doing better than developed. We plan to be slightly overweight in emerging
markets while generally maintaining a neutral weight in developed markets.

Real Estate
    Real estate returns over the past five fiscal years (2002–2006) have been near 14% per year as
industry capitalization rates declined substantially. With this decline essentially over, real estate returns
should revert back to normal levels. However, given the lag effect of the benchmark appraisal process,
we forecast one last year of superior benchmark performance. New acquisitions, which are marginally
priced, would have projected returns closer to 7%. With our underweight in real estate, we will continue
to look for new acquisitions while our sale candidate list has essentially been exhausted.

Alternative Investments
   STRS Ohio has been attempting to aggressively increase the funded weighting of its alternative
investments, which are currently 2.7% of investment assets. The $1.3 billion of commitments made in
    Fiscal 2007 Investment Plan
8



       fiscal 2006 will be funded over the next several years. With the policy neutral weight raised to 3% from
       2% with the recent Asset/Liability Study, STRS Ohio will continue to make sizable commitments in this
       asset class in fiscal 2007; however, new commitments will likely be lower than fiscal 2006 due to the
       anticipated opportunities available. The funded weighting should approach 3% by June 30, 2007.


       ASSET ALLOCATION

                                AVERAGE LONG-TERM POLICY WEIGHT, ESTIMATED JUNE 2006
                                        WEIGHT AND STRATEGY FOR FISCAL 2007*
                                                         (as a percentage of total assets at market)

                                                  Average                      Estimated
                                                 Long-Term                     June 2006
                                                 Allocation                     Weight                         General Strategy for Fiscal 2007

           Liquidity Reserves                           0%                          1.5%              Maintain a tactical weight to take advantage
                                                                                                      of the potential volatility in the other asset
                                                                                                      classes. The expected return is forecasted
                                                                                                      higher than normal, though less than other
                                                                                                      asset classes.
           Fixed Income                              20.5%                        21.5%               Maintain an above-neutral weight as the
                                                                                                      forecast returns are attractive compared to
                                                                                                      other asset classes.
           Equities
            Domestic                                  42%                         40.5%               Projected returns for fiscal 2007 suggest
                                                                                                      maintaining an underweight.
            International                             25%                         26.5%               Continue a slight overweight in emerging
                                                                                                      markets while maintaining a neutral weight
                                                                                                      in developed markets.
           Total Equities                             67%                         67.0%               The total equities weight will likely be near
                                                                                                      neutral as forecasted returns are not robust.
           Real Estate                                 9.5%                        7.3%               The weight will remain slightly below 9.5%;
                                                                                                      however, as prices stabilize we will be adding
                                                                                                      investments to the asset class.
           Alternative Investments                      3%                         2.7%               Commitments made over previous years
                                                                                                      are expected to move STRS Ohio near a
                                                                                                      neutral weight.
           Total                                     100%                        100.0%

       * More detailed asset weightings and projections will be provided quarterly to the Retirement Board, based upon a procedure put in place in February 2005. This
         should provide the Retirement Board more current updates to the overall strategy rather than placing them in the Investment Plan.
                                                                               Fiscal 2007 Investment Plan
                                                                                                             9



RISK BUDGET
    Active management risk refers to portfolio return fluctuations around the benchmark return that
result from active management decisions. Risk budgeting is a tool used by the staff to efficiently allo-
cate active management risk among the asset classes by assigning active management risk ranges. The
goal of a risk budget is to maximize the active management returns earned within a board-approved
active management risk range for the total fund. Empirical evidence shows that less efficient markets
such as real estate and emerging markets offer greater opportunities for active management returns
compared to more efficient markets such as domestic equities and domestic fixed income. Therefore,
the estimated active management risk for real estate and international equities should be higher than
the other asset classes.
   Based upon quantitative work developed by the staff, we estimate that the total fund level of active
management risk is 75 basis points. This means that the STRS Ohio total fund return should track
within plus or minus two times the expected active management risk level relative to the total fund
composite benchmark. Thus, if the total fund composite benchmark earns 8% for the year, the STRS
Ohio return is expected to be within 1.5% (two times 0.75%) of this return, i.e., between 6.5% and
9.5%. Similarly, in a year when the benchmark return is –3%, the STRS Ohio return is expected to be
between – 4.5% and –1.5%.
    The suggested policy ranges of active management risk for the total fund and the asset classes
were originally presented to the board in December 2005 as part of the revised Statement of Invest-
ment Objectives and Policy, and again presented in the “Risk Budgeting” presentation in April 2006.
The staff recommended the inclusion of these range limits around the normal risk already specified
in policy. Due to a requested change in the Investment Policy format, only part of it was accepted in
December. The recommended active management risk range of 60 to 140 basis points for the total
fund has yet to be officially approved. The fiscal 2007 anticipated range of 65 to 95 basis points falls
within current policy guidelines.
    The policy range of active management risk for the total fund is established to achieve the net active
management return goal of 40 basis points as specified in the Asset/Liability Study. This policy range
is the basis for the policy ranges of the individual asset classes. Since the fund’s asset allocation is
approved by the board, the policy ranges of active management risk should also receive board approval.
Expected operating ranges for the asset classes are created by staff each year to efficiently achieve
the desired level of active management risk for the total fund. Operating ranges must fall within the
policy ranges for each asset class and for the total fund. The actual ranges of active management risk
will be presented to the board quarterly.
    The table on Page 10 shows the June 2006 estimate and the fiscal 2007 expected operating range of
active management risk for each asset class. These measures are expected to fluctuate slightly over the
fiscal year; however, no material deviations from these measures are anticipated. The active manage-
ment risk of the total fund is expected to fall in the range of 65 to 95 basis points during fiscal 2007.
This range includes tactical risk due to asset allocation bets that do not occur within the asset class.
These numbers are estimates and are likely to vary throughout the year.
     Fiscal 2007 Investment Plan
10




                                                    Fiscal 2007 Active Management Risk
                                                Estimated
                                            June 2006 Active  Fiscal 2007   Current Policy                                                       Proposed
                                            Management Risk Operating Range Normal Risk                                                         Policy Range
         Asset Class                          (basis points) (basis points) (basis points)*                                                    (basis points)**
         Liquidity Reserves                             N/A                               N/A                             N/A                           N/A
         Fixed Income                                     47                             20–70                             70                         0–150
         Domestic Equities                                55                             45–65                             60                        20–150
         International Equities                          140                           120–170                            200                       100–250
         Real Estate                                     350                            350****                         275***                      200–700
         Alternative Investments                        N/A                               N/A                             N/A                           N/A
         Tactical Asset Allocation                        35                             20–70                            N/A                           N/A
         Total Fund                                       75                             65–95                         60–100                        60–140
           *This is in the current Investment Policy that was approved by the Retirement Board in late 2004.
          **This revised policy was not approved by the Retirement Board in December 2005 due to an overall policy format question.
         ***This was the best estimate at the time the current Investment Policy was written. Further research suggests that the proposed range and point estimate are more
            accurate as discussed with the Retirement Board at the Risk Budgeting presentation at the April 2006 board meeting.
        ****This estimate is static unless a significant portfolio adjustment occurs.


            Unlike other asset classes, real estate does not have a model that can be used to accurately estimate
        active management risk. Instead, the estimate is based on historical active management returns, the
        amount of leverage in the portfolio and past real estate market volatility. These factors are unlikely to
        change much over time without a significant change to the portfolio; therefore, the estimated active
        management risk for real estate will be static in most years. As discussed in the April 2006 board meet-
        ing, recent research conducted by the staff suggests the current level of active management risk for
        the real estate portfolio is 350 basis points. This is higher than the current policy normal level of 275
        basis points. This research is not yet complete; however, it should be assumed that the new estimate
        is the most accurate.
            The chart on Page 11 explains where the active management risk for the total fund is generated. As
        expected, the inefficient asset classes (real estate and international equities) contribute dispropor-
        tionately more than their asset class weight. The efficient asset classes (domestic equities and fixed
        income) contribute disproportionately less. Tactical asset allocation is contributing about one-third of
        the total active management risk, which is slightly lower than a year ago. This is due to higher bond
        yields which have reduced tactical asset allocation opportunities.
                                                                                Fiscal 2007 Investment Plan
                                                                                                                   11



                  Contribution to Active Management Risk
40%

                     35%
35%
                                                                                                      31%
30%


25%


20%

       15%
15%                                               14%

10%

                                     5%
5%

                                                                   0%               0%
0%
      Domestic   International   Fixed Income   Real Estate    Alternative   Liquidity Reserves   Tactical Asset
      Equities      Equities                                  Investments                           Allocation
     Fiscal 2007 Investment Plan
12
                                                                               Fiscal 2007 Investment Plan
                                                                                                             13



IV. Economic Outlook
OVERVIEW
    Nearly two years ago at the end of fiscal 2004, the Federal Reserve began gradually raising short-
term interest rates to set monetary policy back onto a normal course. It had kept interest rates at a
35-year low for a year to combat the real threat of deflation spreading to the United States from Asia.
At that time, many economists and financial market watchers were surprised the Federal Reserve was
no longer worried about deflation. Unlike the STRS Ohio economic forecast that called for small
steady steps of higher short-term interest rates, they generally expected there would be no change in
monetary policy until the end of fiscal 2005. The Federal Reserve, instead, has raised the federal funds
rate 0.25% at each of its last 16 meetings, pushing short-term rates to 5% — the highest level since
the start of the 2001 recession.
    Today, many of the same economists and financial market watchers, who worried the Federal
Reserve was not conducting appropriate policy when they feared deflation would grab hold of the
United States, now fear that core inflation (inflation excluding volatile energy and food price changes)
in the United States is on the cusp of breaking above an 11-year pattern of moving within a relatively
narrow band. Yet, the Federal Reserve at its most recent meeting in May indicated that it would soon
pause its campaign of raising short-term interest rates to gauge the economic impact of past rate
increases. Long-term interest rates have begun to finally move higher and are increasingly threatening
growth from interest-rate sensitive sectors of the economy. Furthermore, energy cost increases continue
to weigh on economic growth by acting as a tax upon consumers and businesses, thereby damaging
growth prospects elsewhere in the economy.
    Monetary policy has moved into a slightly restrictive area where the real federal funds rate (adjusted
by the core personal consumption expenditures [PCE] price index, which is the Federal Reserve’s
preferred inflation measure) sits at roughly 3% — notably higher than the 2.4% average real funds rate
since 1960. Consequently, the Federal Reserve will need to be more cautious about raising short-term
interest rates to combat any inflation threat. If central bankers have gone too far, a fundamentally robust
economy could register significantly reduced growth from its potential or, worse, slip into a recession
in a future year. On the other hand, if they have not gone far enough, then the threat of higher core
inflation and the disruptions that would introduce into the economy could force the Federal Reserve to
adopt a much more restrictive monetary policy. It is clear that policymakers have adjusted monetary
policy back into an area where fine-tuning, rather than a steady stream of rate changes in one direc-
tion, is now the preferred course to be taken. The economy has returned to a more normal growth area
as well, with quarterly economic gains fluctuating more closely around longer-term potential growth
rather than being tilted to one side of the economy’s longer-term potential.
   During fiscal 2006, the economy withstood punishing blows from higher interest rates, soaring
energy costs and devastating hurricanes. After growing 4.6% in fiscal 2004 and 3.6% in fiscal 2005,
the real (inflation-adjusted) GDP is expected to grow by 3.5% in fiscal 2006. The deceleration in
domestically driven activity alone during the same periods has been even more dramatic with real
gross domestic purchases growth easing from 5.1% in fiscal 2004 to roughly 3.5% over the past two
fiscal years.
   As with every year of the current expansion, much of the contribution to economic growth has
come from consumer spending. Personal spending as a share of total economic growth has moved
up to roughly 70% of the economy from 67% as recently as 1997 (which itself marked the end to a
15-year period of a relatively steady consumer spending to economic growth share). In fiscal 2006, real
consumer spending continues to be a significant contribution to economic growth, growing 3.4% during
     Fiscal 2007 Investment Plan
14



        the first three quarters after advancing by 3.9% in both fiscal 2005 and fiscal 2004. The deceleration
        in consumer spending growth came almost entirely from slower growth in durable goods purchases,
        particularly real spending on motor vehicles and parts. Growth in consumer spending on nondurable
        goods and services remained quite steady in recent years.
             Business spending on information processing, industrial, transportation and other equipment also
        continued to contribute significantly to solid economic growth during the fiscal year. In fiscal 2005, the
        contribution from that segment of the economy accounted for 0.9% of the 3.6% growth in real GDP. So
        far in fiscal 2006, it has made up 0.8% of the 3.7% gain in the economy. Business equipment spend-
        ing grew at an annualized rate of 9.7% through the first three quarters of fiscal 2006 after advancing
        by 11.8% in fiscal 2005 and 11.9% in fiscal 2004. Meanwhile, business investment in structures ac-
        celerated in fiscal 2006, growing by 5.5% over the first three quarters of the year after advancing only
        1.7% in fiscal 2005 and 1.5% in fiscal 2004. However, most of the increase in structures investment
        occurred in the third quarter of the fiscal year, when the growth rate hit an annualized 11.4%. There
        is little evidence that the trend has turned significantly higher.
            While strong consumer and business spending has held up the economy, there have also been
        areas of disappointment. The contribution to economic growth from home building has begun to ease.
        Through the first three quarters of fiscal 2006, real residential investment grew at an annualized rate of
        4.4% — a solid growth pace but well short of the 6.1% growth rate in fiscal 2005 and the phenomenal
        13.9% pace in fiscal 2004. In addition, the continued deterioration of the United States’ international
        trade position played a part in slowing overall economic growth. After taking just 0.1% off economic
        growth in fiscal 2005, trade’s impact on the economy returned to the behavior of fiscal 2004 when it
        deducted 0.6% off economic growth. In fiscal 2006, real net exports have so far held back economic
        growth by 0.7%, while the deficit has widened from an average of $625 billion in fiscal 2005 to $648
        billion through the first three quarters of fiscal 2006.
            Soaring energy costs developing from severe disruptions to production facilities and refineries
        from devastating Gulf Coast hurricanes at the beginning of the fiscal year and the ongoing depletion
        of spare production capacity from OPEC countries as demand from other countries begins to grow
        more rapidly has forced total price inflation measures higher. The CPI has grown 3.7% through the
        first three quarters of the fiscal year after advancing 3% in fiscal 2005 and 2.8% in fiscal 2004. The
        PCE price index has grown 2.9% so far in fiscal 2006, after growing 2.5% in the prior fiscal year and
        2.7% in fiscal 2004.
           However, energy price surges act more like a tax upon the economy, than they do as inflationary
        events that spread into other price components, by limiting growth. This is particularly true during
        high productivity periods like the U.S. economy has been experiencing since the mid-1990s. Strong
        productivity gains have allowed businesses to limit the pass-through of higher energy and commodity
        costs to their final products, and with labor costs remaining well behaved, companies have not felt the
        need to ask for more rapid price increases. As a result, core inflation measures that exclude volatile
        energy and food prices have remained well contained, though the fluctuation in food prices has been
        muted in recent years compared to prior periods like the 1970s and 1980s. The core CPI has grown by
        2.1% so far in fiscal 2006, matching the increase registered for fiscal 2005. The core PCE price index
        has grown just 1.9% in fiscal 2006 after 2% gains in both fiscal 2004 and 2005.
           Though core inflation gauges have hardly budged in recent years, the bond market has become
        increasingly worried that higher inflation may be a problem for the U.S. economy. Entering fiscal
        2006, the 10-year Treasury yield was roughly 4%. Yields remained in a 4% to 4.7% range until March
        when they broke to the upside. Inflation expectations priced into Treasury inflation-indexed securities
        began to move a bit higher as well when the sustained increase in Treasury yields occurred at the end
        of March. However, even with the latest increase in those inflation expectations, the market’s assess-
                                                                              Fiscal 2007 Investment Plan
                                                                                                            15



ment of future inflation remains pretty steady with where it was prior to the recent move higher in
10-year Treasury yields.
    So, while it appears that the Federal Reserve would like to pause its interest rate tightening moves
of the past two years, the bond market is still worried that total inflation could be problematic for the
U.S. economy. As monetary policymakers noted at their most recent meeting on May 10, any future
monetary policy actions will be heavily dependent on economic data. Though they believe the economy
will moderate and inflation pressures will remain contained in coming quarters, they acknowledge that
the financial markets are more worried about the growth and inflation outlook and, therefore, they will
have to be on watch for deviations from their forecasts.


U.S. ECONOMIC GROWTH AND INFLATION OUTLOOK
   The economy overcame many obstacles, including higher interest rates, energy cost surges and
devastating physical damage from hurricanes, in fiscal 2006 while it continued to move through a mid-
cycle slowdown. Unlike the prior mid-cycle slowdown in the mid-1990s, economic growth has not
decelerated by as much or as rapidly. From the first quarter of fiscal 1995 through the second quarter
of fiscal 1996, real GDP growth fell to 2% from 4.3%. The latest slowdown began around the time
that the Federal Reserve started to raise short-term interest rates at the end of fiscal 2004. Economic
growth peaked at 4.6%, but has only decelerated over the past seven quarters to 3.6%.
    A major part of the reason for the still strong growth in the U.S. economy must be attributed to the
gradualist approach the Federal Reserve took toward raising interest rates. In the 1990s slowdown, the
Federal Reserve had doubled short-term interest rates to 6% from 3% in slightly more than a year. This
time, it took the Federal Reserve nearly a year-and-a-half to raise short-term rates by three percentage
points. Long-term rates also have behaved differently. In the 1990s slowdown, the 10-year Treasury
yield rose from 5.3% three months before the Federal Reserve began to raise short-term interest rates
in 1994 to a peak of 8% about three months before it stopped raising rates in 1995. In the latest slow-
down, 10-year Treasuries were at roughly 3.8% three months before the Federal Reserve began to
raise short-term rates in 2004 and have only recently hit a peak of 5.2% — an increase in the yield of
just 140 basis points compared to double that amount in the 1990s slowdown.
    Higher interest rates compared to a few years back and continued high energy costs are likely for
the upcoming fiscal year. However, there are increasing signs that the U.S. economy is moderating
further in this gradual slowdown engineered by monetary policymakers. Meanwhile, domestic infla-
tion — outside of the continuing big fluctuations in energy costs — remains well contained. Global
competition has forced companies to strive for solid productivity gains that keep prices largely in check
and the U.S. labor force comparatively competitive with foreign companies. With economic activity
slowing below potential and core inflation measures remaining well behaved, the Federal Reserve
can afford to take a pause in its campaign to combat inflation and inflation expectations. As the fiscal
year progresses, monetary policymakers may even consider lowering short-term rates on the margin
to prevent significantly slower growth, but the STRS Ohio baseline forecast keeps the Federal Reserve
on hold for much, if not all, of fiscal 2007.
    Economic activity in the upcoming fiscal year should look much like the current fiscal year, only at
a slightly slower pace. Much of the slowdown in economic growth should come from consumers who
begin to save a bit more and spend less. Housing activity and consumer purchases related to growth
in the housing sector should decelerate before they eventually decline. However, consumer spending
should not collapse because there will be continued solid job and income growth.
     Fiscal 2007 Investment Plan
16



            During fiscal 2007, the business sector will be relied upon to lead the way with strong, though
        moderating, activity. Growth in capital equipment investment should remain fairly steady because of
        the need for strong productivity gains. Inventory investment will likely stabilize as the business sector
        deals with more moderate domestic demand. Corporate profit growth should ease further in fiscal 2007,
        decelerating toward longer-term potential growth after stellar growth in the prior five fiscal years.
           Since 1997, the relative trade position of the United States has steadily weakened. In fiscal 2007,
        real net exports should finally stabilize around a deficit of roughly $675 billion. The adjustment will
        come from weaker demand for foreign goods within the United States, as well as a relatively stron-
        ger position for U.S. goods and services in foreign markets due to the gradually declining dollar and
        improving foreign economies. But, there is still little reason to believe the trade deficit will turn around
        during the year.
           Federal, state and local government spending should continue growing at rates similar to that
        experienced over the past couple of fiscal years. The federal budget deficit is returning to levels that are
        more manageable, after a rapid deterioration in the fiscal balance due to funding wars and providing
        tax cuts for individuals and businesses that helped to keep the economy from sliding into deflation.
        Indeed, the federal fiscal 2006 budget deficit will likely be about $60 billion less than the most recent
        forecast by the Congressional Budget Office (CBO) and about $150 billion less than the White House’s
        most recent forecast. Receipts have surged because of continuing economic strength.
            The STRS Ohio economic forecast calls for year-over-year GDP growth of 3% for fiscal 2007.
        Activity should be at or slightly below the economy’s longer-term potential growth of roughly 3.25%
        for the entire fiscal year. Past interest rate increases will likely hurt interest rate-sensitive sectors of
        the economy, while continuing high energy costs will moderate consumer spending further. As for
        inflation, growth in the GDP price index should decelerate by a significant amount, advancing by 1.9%
        on a year-over-year basis after 3.3% growth in fiscal 2006. In addition, growth in consumer prices
        should ease to 2.1% year-over-year by the end of fiscal 2007 from 3.7% in fiscal 2006. Much of the
        expected slower growth in inflation should come from the stabilization of energy costs at high levels.
        That would act to limit broad-based price increases as the economy finally adjusts to the higher energy
        cost environment. Therefore, by fiscal year-end, nominal GDP growth (the combination of real growth
        and inflation) should run at roughly 5% — a moderate growth environment after roughly 6.75% growth
        in fiscal 2006 and 6.1% growth in fiscal 2005.
                                                                               Fiscal 2007 Investment Plan
                                                                                                             17



                           REAL GROSS DOMESTIC PRODUCT (GDP)
                                      versus one year ago (fiscal-year basis)




            Gross Domestic Product
            Forecasted GDP

      Note: Shaded areas denote recession.



    The primary alternative to our baseline forecast is that growth in the United States remains mod-
erately above the economy’s longer-term potential with inflation expectations moving higher, though
core inflation rates (like the PCE price index) remain in a 1% to 2% band. Though some economic
sectors (e.g., housing) would continue to soften under this scenario, consumer and business spending
would remain strong because underlying economic fundamentals are solid. The secondary alternative
would consist of slower than the slightly below-trend growth expected in our baseline forecast. It
would be caused by ever-soaring energy costs that weigh heavily on domestic activity and drive total
inflation higher than anticipated. Another devastating hurricane season or geopolitical risks, such as
terrorist attacks on the United States or a significant escalation of tensions in the Middle East, could
also drive a slower growth/higher headline inflation outcome. Under either alternative, core inflation
measures should remain largely contained due to continuing solid productivity and global competition.
Because we place high confidence in our baseline forecast, we would put only moderate confidence
in the primary alternative or the secondary alternative occurring.


Our fiscal 2007 baseline economic forecast is predicated on these insights and assess-
ments:
    Consumer-Driven Sectors of the Economy. After four years of lower interest rates allowing
homeowners to extract mortgage equity that could then partially go toward greater consumer spending,
the keys for consumer spending in fiscal 2007 will turn toward labor market strength and wage growth.
The labor force is growing each month by roughly 125,000 to 150,000 people. So far in fiscal 2006,
jobs have been added at a rate of 169,000 a month. Meanwhile, wage and salary growth has averaged
about 5.75% during the fiscal year.
     Fiscal 2007 Investment Plan
18



            The STRS Ohio economic forecast expects that job growth each month will remain in the 150,000 to
        200,000 range. Surveys of hiring intentions remain steady at high levels and suggest that employment
        growth will continue at a similar pace to fiscal 2006 during fiscal 2007. Initial claims for unemploy-
        ment insurance surged following the hurricanes hitting the Gulf Coast last summer, then fell off and
        returned to the gradual decline of the prior two years before recently turning marginally higher as the
        economy moderated. Currently, unemployment claims are averaging between 315,000 and 325,000
        per week — a level that in relation to the size of the labor force puts unemployment down near the
        historic lows recorded in late 1999 and early 2000. As the economy moderates further from today’s rate
        of growth, the unemployment rate should stabilize around the current 4.7% rate and then edge higher
        in fiscal 2007 into the 4.8% to 4.9% range. Though the best period for the jobs market is likely behind
        us, the expected jobs environment will continue to support solid income growth and keep consumer
        spending growing at a pace slightly below the longer-term potential.
           The economic forecast calls for real disposable income growth of 3.2% in fiscal 2007 after an
        expected 2.3% gain in fiscal 2006. With less ability to use homeowner equity as a prop for consumer
        spending, consumers will likely begin to save more out of current income to improve their financial
        well-being. As a result, the economic forecast expects to see a noticeable change in consumer spending
        between the expected 3.2% pace of fiscal 2006 and the 2.7% pace called for during fiscal 2007.
            Along with the expected moderation in consumer spending, home purchases and home building
        are expected to slow further in fiscal 2007. Higher interest rates in the economy should begin to eat
        away at interest rate-sensitive spending and force real residential investment into negative territory
        for the first time since 2001. The decline should be gradual, however, as home building accelerates
        in the hurricane-devastated Gulf Coast region. However, home builders are also now recording the
        least optimistic views of the housing market since 2001, finally catching up to the severe drop-off in
        housing affordability that began in the early part of calendar 2005.
            At the same time, home prices nationwide will likely grow at a much slower pace than in recent
        years. From the beginning of fiscal 2004 through mid-fiscal 2006, the U.S. house price index of homes
        that have gone through repeat sales or refinancings of the same properties has increased at an annual
        rate of 12.1%. That rate of increase is more than double the historical average prior to this period of
        5.6%. In the low-interest-rate world, property prices could afford to soar. However, now that both
        short- and long-term interest rates have moved higher, price growth should slow significantly.
            The STRS Ohio economic forecast expects that housing starts peaked in January when mild weather
        allowed home builders to construct homes at an abnormally high annual rate of 2.3 million units. Starts
        should fall to 1.85 million units over the next couple of quarters before slipping further toward 1.8
        million units in the second half of fiscal 2007. That would return home building activity to the level
        it was at prior to the run up in production of the past three fiscal years. Real residential investment is
        expected to fall by 1% during fiscal 2007 after growing 1.9% in fiscal 2006 and 6.1% in fiscal 2005,
        making the housing sector an area of weakness for economic growth.
            Another sector of the economy where the consumer continues to play an important role is interna-
        tional trade. American demand for foreign goods has been extremely strong over the past four fiscal
        years, resulting in solid import growth of 8% over the past 17 quarters. This, along with soft demand
        for U.S. goods and services in foreign markets, has pushed the U.S. trade balance into record deficit
        territory. During fiscal 2007, the STRS Ohio economic forecast expects the trade situation will finally
        stabilize from slower domestic demand for foreign goods and services and gradually better foreign
        demand for U.S. goods and services. The U.S. dollar will likely continue weakening in the upcoming
        fiscal year — making U.S. goods and services relatively more affordable — at the same time that
        foreign economies continue to experience better domestic growth.
           Import growth should slow with lessening consumer demand. We expect real imports will grow by
        4.2% during the fiscal year, almost half of the 8% import growth expected for fiscal 2006. Meanwhile,
                                                                               Fiscal 2007 Investment Plan
                                                                                                             19



real export growth should remain steady at about 6.4% from the better trade position that the four-year
decline of the dollar provides.
    Overall, consumer spending should advance at a less than longer-term trend pace during fiscal 2007.
The labor market should continue to provide job gains and wage growth will continue to be solid.
There will be less stimulus like in past fiscal years for consumer spending from low interest rates and
tax cuts, but the consumer stands on firm ground and will be able to sustain spending at a decent pace.
The STRS Ohio economic forecast expects personal consumption to grow by 2.7% year-over-year in
fiscal 2007 after a 3.2% advance in fiscal 2006.
   Business-Driven Sectors of the Economy. During fiscal 2006, business spending continued to
surge. Capital equipment and software investment soared 9.7% during the first three quarters of fiscal
2006 after 11.8% growth during fiscal 2005. New orders for computers and related equipment were
once again a strong sector, posting a year-over-year result of 11% through March. Investment in com-
puters and related equipment now makes up 57% of all business spending on capital equipment. From
1992 to 1994, its share of capital equipment investment was roughly 33%, and then the five-year surge
from 1995 to 2000 raised the share to roughly 53%.
    Looking ahead, the STRS Ohio economic forecast expects the business sector to continue playing
a large role in economic growth. Business confidence measures remain fairly optimistic, suggesting
that activity should remain strong. Corporate profit growth has been strong since the expansion began
in late 2001, adding support for a solid business environment in future quarters. After-tax corporate
profits as a share of nominal GDP registered an all-time high in the third quarter of fiscal 2006 when
it hit 8.9%. Though profit growth should decelerate in the coming fiscal year, it will likely exceed
nominal GDP growth and lead to more records for profits as a share of the nominal economy.
    As a result, the economic forecast expects capital equipment investment to grow by 8.2% year-
over-year in fiscal 2007 after an expected 9.7% advance for fiscal 2006. In addition, the STRS Ohio
economic forecast expects structures investment to add marginally to GDP growth as business leaders
continue to expand operations. We expect structures investment to post a 2.4% year-over-year growth
rate.
    Business investment should continue to be a bright spot for economic growth during the upcoming
fiscal year. As with other sectors of the economy, the mid-cycle slowdown will mean that growth in
business spending will not be as strong as in recent fiscal years. However, it will continue to grow at
a pace that exceeds the economy’s longer-term potential and contribute greatly to overall economic
activity. The STRS Ohio economic forecast projects that non-residential investment will grow 6.9%
in fiscal 2007 after advancing by 8.4% in fiscal 2006.
    Fiscal and Monetary Policy, Inflation and Interest Rates. Federal fiscal policy is expected to
be a minor player in economic activity during fiscal 2007. After moving back into a deficit in fiscal
2002 following four years of federal budget surpluses, the federal budget deficit steadily deteriorated
until federal fiscal 2005. Through the first seven months of the current federal fiscal year, the budget
deficit is running about $53 billion less than in fiscal 2005, a year in which the federal budget deficit
fell to $318 billion from the all-time high of $413 billion recorded in federal fiscal 2004. Some budget
forecasters now project that the fiscal 2006 deficit will fall to $275 billion, lowering the deficit as a
share of nominal GDP to less than 2.1% from last fiscal year’s 2.6%.
    There are no current discussions of providing significantly new tax cuts after the tax-cutting wave
earlier this decade. But, there has been greater attention given to controlling federal spending, particu-
larly after a lapse in that control during the current fiscal year. As a result, the federal budget deficit
should continue to narrow in upcoming fiscal years. The CBO projects a federal budget deficit of $270
billion in fiscal 2007 and $259 billion in fiscal 2008. However, those estimates were made before
recent budget data showed an unexpected surge in receipts from a still strongly growing economy. The
next battle over the federal budget will likely involve whether to extend the tax cuts as they currently
     Fiscal 2007 Investment Plan
20



        are beyond 2010, when they are set to expire. Should tax rates return to the pre-2001 levels, the CBO
        projects that federal budget surpluses would return.
           Federal consumption and investment is expected to advance by a modest 2.4% year-over-year pace
        in fiscal 2007 with defense spending remaining the major contributor. Meanwhile, the STRS Ohio
        economic forecast expects state and local governments to remain extremely cautious with their spend-
        ing plans, resulting in only a 1.1% year-over-year increase during the upcoming fiscal year.
            Monetary policy will likely remain on hold for most, if not all, of fiscal 2007. The federal funds
        rate (controlled by the Federal Reserve) entered fiscal 2006 at 3.25% after a 0.25% increase on the
        last day of fiscal 2005. The Federal Reserve continued its policy throughout fiscal 2006 of gradually
        raising short-term interest rates to slow robust economic growth and keep future inflation in check.
        The federal funds rate will likely exit the fiscal year at 5% because the Federal Reserve has indicated
        it would like to pause and watch economic developments versus the policymaking body’s forecast
        before it determines its next course of action.
            In fiscal 2006, while total inflation growth moved higher due to escalating energy costs, core infla-
        tion measures (which exclude volatile food and energy costs) remained relatively steady at the higher
        end of the Federal Reserve’s acceptable range. Consumer prices grew 3.7% at an annualized rate
        during the first three quarters of the fiscal year after having grown 3% in fiscal 2005. Core consumer
        prices, however, have grown just 2.1% so far in fiscal 2006 after advancing by a similar amount in
        fiscal 2005. Meanwhile, the broadest inflation measure for the economy that includes energy costs
        — the GDP price index — grew at a higher 3.4% pace through the first three quarters of the fiscal year
        compared to 2.5% in fiscal 2005.


                         CONSUMER PRICE INDEX (CPI) AND GDP PRICE INDEX
                                              versus one year ago (fiscal-year basis)




                     CPI
                     GDP Price Index
                     Forecasted CPI
                     Forecasted GDP Price Index

               Note: Shaded areas denote recession.
                                                                              Fiscal 2007 Investment Plan
                                                                                                            21



    Looking ahead, inflation pressures are likely to ease as the economy continues to moderate. It
generally takes about six months to a year before changes in monetary policy really impact the economy
and inflation. The Federal Reserve has moved monetary policy into a slightly restrictive stance toward
the end of the current fiscal year that should slow economic growth and keep inflation in check in the
upcoming fiscal year. Energy costs will continue to play an important role in determining the level of
broad inflation, though they will have a smaller effect on core prices as businesses continue to generate
strong productivity gains. Oil prices have spent fiscal 2006 in the $55 to $75 range. Though fundamental
supply-and-demand conditions in the United States suggest oil should be more appropriately priced in
the mid-to-high $40 range, OPEC has increasingly approached capacity constraints that have pushed
prices to extraordinary levels as oil traders fear global supply will not keep up with global demand.
The STRS Ohio economic forecast expects oil prices will fluctuate for most of the fiscal year within
a $55 to $65 range as demand softens with the moderating economy.
   The economic forecast expects consumer prices will advance by 2.1% year-over-year through the
end of fiscal 2007 after growing 3.7% in fiscal 2006. Energy prices are expected to moderate and keep
headline inflation indicators moving downward, while the costs of other consumer goods should remain
well contained and keep core consumer prices growing around 2%. Broader measures of inflation are
expected to behave similar to the overall CPI. The GDP price index should advance by 1.9% during
the fiscal year after growing 3.3% in fiscal 2006.
    The 10-year Treasury note yield began fiscal 2006 at roughly 4%. Yields remained in a 4% to 4.7%
range until March when they broke to the upside. Inflation expectations priced into Treasury inflation-
indexed securities began to move a bit higher as well when the sustained increase in Treasury yields
occurred at the end of March. However, even with the latest increase in those inflation expectations,
the market’s assessment of future inflation remains pretty steady with where it was prior to the recent
move higher in 10-year Treasury yields.
    So, while it appears that the Federal Reserve would like to pause its interest-rate tightening moves
of the past two years, the bond market is still worried that total inflation could be problematic for the
U.S. economy. As monetary policymakers noted at their most recent meeting on May 10, any future
monetary policy actions will be heavily economic data dependent. Though they believe the economy
will moderate and inflation pressures will remain contained in coming quarters, they acknowledge that
the financial markets are more worried about the growth and inflation outlook and, therefore, they will
have to be on watch for deviations from their forecasts.
     Fiscal 2007 Investment Plan
22



                                                         INTEREST RATES
                                        Treasury Bond and Federal Funds Rate (fiscal-year basis)

                   20%


                   18%


                   16%


                   14%


                   12%


                   10%


                    8%


                    6%


                    4%


                    2%


                    0%




                           Federal Funds
                           Treasury Bond

                    Note: Shaded areas denote recession.




            The STRS Ohio economic forecast expects long-term interest rates will move moderately lower
        as the fiscal year progresses, once the bond market takes into account slower economic activity and
        a weaker threat of higher inflation. While the Federal Reserve could very well keep monetary policy
        constant for most, if not all, of fiscal 2007, the bond market will anticipate future actions from the
        monetary policymakers. The slower growth and still-contained inflation outlook built into the STRS
        Ohio economic forecast should at some point in the upcoming fiscal year comfort the bond market
        and lead to lower long-term interest rates from today’s levels.


                            Period                   Federal Funds Rate                     10-Year Treasury Yield
                    Fiscal 2007 Ranges                   4.25% –5.75%                              4.00% –5.50%

        Note: The ranges listed anticipate capturing 90% of the daily closes during the period described.
                                                                                             Fiscal 2007 Investment Plan
                                                                                                                            23



                                         U.S. ECONOMIC FORECAST

                                    Fiscal Year      FY           FY 2007           FY           FY 2006           FY
                                      Ranges        2007        H1      H2         2006        H1       H2        2005
Composition of Real GDP
Gross Domestic Product             2.25%–3.75%      3.0%       3.1%     2.9%       3.5%       2.9%       4.0%     3.6%
Personal Consumption                 2%–3.5%        2.7%       2.8%     2.6%       3.2%       2.5%       4.0%     3.9%
Nonresidential Investment          2.5%–12.5%       6.9%       7.2%     6.7%       8.4%       6.5%      10.5%     9.2%
Residential Investment                             (1.0%)     (2.0%)    0.0%       1.9%       5.1%      (1.0%)    6.1%
Exports of Goods & Services                         6.4%       6.3%     6.5%       7.2%       3.8%      10.9%     7.7%
Imports of Goods & Services                         4.2%       4.2%     4.1%       8.0%       7.2%       8.9%     5.7%
Federal Consumption & Investment                    2.4%       2.4%     2.4%       4.2%       2.4%       6.1%     1.9%
State & Local Consumption &
 Investment                                         1.1%       1.3%     1.0%       0.6%       0.2%       0.9%     1.7%
Final Sales                                         3.0%       3.0%     3.0%       3.2%       2.2%       4.2%     4.2%
Domestic Final Sales                                2.8%       2.9%     2.8%       3.5%       2.8%       4.3%     4.1%
Incomes
Real Disposable Personal Income                     3.2%       3.2%     3.1%       2.3%       1.9%       2.8%     2.1%
Nominal GDP Corporate Profits,
 After Tax                         2.5%–12.5%       7.0%       7.3%     6.8%      20.2%       25.8%     23.0%     9.9%
Prices
Producer Price Index                                1.8%       1.9%     1.7%       4.5%       6.9%       2.2%     4.1%
Consumer Price Index                 1.5%–3%        2.1%       2.1%     2.1%       3.7%       4.4%       3.1%     3.0%
Chain-Weighted GDP Price Index                      1.9%       1.9%     1.9%       3.3%       3.4%       3.1%     2.5%
GDP Implicit Price Deflator                          1.9%       1.9%     1.9%       3.3%       3.4%       3.1%     2.4%
Other Key Measures
Real Net Exports ($B)              ($700)–($640)   ($673.2)   ($673.5) ($672.9)   ($653.7)   ($636.4)   ($671.0) ($625.1)
Real Change in Business
 Inventories ($B)                                   $35.6      $36.3    $35.0      $21.7      $12.3      $31.2    $39.3
Light Vehicle Sales (M)                             16.69      16.63    16.75      16.89      16.93      16.85    17.03
New Housing Starts (M)               1.70–1.90      1.82       1.84      1.80      2.04        2.08      1.99      2.02
Unemployment Rate                                   4.8%       4.8%     4.9%       4.8%       5.0%       4.7%     5.3%
Industrial Production                               3.2%       3.4%     3.1%       4.4%       3.3%       5.4%     3.0%
     Fiscal 2007 Investment Plan
24



        INTERNATIONAL ECONOMIC GROWTH AND INFLATION OUTLOOK
            After the global cyclical rebound is over by the end of fiscal 2006, the STRS Ohio economic fore-
        cast expects that activity in many economies will likely moderate toward trend-like patterns as fiscal
        2007 progresses. Barring unforeseen shocks from energy prices, inflation should remain well contained
        even as core inflation moves up gradually. Despite subdued consumer price inflation and reasonable
        inflationary expectations, the recent healthy turnaround in global economic growth should lead some
        central banks to start normalizing policy interest rates from the current low levels. But, appreciation
        of their currencies against the U.S. dollar would slow the pace of normalization and leave monetary
        conditions still conducive to economic growth.
            After several years of anemic economic activity, Germany will likely lead the Eurozone’s economy
        again. In contrast to the past five years or so, most economic indicators are pointing toward better
        current and expected business conditions. A clearer political backdrop, the effects of past labor market
        reforms and easy monetary and credit conditions, along with robust foreign demand, are likely to
        ensure a more sustainable economic recovery than in the past. Nevertheless, the inability of private
        spending to catch up to other sectors remains the main risk to the outlook. For that risk to subside, the
        slack in the labor markets would have to continue to fall, and most signs are suggesting that such an
        improvement is only gradually occurring. Consequently, unemployment is expected to ease during
        fiscal 2007.
            Meanwhile, core inflation is expected to edge up from its current level because demand is expected
        to be steadier than it was during prior years. Moreover, the value-added taxes effective January 2007
        are going to add to that upward movement in prices. Together with higher energy prices, the taxes
        could potentially dampen the nascent recovery in consumer spending.
            As Germany surfaces from its lackluster performance, economic activity in France will be moder-
        ating because it began fiscal 2006 on a much stronger note than Germany. However, housing activity
        and the accompanying consumer spending would return the economy to its prior strength. Meanwhile,
        Italy is likely to lag both France and Germany, and its upswing is likely to remain more tentative. The
        inability of the new coalition government to push through labor market reform is going to be the main
        risk the Italian economy faces over the short term. Absent such reform in both Italy and France, foreign
        demand is going to remain crucial to the tenor of economic growth for yet another year.
            Rising energy prices during the second half of fiscal 2006 led the headline inflation in most coun-
        tries of the region to surpass the European Central Bank’s (ECB) target of 2%. After trying to combat
        inflationary expectation by raising the policy rate to 2.5% from 2%, the ECB paused and inflation
        receded toward the rate prior to the spike in energy prices. Core inflation, which excludes energy
        prices, has also been growing more slowly than anticipated and the second-round effects of higher
        energy prices have so far been elusive. While such effects could yet surface, improving underlying
        demand rather than the spillover from past energy price increases is likely to be the main reason for
        core inflation to edge upward.
            Despite reasonable and steady inflation expectations, the ECB is going to raise its short-term interest
        rate to normalize monetary policy. The real policy interest rate has been largely negative since calendar
        2004 and that has become inappropriate for this time of better economic growth. Normalization requires
        setting the nominal rate so that the real rate remains positive. Given the inflation outlook, it will entail
        raising the policy interest rate by 0.5% during the first half of fiscal 2007. That will likely be followed
        during the second half by another 0.25% increase that brings the policy rate to 3.5% — a neutral level
        for the underlying economic conditions expected. The risk to this monetary policy outlook, however,
        is that the appreciating euro could prompt a more gradual increase in the policy rate. However, that is
        more likely to affect the timing of the rate increases than the amount.
                                                                                 Fiscal 2007 Investment Plan
                                                                                                               25



    As lasting recovery takes hold in the Eurozone, economic activity in the United Kingdom faces
relatively greater risk of remaining below trend. Since early calendar 2005, unemployment has gradu-
ally increased, wage growth has slowed and retail activity has been disappointing. While the services
sector had remained the main engine of growth, weakness in the manufacturing sector had impeded
growth. But surveys are now indicating that the manufacturing sector will have recovered fully at the
latest by the onset of fiscal 2007 and will be able to sustain positive growth thereafter.
    Meanwhile, despite easier monetary conditions, consumer spending has remained tentative. However,
that could turn around soon because housing activity has picked up its pace and better retail activity
usually follows. Meanwhile, business surveys of both manufacturing and services sectors appear to
be pointing toward optimistic hiring plans in the months ahead and that, too, should boost consumer
spending. Toward the end of fiscal 2006, real GDP could grow faster than trend, but will likely return
to the trend-like pattern during the first half of fiscal 2007. That tendency is going to be led by the
uncertainty in private investment spending. Despite revenue growth and low borrowing costs, private
investment spending has remained sluggish as businesses have been diverting some revenues away from
potential investments toward the reduction of their pension funding gaps. This regulatory requirement,
extending beyond fiscal 2007, may crimp private investment spending and prevent real GDP growth
from outpacing the longer-term trend of about 2.5%. Lackluster investment spending could, in turn,
hurt the rate of hiring by businesses.
    Expecting consumer spending to strengthen, the Bank of England has maintained its policy interest
rate at 4.5% since November 2005. Barring an unexpected negative shock to the economy, the central
bank should leave the rate at that level for at least the first half of fiscal 2007, and then signal a further
increase of 0.25% during the second half. However, if the housing sector turns out to be stronger than
anticipated, the accompanying retail activity could lead the central bank to raise its policy rate sooner.
The current policy rate, however, is very close to neutral for the underlying business conditions, and
any modest increase in the interest rate is unlikely to make monetary policy overly restrictive.
    The robust pace of growth in China and India is going to remain at the core of solid economic
activity in Asia. Instead of being pegged solely to the U.S. dollar, China’s currency, the yuan, is now
pegged to a basket of currencies that includes the euro, the yen, the Korean won, the Singapore dollar
and others. Though the relative weights of various currencies in the basket are unknown, it is believed
that the U.S. dollar still accounts for the bulk of the total and the yuan remains essentially pegged
to it. After a symbolic adjustment that amounted to about a 2% appreciation of the yuan against the
U.S. dollar, the international pressure for additional adjustment to the exchange rate eased during the
first half of fiscal 2006 because the dollar had ceased to depreciate against other currencies the way
it had in prior years. However, as global growth has improved, the dollar appears to have resumed its
longer-term depreciation and, along with it, the yuan (which is widely considered undervalued) has
begun to depreciate as well.
    This development in currency markets is going to increase the calls for more adjustment to the
yuan’s exchange rate. China’s policymakers may respond this time by marginally adjusting the weights
of other currencies in the basket, such as the Korean won, the Singapore dollar and the Japanese yen.
All told, a radical shift from the current exchange rate policy will be surprising, especially when
China does not have the basic financial infrastructure for such a shift to occur safely. It has yet to
introduce even rudimentary features such as deposit insurance necessary for private banking and capital
markets to function smoothly. A freely floating yuan in this scenario opens the possibility of net
financial outflows (rather than inflows) and a depreciation of the yuan (rather than the widely expected
appreciation). The potential for sharp financial fluctuations and the accompanying uncertainty are likely
to lead policymakers to remain cautious about floating the currency prematurely despite the U.S.-led
international pressure. With only marginal changes expected in the currency policy, China’s solid
     Fiscal 2007 Investment Plan
26



        growth will continue to be propelled by domestic and foreign investments and by private consumption
        fueled in part by robustly growing export incomes. That, in turn, is going to ensure that the rest of the
        countries in the Asian region sustain a healthy pace of economic growth.
            Nevertheless, continued pressure from the dollar’s depreciation will lead the Asian central banks
        to provide easier monetary conditions so that their currencies do not appreciate too much. Or, at the
        very least, they are likely to exercise utmost caution before tightening monetary policy. However, they
        could be forced to raise policy interest rates as further increases in energy prices increase inflation and
        boost its expectations beyond the acceptable ranges. This uncertainty about the path of energy prices,
        along with the dollar’s depreciation, may lead to monetary policy errors, especially by the region’s
        inflation-targeting central banks. Consequently, the path of policy interest rates during fiscal 2007 is
        going to become more uncertain than usual.
            Meanwhile, economic activity in Japan sped up considerably since the second quarter of fiscal
        2006. The cyclical upswing is likely to peak during the first half of fiscal 2007 and growth thereafter
        will moderate, though it will remain healthier than the unsteady pattern of the past several years.
        Accompanied by gradually waning deflation, rising asset values and a tightening labor market, this
        lasting recovery is likely to prompt the Bank of Japan to depart from its zero-interest-rate policy
        after nearly six years. However, that departure is going to be slow because the run up in the long-term
        interest rates and in the exchange value of the yen by themselves may cool some of the economic
        activity. By the end of the first half of fiscal 2007, the policy interest rate is likely to reach only 0.5%.
        Despite that increase, monetary conditions would still be easy and may remain that way until inflation
        is firmly entrenched and until policymakers are confident that the chances of slipping back into the
        deflationary spiral are slim.
            In Latin America, fiscal 2006 was marked by considerable softening of economic activity in
        Brazil. In response, the central bank slashed interest rates to 15.75% from 19.75%. More interest rate
        cuts amounting to about 3% may be in the offing because inflation has been running near the central
        bank’s target of about 4% and the real interest rate is currently much higher than is appropriate for
        the underlying economic conditions. With inflation under control and substantial monetary stimulus
        in the pipeline, the stage is set for much better economic growth going into fiscal 2007. However,
        firmer economic growth may not lead the central bank to take away all of the monetary easing as long
        as the currency’s exchange value remains relatively stable and inflation continues to remain near the
        target. Therefore, even if the central bank prepares the markets for some monetary tightening during
        the second half of fiscal 2007, the ensuing increases in the policy rate may turn out to be much less
        than the increases experienced during prior business expansions. In this probable structural change,
        real and nominal rates in Brazil may remain permanently lower than in the past.
            Similarly in Mexico, the central bank has eased monetary conditions considerably. However, unlike
        Brazil, lesser monetary easing may be in the offing. Inflation has fluctuated within the central bank’s
        target range of 2% to 4%. Though past interest rate cuts will tend to boost economic growth, that out-
        look remains vulnerable to the expected moderation in the U.S. economy to which Mexico is closely
        linked via exports. In contrast, Brazil has better growth prospects because its international trade links
        are more diversified and exports account for a smaller fraction of its economy.
            Meanwhile, Canada’s economy remains closely aligned to that of the United States. Its central
        bank, too, has followed the Federal Reserve in raising interest rates. With the bulk of the increases
        in the policy interest rate behind it, the central bank is likely to pause because the Canadian dollar
        has appreciated against the U.S. dollar by about 10% so far in fiscal 2006. That is likely to dampen
        the exporting sector over and above the slower growth because of moderating import demand from
        the United States. Meanwhile, the central bank has already raised its policy rate by 1.5%, bringing
        it to 4% — the highest level since late 2001. Together with the appreciation of the Canadian dollar,
                                                                                Fiscal 2007 Investment Plan
                                                                                                              27



this tightening of monetary conditions is likely to prove sufficient, especially given that inflation is
expected to remain well contained. This should allow the central bank to be cautious about raising its
policy interest rate too much further from the current level.
    In summary, global growth during fiscal 2007 is going to be much better than prior years as major
countries such as Germany and Japan fortify their economies. However, the cyclical rebound under
way at the onset of the fiscal year is going to give way to a more trend-like pattern as the year pro-
gresses. Central bank policies are likely to vary across regions and will be influenced by the uncertainty
of energy prices and by the developments in exchange rates across countries. Despite normalization
of monetary policies to reflect the underlying business conditions, monetary conditions are going to
remain relatively easy and supportive of economic growth for yet another year.




                                  INTERNATIONAL FORECASTS

                            Real Gross Domestic Product                      Consumer Prices
  Country/Region              2007                 2006                  2007               2006
  Canada                      2.6%                 2.8%                  2.4%               2.3%
  United Kingdom              2.4%                 2.1%                  2.1%               2.2%
  Eurozone                    1.9%                 2.0%                  2.5%               2.2%
     Germany                  1.8%                 1.4%                  2.5%               2.1%
     France                   1.6%                 1.7%                  2.1%               1.8%
     Italy                    1.5%                 1.2%                  2.4%               2.2%
  Asia–Pacific
     Japan                    2.8%                 2.2%                  0.5%               0.7%
     China                    9.5%                10.0%                  2.5%               2.0%
     Hong Kong                5.5%                 7.0%                  2.2%               2.4%
     South Korea              5.2%                 5.5%                  2.9%               2.5%
  Latin America
     Brazil                   3.8%                 2.9%                  4.3%               4.0%
     Argentina                7.0%                 7.5%                  9.0%               10.3%
     Mexico                   3.2%                 4.8%                  3.0%               2.8%
     Fiscal 2007 Investment Plan
28
                                                                               Fiscal 2007 Investment Plan
                                                                                                             29



V. Fixed-Income Investments
                                     TREASURY YIELD CURVE

                   5.50%



                   5.00%
                                                                                   5.13%

                   4.50%
   Percent Yield




                   4.00%

                                                                                   3.94%
                   3.50%



                   3.00%



                   2.50%
                           3m   6m        2yr           3yr           5yr            10yr           30yr

                                                  Maturity
                                          June 2005             May 2006




OUTLOOK
Bond Market Returns
    We expect returns in the fixed-income market to be above the STRS Ohio normal policy
returns of 5.50%. The expected total return is a combination of the market’s coupon income plus the
change in the price of the market’s securities. With the yield of the 10-year Treasury currently at 5.13%,
the income from the Lehman Universal Index is approximately 5.85%. If rates fall moderately as we
forecast, then security prices will rise and total returns will be near 6.50%. Our outlook for returns
puts this asset class at its most attractive level relative to other asset classes in several years. With
our forecast that fixed-income market returns will be greater than policy returns, the fixed-income
underweight has been removed.


Federal Reserve
   The Federal Reserve has largely completed its campaign to normalize monetary policy after an
extended period of accommodation. Following a very strong third quarter in fiscal 2006, the Federal
Reserve is currently dealing with above-trend economic growth in the United States while spiking
energy prices are adding to concerns about inflation risks. Federal Reserve Chair Ben Bernanke has
recently spoken of the lagged effects of monetary policy and the importance of the Federal Reserve
forecast to the implementation of policy. After marching the federal funds rate up 400 basis points at
     Fiscal 2007 Investment Plan
30



        a measured pace, the Federal Reserve seems to be cautious about over-shooting policy as it pursues
        the dual goal of full employment and long-run price stability. It has signaled that monetary policy is
        now more data dependent, which could create uncertainty for the markets. The STRS Ohio economic
        forecast describes the federal funds rate level of 5.00% as slightly restrictive. Relatively stable core
        inflation should limit the need to move toward a fully restrictive policy. As the economy moderates
        and inflation remains well contained, the Federal Reserve may find it can lower the federal funds rate.
        Therefore, we find the risks symmetrical around 5.00%, forecasting a range of 4.25% to 5.75%.


        Market Interest Rates
            The graph of the Treasury yield curve at the beginning of this section shows the continued flattening
        of the yield curve. Short-term interest rates have increased by 175 basis points, while 10-year yields
        have increased approximately 120 basis points. The yield curve has shifted higher and retains a small
        positive slope, reflecting an economy growing above trend with slightly restrictive monetary policy.
        Generally, the yield curve has reached a level and shape where significant changes are not expected
        over the coming year. If the Federal Reserve lowers short-term rates after the economy moderates,
        then market rates should decline and the yield curve should steepen.
            Our expected interest rate range on the 10-year Treasury note is based on the forecast that economic
        growth will moderate and inflation will remain contained. The fixed-income market is searching for an
        interest rate structure that is consistent with trend growth in the United States and improving growth
        prospects in the developed world. The United States is a large debtor and needs to continue attracting
        capital from around the world with competitive interest rates. Considering these issues, our range for
        10-year yields is 4.00% to 5.50%. Our tactical operating range is symmetrical around 4.75%, with a
        range of 4.25% to 5.25% reflecting the balanced nature of the risks in the coming year.


        Credit Quality
           Firms maintained a high level of credit quality during fiscal 2006, following three years of improve-
        ment. We expect stable-to-declining credit quality as companies continue to explore ways to enhance
        shareholder value by increasing leverage in the capital structure, marking the peak in the credit cycle.
        We expect a gradual decline in credit quality to be persistent and to continue in the coming years. We
        forecast slowing cash flow growth resulting from moderating economic conditions and developing
        cost pressures. Firms will increasingly rely on debt to fund capital expenditures, share repurchases
        and dividends — a trend which has already begun.
            A wide variety of capital market participants are willing to extend credit at favorable terms, sup-
        porting the attractiveness of increasing debt in the capital structure. More frequently, some firms are
        materially changing their capital structure by increasing the use of leverage to pay large liquidating
        dividends, engaging in private buyouts and participating in mergers and acquisitions. Little penalty
        is assigned to companies that reduce credit quality, creating strong incentives to favor shareholder
        interests. Against this backdrop, our long-term credit outlook is for deteriorating credit quality and
        widening spreads.
            High yield has recently experienced low default rates supported by strong earnings and abundant
        liquidity. However, underlying trends point toward stable-to-declining credit fundamentals as we
        expect default rates to slowly move toward the long-term averages of 4% –5% over the next several
        years. Even during the recent favorable environment of strong economic growth and low interest rates,
        rating agency downgrades have exceeded upgrades for high yield companies. Similar to investment
        grade credit, companies are generally showing a renewed interest in shareholder enhancement strate-
        gies. It is also troubling that more companies are beginning to increase leverage at a time when global
                                                                                Fiscal 2007 Investment Plan
                                                                                                              31



monetary policies are becoming less accommodative. Lending terms continue to ease, which has little
immediate impact, but will have negative ramifications in the future when market conditions are less
favorable. As the U.S. economy shows moderation in growth during fiscal year 2007, we believe these
trends will cause more concerns for investors than currently exist in today’s market.
    Emerging market credit quality has experienced a secular improvement that should result in a
stable-to-improving outlook for fiscal 2007 and lower volatility of credit quality in the future. The
average credit rating of the emerging market debt index has increased two rating categories during
the last 10 years and resides just below investment grade ratings. Many countries are reducing debt or
improving their debt profile by retiring short-term, high-cost debt and extending to longer maturities.
Debt service has also improved through better fiscal and current account positions and accumulation
of large hard currency reserves. While more resilient than the past, emerging countries are still sensi-
tive to the global economy and its impact on commodity prices and capital flows around the world.
These trends will be important to monitor as global liquidity is withdrawn by major foreign central
banks in the coming year.


STRATEGY
   Overview. The fixed-income portfolio will begin fiscal 2007 with an active management risk of
47 basis points, reflecting a lower-risk strategy. Reduced risk premiums and low volatility in the cur-
rent market justify a level of risk below our long-term average. If opportunities arise with the level
and volatility of interest rates or sector valuations, then we plan to increase active management risk
where excess returns are possible with high probabilities of success.
    Approximately two-thirds of the risk is allocated to a longer-than-market duration strategy, antici-
pating market interest rates to decline from the upper half of our forecasted range. This strategy will be
rewarded as the economy moderates to trend growth and inflation risks remain contained, generating
excess returns for fixed-income investments. Currently, the fixed-income portfolio’s relative duration
is 109%. Within our forecasted interest rate range of 4.00% to 5.50% on the 10-year Treasury, we will
actively manage the relative duration in a range of 85% to 115%.
    The remaining one-third of the active management risk is allocated to sector strategies. We are
positioned to take advantage of moderating economic conditions, deteriorating credit quality and
relative value among the sectors. We will remain underweight in lower quality corporate bonds as
the economy moderates and deteriorating credit quality leads to wider spreads. The risk and reward
trade-off for accepting credit risk relative to other high quality structured products with senior secured
characteristics results in an underweighting of the corporate bond sector. We believe residential and
commercial mortgage-backed securities are the most attractive high quality sectors to enhance yield
as a substitute for underweighting corporate bonds. We expect to hold above-market exposures to
high quality sectors such as Treasuries and residential and commercial mortgage-backed securities
throughout the fiscal year.
    Treasuries. During fiscal year 2006, we moved Treasuries from underweight to overweight as a
result of two important factors. First, this was the primary sector used to lengthen the relative duration
of the portfolio, thereby increasing the interest rate exposure of Treasuries. Second, we implemented a
strategy to increase portfolio credit quality as credit spreads tightened and relative value for Treasuries
improved throughout the year. The U.S. Treasury’s recent decision to resume issuance of 30-year bonds
after a four year absence improved the distribution of supply more evenly across the yield curve. This
accommodates increasing demand by investors for a long-maturity, liquid Treasury investment. We
will likely remain overweight in Treasuries unless credit spreads widen substantially or interest rates
decline to the lower end of our interest rate ranges.
     Fiscal 2007 Investment Plan
32



            A subcomponent of Treasuries, Treasury Inflation-Protected Securities (TIPS), was liquidated in
        the portfolio during the year from approximately 10% of total STRS Ohio Treasury exposure. TIPS
        are unlikely to be a meaningful part of our portfolio strategy this year because we forecast inflation to
        remain contained, limiting the excess return potential from TIPS.
           Government Related. Supply has been moderate in the agency sector as Fannie Mae and Freddie
        Mac, the primary issuers, have shrunk their balance sheets to help them successfully meet regulatory-
        imposed capital requirements. Along with moderate supply, valuations have been augmented by strong
        demand from foreign entities, as these investors have sought highly rated, liquid securities that yield
        more than Treasuries. While legislative and political issues remain unresolved, we expect an outcome
        that will continue to support strong agency sector credit quality. Thus, we will opportunistically increase
        our allocation to this sector as we upgrade credit quality in the portfolio.
            CMBS (Commercial Mortgage-Backed Securities) and ABS (Asset-Backed Securities). As
        we reduced exposure to corporate bonds during fiscal 2006, we moved to a large overweight position
        in AAA-rated, seasoned CMBS, favoring their high quality, structured cash flows with senior secured
        characteristics. While new issuance in CMBS has been strong and the sector has been a growing part
        of the benchmark, we chose to concentrate a majority of our purchases on seasoned AAA-rated CMBS
        originated between 2000 and 2004. These securities have similar yield spreads to new issues, but were
        originated with tighter underwriting standards and derive credit support from property values that have
        already appreciated in value. We expect to selectively add seasoned AAA-rated CMBS issues as their
        strong credit characteristics and attractive valuations relative to corporate bonds support a continued
        overweight of this sector.
            In regards to ABS, we have remained near market weight in this relatively small sector. We expect
        to selectively add exposure to AAA-rated ABS issues as valuations relative to corporate bonds support
        exposure to this sector.
            Mortgages. We maintain a moderate overweight to this sector as we favor the high quality risk
        and reward characteristics of residential mortgages over lower quality corporate bonds. Mortgage
        rates have risen to the highest levels in four years. As a result, a limited supply of fixed-rate mortgages
        should be readily absorbed by strong demand from banks, money managers and foreign investors.
        Consistent with our interest rate expectations, we believe the mortgage market will also benefit from
        low interest rate volatility over the coming year.
            The rise in mortgage rates has caused the benchmark to go through a significant transition. Three
        years ago when mortgage rates were nearly 1.50% lower than today, more than 90% of the mortgage
        market was priced above par ($100) and mortgages were being refinanced at unprecedented levels.
        Now, less than 10% of the market is above par. As a result, the concern in the mortgage market has
        shifted away from risk of refinancing to risk of a weaker-than-expected housing market. Current high
        levels of housing turnover add to returns as mortgages priced below par are redeemed at par. We expect
        recent aggregate home price appreciation of more than 10% annual growth to moderate to more normal
        levels of 3% –5%, which should still be strong enough to support current mortgage valuations. We will
        monitor relative valuations, decreasing the weight to mortgages when valuations fail to incorporate all
        risks, and increasing the weight to mortgages if the outlook and valuations become more favorable.
            Investment Grade Corporates. We begin the year underweight to the investment grade corporate
        sector, anticipating deteriorating credit quality from its current peak. The portfolio is structured toward
        higher quality issuers with an underweight to BBB-rated issuers. Currently, corporate yield spreads
        are tight, reflecting a stable credit risk environment with little compensation for deteriorating credit
        quality. Credit spreads will widen as they reflect a weakening credit environment. We do not anticipate
        an improvement in aggregate credit quality and will remain underweight to the sector based upon our
        long-term credit outlook.
                                                                              Fiscal 2007 Investment Plan
                                                                                                            33



    High Yield Corporates. We are currently underweight in high yield with an emphasis on a defen-
sive portfolio structure biased toward higher quality issuers and securities. The weighting was steadily
lowered throughout fiscal 2006 as yield spreads tightened and credit quality peaked. Yield spreads
are currently near the lowest levels historically for the high yield market. We are concerned with tight
yield spreads at a time when we forecast the beginning of some deterioration in credit quality for the
high yield market. Given this forecast and the current valuation, we will likely remain underweight
to high yield during fiscal 2007.
    Emerging Market Debt. We begin fiscal 2007 near neutral in emerging market debt after maintain-
ing an overweight since its fiscal 2001 inception. Emerging market debt has performed exceptionally
well within the fixed-income market. The sector has moved from being undervalued to fair value
relative to other fixed-income sectors. Yield spreads have moved to historically tight levels, but are
supported by stable-to-improving credit fundamentals. We will adjust our weighting depending upon
relative valuation with consideration given to the favorable credit outlook.


                                      SECTOR WEIGHTINGS
                                            STRS Ohio             Relative
   Sector                                     Weight           to Benchmark
   Treasuries                                  20.1%                126%
   Government Related                           8.9%                 61%
   Mortgage                                    31.8%                108%
   CMBS & ABS                                  11.6%                126%
   Investment Grade Corporates                 18.9%                 75%
   High Yield Corporates                        5.3%                 77%
   Emerging Market Debt                         3.4%                105%
   Total                                       100%
     Fiscal 2007 Investment Plan
34
                                                                               Fiscal 2007 Investment Plan
                                                                                                             35



VI. Domestic Equities Investments
OUTLOOK
Summary
    The U.S. equity markets have had another strong showing in fiscal 2006 with the S&P 500 up more
than 12% for the year to date and more than 70% from its lows in 2002. The markets are a little ahead
of our point estimate forecast of 8% from the last annual plan, but they remain well within our expected
trading range. Although earnings growth has been stronger than expected, pushing the markets higher,
a further upside to earnings now appears limited and slowing growth will begin to be priced into equi-
ties. Market valuations do not seem overly stretched, but in the context of slowing earnings growth,
do not seem attractive either and will not likely be the driver of continued equity gains.
   We expect the S&P 500 to trade up modestly to a central target of 1375 for fiscal 2007 (from the
current level of 1315), resulting in close to a 6% total return for the market. This is slightly below the
policy expectation for this asset class, although there is some degree of variability around this central
forecast and a range of 1150–1550 (–15 to +17%) would not be unexpected. This forecast argues for
an opportunistic strategy, taking advantage of trading moves in the markets as well as a disciplined
stock selection strategy within our portfolios.




                                        S&P 500 PRICE INDEX




            Source: Financial Times/Haver Analytics
     Fiscal 2007 Investment Plan
36



        Economic Drivers
            The STRS Ohio forecast is for moderating economic growth throughout the year, creating a solid,
        if unexciting, environment for corporate sales and earnings. In addition, high energy prices and rising
        interest rates have been weighing on the market during the past several years. These trends are ex-
        pected to wane by the end of fiscal 2007, but are not expected to lift corporate earnings or valuations
        significantly.
           High levels of profits from energy companies have been the main driver of equity market earnings
        growth over the past few years and may reverse this year. Oil prices rose to significantly higher levels
        than what we anticipated in last year’s annual plan as Hurricanes Katrina and Rita disrupted U.S.
        Gulf Coast oil supplies. In addition, concerns over supplies from Iraq, Iran, Nigeria and Venezuela
        have exacerbated an environment of tight spare capacity among OPEC members. The combination
        of weather and geopolitics has made the energy markets extremely nervous as we approach the 2006
        hurricane season, pushing the current price above $70. These high prices, however, will bring increased
        competition from new sources of energy. Two examples are the Canadian oil sands, which are now a
        profitable source of oil, and the increased interest in ethanol as an alternative fuel. Increasing conser-
        vation from consumers in the face of high prices could further reduce demand for energy, resulting in
        lower oil prices as the fiscal year develops.


                                                 ECONOMIC HEADWINDS
                            Domestic Spot Market Price: Light Sweet Crude Oil, WTI, Cushing
                                                           EOP, $/Barrell

                               Federal Open Market Committee: Fed Funds Target Rate
                                                                %
                 80                                                                                   5



                 70

                                                                                                      4

                 60



                 50                                                                                   3



                 40

                                                                                                      2

                 30



                 20                                                                                   1
                       02                   03                      04                 05

                      Sources: Wall Street Journal/Federal Reserve Board/Haver Analytics



           We projected an end to the Federal Reserve interest rate hikes during fiscal 2006 and we currently
        appear to be on the threshold of the last rate increase at either the May or June Federal Reserve meeting.
        The pause has been highly anticipated by the market and has largely been priced into current equity
        valuations. In addition, interest rates are more likely to stay steady rather than fall so they may not
                                                                              Fiscal 2007 Investment Plan
                                                                                                            37



be a catalyst for increased valuations. While an end to rate increases might initially be a short-term
boon to equity markets, we do not think that it will result in higher equity valuations until the Federal
Reserve begins easing.
    We are still concerned with the state of the U.S. consumer, particularly with the recent signs of a
slower housing market. The consumer is highly indebted and has been using home equity withdrawals
to fund spending over the past several years. Any further deterioration in the housing market could
result in lower earnings growth as well as lower valuations in the equity market.


Earnings
    S&P 500 earnings have continued to be strong throughout fiscal 2006, exceeding consensus and
our projections. Earnings will be approximately $78–$80 versus our expectations of $70–$75 in last
year’s annual plan. This represents an 8–11% increase over the previous fiscal year’s $72.25. Much
of this upside has been generated by the energy and materials sectors where commodity prices have
gone to far higher levels than we anticipated. We still believe that earnings are close to a cyclical
peak and that year-over-year growth rates will fall throughout fiscal 2007. Corporate profitability is at
unprecedented levels, whether measured by profit margins or by corporate profits as a percentage of
GDP. Three factors should act to reduce profitability in fiscal 2007. First, record profits should attract
competition and capacity expansions, particularly in those sectors earning above-normal returns like
materials and energy. Second, tighter labor markets should increase wage pressures and any gains
from here could accrue largely to labor. Lastly, high commodity prices that we have seen in fiscal
2006 are unlikely to be sustained for an extended period of time. Despite these trends, analysts are
projecting another strong year for earnings with double-digit gains expected. We are somewhat more
conservative, projecting earnings in the $80–$85 range for fiscal 2007, with a point estimate of $82.50,
a 3%–5% gain.

                                S&P 500 OPERATING EARNINGS
                                S&P Operating Earnings per share
                                     4-qtr Moving Total — ann   $/share

                                S&P Operating Earnings per share
                                     % Change — Year to Year    $/share




          Source: Standard and Poor’s/Haver Analytics
     Fiscal 2007 Investment Plan
38



                             CORPORATE PROFITS AS A PERCENTAGE OF GDP




        Valuations
           Valuations on the market remain reasonable, neither looking overly stretched nor cheap. The market
        P/E (price-to-earnings) multiple, at 17.3 times trailing 12-month earnings, is close to the long-term
        average multiple of 14–15 times. It is not unusual for the market to trade at a higher multiple in a low
        inflation, moderate growth environment; however, if we are right that earnings are at, or close to, a
        cyclical peak, a lower multiple would be justified. In any case, the multiple is unlikely to expand fur-
        ther from here and may actually contract if earnings exceed our forecast. We see a multiple between
        16 and 17 times as appropriate for our target.


        STRATEGY
           In total, the expected return on the market looks relatively modest with a central target of 1375 (16.6
        times $82.50 in earnings) for the S&P 500, representing close to a 6% total return when dividends are
        factored in. We would expect a trading range for the market of approximately 1150-1550, consistent
        with a normal level of volatility for the equity market.
           Once again, no segment of the domestic markets appears to be more attractive than another. Small-
        cap stocks have had another year of outperformance and look a little expensive relative to large-cap
        stocks. This is generally being reflected within portfolios through stock selection, and we have not
        chosen to overweight our large-cap portfolios at this time. Growth stocks also appear marginally
        more attractive than value stocks, but again, not enough to make a significant allocation change at this
        point. We have taken advantage of short-term trading opportunities throughout fiscal 2006, selling as
        markets rise and buying as they fall, and this will continue in 2007. However, should the markets rise
        appreciably, we may look to reduce our equity allocation in a more meaningful way.
                                                                                        Fiscal 2007 Investment Plan
                                                                                                                         39



VII. International Investments
OUTLOOK
    The international markets experienced their third straight phenomenal year in fiscal 2006. They ex-
ceeded the normal returns expected for the asset class by a very wide margin. Despite returning 28.5%
in fiscal 2004 and more than 19% in fiscal year 2005, the fiscal 2006 returns to date are exceptionally
strong. The World ex US Index (50% hedged) for developed markets is up 35% through mid-May,
while the MSCI EMF* Index for emerging markets is up nearly 60%. As a result, the STRS Ohio
Hybrid Index**, now consisting of 80% of the World ex US Index (50% hedged) return and 20% of
the MSCI EMF Index return (as of Jan. 1, 2006) shows a stunning increase of nearly 40%. The staff
forecasted average returns for this asset class in the 2006 Annual Plan and this has proven to be overly
conservative. At this writing, the staff expects slightly below average returns from the international
asset class over the next 12 months.

Developed Markets
    The developed markets continued their sharp ascent in the past year, returning 35%. The strong
returns resulted almost entirely from gains in country-specific equity markets and a very small portion
from the appreciation of various currencies against the U.S. dollar. However, the global business expan-
sion has entered its mature stage with continued earnings growth being met with contracting valuation
measures that will moderate potential equity gains. The Federal Reserve and ECB will respond with
further monetary tightening if core inflation rates increase from current acceptable levels. Additional
tightening measures would be detrimental to equity returns. Since the longer-term global imbalances
remain, there is potential for the dollar to fall further and offer yet more currency-based gains in the
future, but that may not necessarily happen during the current plan’s horizon.
    As far as valuation is concerned, international equity markets appear to be fully valued and will
likely fall short of normal returns. As the upswing in the current business cycle stretches beyond the
typical duration, we expect the markets to become more volatile. STRS Ohio is slightly more exposed
than the benchmark to the smaller developed markets such as Austria, Belgium, Norway and Singa-
pore as well as the Japanese market and continental Europe, where we see superior potential returns.


Developed Asia–Pacific
    Among large markets, Japan offers the greatest potential for long-term returns. Though deflation
fears are fading from view, broad-based price increases have yet to gain traction. Real estate prices are
rising in the Tokyo area, but have yet to show recovery in the remainder of the country. Nevertheless,
after more than a decade of caution, the anticipation of a healthier trend in prices has led investors to
look upon Japan’s banking sector more favorably. Banks have benefited from the asset reflation play of
choice — the equity market — which has more than doubled from its bottom but remains in a 14- year
trading range. Driven by exports to China and the United States, capital investments have gained some
steam, even though they are far below the pace that Japan can potentially undertake. Consequently,
even a modest revival of domestic consumption and credit growth from its still subdued state could
prompt the Japanese equity market to rally more than others.


 *Morgan Stanley Capital International/Emerging Markets Free Index
**Prior to July 1, 2003, the STRS Ohio Hybrid Index consisted of 75% EAFE (50% hedged)/25% EMF; prior to Oct. 1, 2000,
  the STRS Ohio Index consisted of 70% EAFE/30% EMF; and prior to Oct. 1, 1998, the STRS Ohio Hybrid Index consisted
  of 60% EAFE/40% EMF
     Fiscal 2007 Investment Plan
40



            Singapore is one of the smaller developed markets where we see value. The direct economic bene-
        fits that Singapore is experiencing from the booming Asian region makes its current valuations all the
        more attractive relative to other countries in the developed markets index. Moreover, like many other
        Asian economies, the monetary authorities in Singapore are also expected to defend the exchange
        rate of their currency against the U.S. dollar by maintaining easy monetary conditions. Thus, liquidity
        conditions in Singapore are expected to be more favorable relative to most other developed markets,
        where the central banks have either already tightened monetary conditions or are well on their way
        to doing so.
            After interest rate increases by the Reserve Bank of Australia, the country’s economy appears to
        have moved into the mature stage of its business cycle. Housing prices have moderated from their peak
        because of a rise in interest rates. In the past, Australia’s equity markets had posted strong gains and,
        for U.S. dollar-based investors, the depreciation of the U.S. dollar had added to those returns. However,
        over the next 12 months, moderating growth will likely put a lid on returns from Australian equities.
        Furthermore, since Australia’s currency is not expected to appreciate substantially against the U.S.
        dollar, the currency-related addition to the total return from Australia appears to be limited as well.


        Europe
            Continental Europe is mildly overweighted in the developed markets portfolios. Despite some
        broader setbacks at the country level, like the recent withdrawal by the French government of its
        youth labor reforms, company-specific restructuring measures are bearing fruit in financial results.
        Low interest rates have contributed to robust real estate markets, which have helped generate solid
        earnings results for banks. Valuations in continental Europe are slightly more favorable than the rest
        of the developed markets at current levels.
           Economic activity in the Eurozone has exceeded expectations and is currently approaching a
        cyclical peak. Moderate growth is likely over the next 12 months. Given the uncertainty surrounding
        consumer behavior in key countries like Italy and Germany, the region is likely to exhibit more late-
        cycle type characteristics sooner than anticipated. Not having experienced a recession in more than a
        decade, the United Kingdom’s economy is likely to exhibit a pattern typical for the mature stage of a
        business expansion.
            Meanwhile, the departure from the past economic malaise will likely lead the ECB to normalize
        its monetary policy by tightening monetary conditions. In this tightening cycle — the first in several
        years — the real rate will finally move out of negative territory as the ECB raises its policy interest
        rate by at least 0.75% during the fiscal year. This tightening will be motivated also by the gradual
        rise in core inflation, even as headline inflation fluctuates — albeit more widely because of energy
        prices – around the ECB’s target of 2%. The current overweight in the European region will likely be
        removed as the fiscal year progresses.


        Emerging Markets
            Emerging markets continued to generate robust returns, rising nearly 60% to date in the fiscal
        year, and once again far outpacing both the developed international and domestic equity markets. The
        main drivers of the strong performance have continued to be vigorous earnings growth, ample global
        liquidity and declining risk spreads. Many of the emerging countries have benefited from strong global
        trade and have improved their economic profiles.
           Returns on equity in emerging markets still exceed those of the developed world, but valuation
        discounts are now less than 10% as measured by price-to-book. Price-to-earnings discounts have also
                                                                               Fiscal 2007 Investment Plan
                                                                                                             41



declined, yet are close to 17%. Overall, we believe that emerging markets are still attractively priced
versus developed markets when considering that earnings growth and profitability should remain strong.
The asset class should also benefit from another phase of U.S. dollar weakening that may begin once
the Federal Reserve ceases raising rates. However, it will be difficult to sustain the magnitude of the
outperformance of the asset class in recent years due to the narrower valuation discounts.
    Emerging markets have been performing well partly due to enormous portfolio fund flows into
both emerging equities and debt. The Federal Reserve interest rate hikes may end soon, which would
remove a major risk to liquidity in the markets. However, both the Eurozone and Japan are likely to be
tightening their monetary policies this year, so it remains uncertain if overall liquidity will be reduced
and create a negative backdrop for emerging markets. Emerging market stocks will be susceptible to
profit-taking if investor appetite for risk-taking is softened due to higher rates or an unforeseen shock
such as a geopolitical event. However, as a group, the emerging market countries are less likely than
in previous downturns to be a source of problematic economic events as current accounts are better
balanced, foreign currency reserves are higher and foreign debt is less onerous. Valuation differences
between countries and industry sectors are still below average, so active management risk will remain
at a reduced level. A summary of our regional outlook for the next 12 months follows.


Asia
    China’s undervalued yuan currency continues to cause friction with various parties in the United
States. After a meager 2% revaluation of the yuan in July 2005, it looks unlikely that China will adopt
another, more aggressive adjustment. The trading range on the yuan is expected to gradually widen,
but the yuan may not appreciate more than 5%–8% over the next 12 months. After a 9.9% increase in
GDP in 2005, China continues to grow — strongly driven by exports, retail sales and fixed investments.
On the back of the economy’s strong performance, equity valuation has also increased significantly.
In particular, the Hong Kong-listed financial and consumer stocks have valuations that many believe
are beyond the fundamental worth of the companies. China is now trading around a 10% premium
to the emerging markets average and looks vulnerable to possible disappointments on earnings, to
volatility related to the underlying economy or to political jitters. The market appears to have greater
downside than upside at this juncture. For the first time in many years, the domestic A shares markets
should offer significant opportunity on the back of state shares restructuring. Unfortunately, the door
to invest in the A shares markets is still almost closed for foreign investors, who must tolerate some
very restrictive rules. We will remain on the sidelines until such rules are further relaxed.
    A buoyant global economy has helped Taiwan’s export sector sustain its strength. However, the
domestic economy is performing below expectations due to problems with consumer credit. The bipolar
equity market has performed like a mirror image of the underlying economy, with the technology stocks
outperforming consumer and financial stocks. Technology stocks look vulnerable if global demand
for PCs, cell phones and flat panels starts to weaken. The slow pace at which the Taiwan central bank
has been raising interest rates should help to nurture the gradual recovery of the consumer sector.
The overall market is still relatively attractive and may have less downside should there be a general
pullback in emerging markets.
    Korean domestic consumption has been steadily recovering along with rising consumer confidence.
Korea has benefited from its high dependency on the strength of the global economy. Korea enjoys a
competitive advantage in several value-added manufacturing goods. Although manufacturing wages
have risen sharply over the last decade, Korea should still be able to maintain its competitive advantage
as it has higher productivity and key technologies. The government’s plan to reduce Korea’s manu-
factured goods dependency and develop more service industry capabilities has not been successful.
     Fiscal 2007 Investment Plan
42



        For instance, a plan to develop Seoul into a financial hub for the region has not gone far. As former
        Federal Reserve Chair Alan Greenspan noted, financial services require a high element of trust and
        Korean financial markets do not currently enjoy a high level of trust.
            The Indian economy continues to expand at a brisk pace, led by strong growth in manufacturing
        and information technology services. India’s economic potential has increasingly become the focus
        of global investors, leading to large inflows of capital into the stock market. With nearly 300 million
        Indians entering the middle-class income level, there should be robust, long-term demand for goods
        and services. Over the long term, this potential should translate into significant earnings growth and
        above-average market returns. However, this apparent potential has been discovered and stocks are
        trading at historically high valuations. This fact — when combined with India’s dependence on volatile
        capital market flows to finance its current account deficit — implies significant risk of a short-term
        market correction.
            With the resignation of Prime Minister Thaksin Shinawatra in April 2006, Thailand will go through
        a period of political uncertainty until the next election is held within a year. This period of uncertainty
        will put all economic reform policies on hold. In Malaysia, corporate restructuring is moving at a much
        slower pace than market expectations. Bureaucracy and political legacy issues are hindering the plans
        of the Badawi administration. Higher energy costs are putting a damper not only on the Malaysian
        economy, but also on other Southeast Asian economies as fuel subsidies have been eliminated or
        reduced. Inflation has become an issue in these countries.


        Eastern Europe, Middle East and Africa
            The Czech Republic, Hungary and Poland are all benefiting from the recent improvement in the
        euro-bloc economies as these three central European countries are major trading partners with western
        Europe. However, the governments in central Europe are not displaying any hurry to more closely
        integrate with western Europe by joining the European Monetary Union due to domestic politics. The
        economic requirements to join the European Union would necessitate major fiscal tightening, which
        was difficult to accomplish in 2005 and 2006 due to election cycles in central Europe. However,
        in the second half of 2006 it will become clearer as to which countries are serious about economic
        reform. Hungary is in the most need of reform and will be punished by the markets if it doesn’t pro-
        ceed soon.
            The Russian equity market has benefited from high commodity prices and favorable global liquid-
        ity conditions. The advantageous economic conditions created by this boom in commodity prices
        have lessened the pressure on the government to continue much-needed reforms. With parliamen-
        tary elections scheduled in late 2007 and presidential elections in early 2008, the window to carry
        out important reforms is quickly closing. The Russian economy is heavily skewed toward the oil
        sector and a decline in oil prices is likely to have a negative impact on Russian equity markets. Turkey
        began negotiations to join the European Union in October 2005. The negotiations are expected to be
        tough and are likely to last a decade. During this time, Turkey will align its economy with those of
        other European countries. Although Turkey has made tremendous progress in containing inflation and
        attracting direct foreign investment, Turkey’s current account deficit is more than 6% and remains a
        source of risk to investors.
            The Israeli economy has benefited from an increase in technology exports and a firmer domestic
        economy. The country calmly went through the process of electing a new prime minister in March
        2006 that happened to coincide with the grave illness of the incumbent Sharon. However, the new
        phenomenon of Hamas now controlling the Palestinian government presents a new risk that will need
        to be factored into the decision to invest in domestic-oriented stocks. The Egyptian market has gener-
                                                                                Fiscal 2007 Investment Plan
                                                                                                              43



ated tremendous returns as the government continues to incrementally push through economic reforms.
The overall stock market in Egypt now appears expensive as investors from the Persian Gulf region
have pushed up valuations to levels closer to their own overvalued markets.
    South Africa’s economy has been strong due to robust exports of high-priced commodities and
government efforts to establish a more viable middle class. GDP growth estimates for calendar 2006
are around 6%. Interest rates have come down over the past few years as a result of lower inflation
rates, which are forecasted to be 4.5%–5.0% in 2006. The hot economy has resulted in a big increase
in imports and has driven the current account situation into a deficit amounting to more than 4% of
GDP. This level of current account deficit is worrisome as South Africa has a suboptimal amount of
foreign currency reserves. The South African equity market currently trades at a level that is richly
valued relative to how the market has traded in the past, so any correction in the commodity export
markets would likely cause a material decline in stock prices.


Latin America
    Several of the investable countries in Latin America are in an election cycle in 2006. There is
rationale fear that these elections will result in a movement toward unproductive economic policies
that Venezuela and Bolivia already espouse. The region’s economies have benefited greatly from the
current global upturn, but the improvements have not been materially felt by a substantial portion of
the populace.
    Mexico’s equity market continues to be strong based on lowered interest rates and signs of eco-
nomic recovery. GDP growth estimates for calendar 2006 are roughly 3.5%. Inflation has come down
sharply over the past few years, to a level approximating current U.S. inflation levels. The Mexican
economy remains closely tied to the United States’ economy as a consequence of the estimated
11 million Mexican nationals working here and sending back money, and also due to the fact that
85% of Mexico’s total exports are to the United States. However, the strong equity market in Mexico
over the past few years has left valuation at a high level compared to previous years. In addition, the
country is in the midst of a presidential election process that could produce a result in July 2006 that is
unfriendly to the markets. Currently, the left wing candidate from the Party of the Democratic Revolu-
tion (PRD) is slightly behind in the polls, but even if he wins, his party is unlikely to have control of
the Legislature, thus limiting the ability to accomplish much.
    The Brazilian market continues to record impressive gains on the heels of solid economic funda-
mentals. Interest rates continue to decline as the inflation outlook for 2006 remains positive. The central
bank has a target inflation rate of 4.5% compared to actual inflation of 5.7% at the end of 2005. Poli-
tics will play a large role during the second half of 2006 as presidential elections are held in October.
The main opposition party to the current administration is considered market friendly and could help
to further economic gains in the country. The current Lula administration, however, is enjoying the
benefits of strong economic fundamentals going into the election year. Brazil continues to increase its
foreign currency reserves and enjoys a current account surplus despite a strong currency. The outlook
for fiscal 2007 will depend on the outcome of the presidential elections. A win for Lula would indicate
a steady course with the possibility of fiscal loosening, while a win for the main opposing candidate,
Geraldo Alckmin, would indicate greater reforms and fiscal restraint.
     Fiscal 2007 Investment Plan
44



        STRATEGY
            As fiscal 2006 draws to a close, the international portfolio is approximately $18.1 billion or
        26.9% of total assets, which is the highest it has ever been. It represents a modest overweight
        relative to the Retirement Board’s new average long-term weight of 25%. For fiscal 2006, we had
        anticipated using a working range of 20% to 22%, with the asset class being moderately overweighted
        for the period. However, as the year progressed, an Asset/Liability Study was undertaken and the
        international equity weight was raised from a 20% target (which had been in place for many years)
        to a 25% target, effective Jan. 1, 2006. Staff allowed the weight in the asset class to drift higher with
        the market strength in anticipation of this change, and added $1 billion on the effective date of the
        change to maintain a slight overweight in the asset class. STRS Ohio benefited considerably from this
        decision, as international equities outperformed all other asset classes over the year. Staff is project-
        ing slightly below normal returns for the STRS Ohio Hybrid Index for the next 12 months, with the
        developed markets returning below their long-term average of 8% and emerging markets exceeding
        that to a modest degree. However, even these returns for international investments will perform in line
        or better than most other asset classes, hence the moderate overweight.
            Looking at the portfolio from a risk budgeting standpoint, the highest amount of risk is coming from
        the external managers. This is due in large part to the large core-EAFE product being run internally.
        Several of the other internal portfolios are being run very actively. The staff does not anticipate much
        of a change in the allocation of risk across the international portfolio in fiscal 2007, but the risk being
        derived from the international asset class may decline as a percent of the total as other asset classes
        modestly increase their risk.
            The chart below shows allocations for internally managed, externally managed, developed country
        and emerging market investments. At fiscal year-end 2006, we will be at a 76%/24% split between
        the developed and emerging markets, which is significantly overweighted in emerging markets versus
        the normal weight of 80%/20%. On a total fund basis, both the developed and emerging markets are
        overweight, reflecting the nearly 2% overweight to the asset class as a whole. Staff withdrew nearly
        $1 billion from the emerging market portfolios during fiscal 2006; however the weight still climbed
        throughout the year as the markets rose even faster. Staff anticipates keeping the emerging market weight
        higher than the targeted normal in fiscal 2007, but will continue to withdraw assets commensurate with
        market action. Developed markets will be kept near a normal weight of 20% of total assets. The split
        between externally and internally managed funds should continue to be approximately 50%/50%.


                                             FISCAL YEAR-END 2006
                                                       (estimated)
                                                                                      Percent of
                                              $ Invested (at Market)             International Assets

           External Managers                      $ 9,500 million                         52%
           Internal Managers                      $ 8,600 million                         48%
                                                  $18,100 million                        100%

           Developed Markets                      $13,800 million                         76%
           Emerging Markets                       $ 4,300 million                         24%
                                                  $18,100 million                        100%
                                                                                Fiscal 2007 Investment Plan
                                                                                                              45



VIII. Real Estate Investments
OUTLOOK
Overview
    As fiscal 2006 winds down, it looks much like fiscal 2005 in many ways. The composite benchmark
return, at 15.3% fiscal year-to-date, will close out the year significantly above the long-term expected
average for the third consecutive year. All of the components of the composite are once again exceed-
ing their long-term expected averages. The largest component of the composite, the National Council
of Real Estate Investment Fiduciaries (NCREIF) Property Index (NPI), which represents 80% of the
composite, stands at approximately 14% through March 31, 2006, which is 200 basis points higher than
this time last year. While the operating environment in real estate continues to show signs of steady
improvement, it is the continued supply of capital coming into the asset class, given its relatively high-
income component and lower volatility than the other asset classes, that is still driving returns.
    Transaction volume in the marketplace once again will likely set a new record this year. On a
trailing 12-month basis as of March 30, 2006, 15% of the NPI was sold, totaling $27.5 billion. This
compares to the same period of the previous two years of $20.6 billion, representing 14% of the index
in 2005, and $13.9 billion, which was 10.4% of the index in 2004. This overabundance of capital has
served to steadily increase values, resulting in an appreciation return in the NPI of an astounding 13%
for the 12-month period ending March 30, 2006.
    While this is good news for owners of existing real estate portfolios, the flood of capital has con-
tinued to put downward pressure on anticipated yields for new acquisitions over the last three years.
Notwithstanding the 16 rate increases by the Federal Reserve since June 2004, required real estate
yields have continued to decline rather than move up. We are beginning to see signs, however, that
we may have reached the bottom in many markets. Capitalization rates are likely to float around this
level for a period of time given the positive outlook for real estate fundamentals. However, we would
expect to see some increase in the second half of the fiscal year, although very modest.
    As was discussed last year, real estate is now considered a “mainstream” asset class and is included
in most asset allocation models and, thus, institutional portfolios. There are increasing global capital
flows into real estate; both the public debt and equity markets have expanded and matured, providing
greater transparency to the asset class. There is significantly increased access to the asset class at the
retail investor level as well. All this was not the case five to 10 years ago and would indicate a much
larger capital base to provide liquidity. Consequently, it is unlikely there will be a major shift of capi-
tal out of the real estate asset class from the institutional side, thus lowering the risk of any sharp or
significant declines in valuations in the near term.
    While the risk of a major change in the real estate capital markets seems relatively low — and
a positive outlook for the economy bodes well for the demand side of real estate — the biggest risk
is likely on the supply side. With the backdrop of improving fundamentals and ample liquidity, the
risk to the asset class is that all the liquidity proves too tempting for developers and investors, and
the construction of new real estate accelerates beyond what market demand can absorb, resulting in
excess supply. However, the risk is lessened somewhat with the rise in construction costs and increase
in interest rates, coupled with the watchful eye of market analysts and regulators. This should help to
keep construction in check and avoid a repeat of the late 1980s and early 1990s.
    The gap between transaction values and appraised values has been narrowing. However, we still
believe there is a lag in appraisals, thus the impact of current transaction pricing will not be fully
reflected in reported performance until late in the next fiscal year or early fiscal year 2008. Increas-
     Fiscal 2007 Investment Plan
46



        ing income streams will help to offset any small increase in capitalization rates this year. We expect
        the asset class to generate a lower return than fiscal 2006, but still well above the long-term expected
        average annual return (6.7%) of the Retirement Board’s policy.


        Property Markets
            The real estate property markets have turned the corner with broad-based improvement in the space
        market fundamentals that is expected to continue into fiscal 2007. Vacancy rates across all the sectors
        declined, with office vacancy rates at their lowest levels since 2001. Demand is expected to increase
        in the office sector as the economy continues to add new jobs and business investment remains strong.
        With demand increasing and vacancies falling in office, industrial and multifamily, there is evidence
        that rental rates have begun to move higher in certain areas, with this trend expected to continue and
        expand as the year progresses. Retail has remained stable and is expected to remain so, but with slower
        growth in sales and leasing activity. All sectors will see modest levels of new construction activity, but
        not to the level that will be threatening.
            Office has been the laggard in the real estate recovery, but the sector is finally picking up steam.
        Nearly all markets are showing signs of improvement with demand increasing and vacancies falling;
        however, the coasts are experiencing the strongest gains. The leading markets in terms of lower vacancy
        and upward movement in rental rates, albeit modest, are clustered in the East and West. Markets with
        the weakest fundamentals are in the South and Midwest. The strong job gains and increase in leasing
        activity this past year helped to push office vacancy rates down to the mid to low teens on a national
        basis. As the larger companies join small businesses in adding new workers, strong absorption is
        expected to outpace new supply in the coming year, supporting further declines in vacancy over the
        course of the year.
            New office supply is expected to rise to 45 million square feet this year, up from 38 million square
        feet in 2005. Despite the increase, deliveries will add only slightly more than 1% to existing office
        inventory. Supply reductions due to conversions and redevelopment projects are also contributing to
        tighter markets. High construction material and labor costs will help keep supply in check over the
        next few years.
            The improvement in the fundamentals of the office sector will likely put this property type back
        on the list for institutional investors’ core holdings. This will make competition stiff for quality office
        investments and thus pricing is likely to stay in the range of current levels. Central Business Districts
        (CBDs) will lead the way as the preferred sector over suburban office projects. Those assets in either
        supply-constrained urban areas or those with diversified economies such as New York, San Francisco,
        Washington, D.C. and southern California will attract the most attention. The success of this sector is
        reliant on an economy that continues to grow and produce more office-related jobs.
            The total transactional volume of apartment sales surged in 2005 by 85% over 2004 levels. An
        estimated 35% of all multifamily sales were to condo converters whose aggressive purchase deci-
        sions helped push prices higher. Increases in mortgage rates and the negative impact this has had on
        home ownership decisions have worked to decrease the condo converters’ influence in recent months.
        However, the pool of capital looking for multifamily investments remains deep, as evidenced by the
        $6.4 billion invested last year to take three multifamily public Real Estate Investment Trusts (REITs)
        — Gables, Amli and Town & Country — from the public markets to private ownership.
            Operating fundamentals in most markets have strengthened over the last year and are anticipated
        to continue gaining ground over the next 12 months — especially in supply-constrained markets. The
        two major risks to this favorable outlook on operating fundamentals are: (1) condo converters, or lend-
        ers who have foreclosed on loans, reintroducing units to the rental market because of poor sales; and
                                                                                Fiscal 2007 Investment Plan
                                                                                                              47



(2) price weakness in the for-sale housing market that makes home ownership look relatively more
attractive. However, increasing mortgage rates would offset some of this gain to potential home-
owners.
   The compression of capitalization rates has largely run its course in most markets and has bot-
tomed in the 5%–6% range, although some of the top-tier markets could be lower. We believe that as
the year progresses, there will be is an upward bias in the capitalization rates from current levels that
could offset, at least in part, the gains from the operating side.
    Demand for warehouse space has nearly mirrored real GDP growth for the past 20 years. The con-
tinuing economic expansion has fueled space absorption, which, in turn, has reduced vacancies. The
national vacancy rate stands at 8.3%. This represents a 25% decline from the last cyclical high of 11%
at the end of 2002. Historically, rent growth begins in earnest when vacancies drop to the 7.5%–8.0%
range. In some markets, this level has been achieved and rent growth is evident.
    As with all property types, the strength of individual markets varies based on intrinsic market
qualities. While all markets are strengthening, the strongest markets are currently in the West while
the Midwest, East and South have been slower to improve. While new space demand has been strong
in many markets, the weaker markets have suffered from over-supply issues due to prolific new
development.
   Investor appetite for well-leased products has been, and still is, extremely strong. This has made
new investment opportunities difficult to obtain due to the flood of money allocated to this property
type. While capitalization rates seem to have stabilized, the strong institutional demand for this sector
will likely hold pricing at current levels.
    The retail sector should continue its extremely strong performance of the last several years into
fiscal 2007. However, appreciation resulting from declining capitalization rates that are now at historic
lows and unlikely to go lower, should slow down. Further valuation gains are expected, but will be
driven by operational improvements in the space markets. Well-leased and well-located retail centers of
all types are generally experiencing strong rental growth as leases roll over. A strong overall economy
has led to fewer significant retailer bankruptcies, which in turn has helped minimize the short-term
drag on earnings from re-tenanting.
    Despite the retail sector’s very strong performance of the past few years, and a positive opera-
tional outlook for fiscal 2007, there are significant threats looming on the horizon. Several of these
threats have been present for years. The “Wal-Mart” factor is ever present and growing stronger,
causing significant problems for traditional grocers and shop tenants who depend upon traffic gener-
ated by those anchors. Most traditional grocers have been steering clear of the supercenter stores, but
Wal-Mart is furthering its encroachment into the territory of these grocers by increasingly opening
smaller, neighborhood grocery stores. The impact has yet to be felt to a large degree, but the effect
may be cumulative, putting in jeopardy the financial viability of the groceries and drug stores that have
traditionally anchored most neighborhood and community shopping centers. As a result, a recent trend
toward nontraditional anchors that operate in a niche less susceptible to the effects of a supercenter,
such as Best Buy in a large community or lifestyle center, or a Trader Joe’s in a smaller neighborhood
center, should continue.
   Other risks to the retail sector’s continued strong performance are more traditional in nature —
primarily, an economic slowdown or recession. Recent increases in interest rates, a surge in energy
costs and a topping out of residential home price appreciation affect consumer spending. Should retail
spending slow down or drop, tenant failures and bankruptcies would increase, and expected continued
healthy rental rate increases may not materialize, putting downward pressure on valuations.
   It is safe to say that if not currently peaking, the retail sector is much closer to a “top” than it has
been, and performance will be weakening, albeit off of tremendous strength. We expect that weaken-
     Fiscal 2007 Investment Plan
48



        ing to be gradual and very dependent upon the condition of the overall economy. Absent a significant
        economic downturn or recession, the retail sector should enjoy at least one more year of absolute and
        relative strong performance.


        Returns
            The real estate sector lags the overall economy from a property fundamental perspective, so
        we would normally expect appreciation to be increasing at this point in the cycle. However, the
        significant supply of capital to the asset class has resulted in significant valuation increases beyond
        that which can be attributable to the fundamentals. This would indicate the capital markets may be at
        or near a peak. This has provided appreciation in the NPI of 13.0% (total return of 20.2%) for the trail-
        ing 12 months through March 2006. The chart below demonstrates the changes in private real estate
        returns over the last three years. A decline in the income component is typically a result of falling rent
        and occupancy levels, but in this case the significant rise in valuation levels is the primary driver of
        the decline. The surge in the price/appreciation component is due to the capital market influence. The
        NPI accounts for 80% of the real estate composite index.

                                           NCREIF Property Index (NPI)
                           One Year Ending                  Income          Price         Total
                           03/31/2006                         6.6%          13.0%         20.2%
                           03/31/2005                         7.3%           7.8%         15.6%
                           03/31/2004                         7.8%           1.8%          9.7%
                           3-Year Average Annual              7.2%           7.4%         15.1%


            Although we anticipate the recovery of the space markets to continue at a measured pace, we believe
        the supply of capital will continue to support values and result in above-average total returns in the
        near term. As mentioned earlier, the index lags actual market performance due to the appraisal nature
        of the index. Although the gap is narrowing, the implied capitalization rate of recently valued proper-
        ties in the NPI is still below that of real-time transactions. This would indicate the NPI likely still has
        imbedded value to be recognized. As properties in the index continue to get revalued, and if transaction
        volume remains high, there will be strong appreciation again this year. Therefore, we anticipate a total
        market return exceeding 7% for private market real estate in fiscal 2007. However, we expect much
        lower returns on new acquisitions than the returns we will see in the index this year.
            The volatility of the public markets makes it much more difficult to predict returns with a high
        degree of certainty. While both public and private markets are ultimately affected by the same under-
        lying fundamentals, the impact of the broader capital markets is more readily seen in the public real
        estate market. Similar to the private real estate market, capital flows continue to propel the publicly
        traded REITs as investors’ appetite for the asset class continues unabated. Unlike the late 1980s, when
        institutional money was also driving up real estate values, property fundamentals are improving rather
        than deteriorating. The relatively benign interest rate environment, along with relatively low return
        expectations for the other major asset classes, are also contributing to strong performance.
            While REIT valuations are stretched by most measures, a number of public REITs have been taken
        private over the last year, which would indicate that at least some large investors consider REITs to still
        be an inexpensive way to access large real estate portfolios at attractive prices. Improving property-
        level fundamentals should help soften any decline from a valuation correction. Therefore, we are not
                                                                              Fiscal 2007 Investment Plan
                                                                                                            49



predicting a “crash” in REIT share prices, but the long stretch of outstanding absolute returns also
seems unlikely to continue. Only a strong negative catalyst would trigger a bear market in REIT prices.
Potential candidates include: interest rates rising much more than expected; a reversal of fundamentals
brought on by a collapse of demand or surging construction; or significantly improving prospects for
other asset classes. Construction levels are increasing, but none of the other potential issues appear
to be likely. In summary, we expect more normalized REIT returns in the high single digits over the
next few years, although short-term volatility can be expected. Public REITs are expected to produce
returns below that of the private real estate market in fiscal 2007, primarily due to the prospect of
multiple contraction.


STRATEGY
Allocation
    We project to end fiscal 2006 with a net increase of about $200 million from the start of the year,
with approximately $4.9 billion in real estate — down from the peak of $6.3 billion at the end of fiscal
2001. With our asset class weighting below neutral and capitalization rates bottoming, we will look to
allocate new investment dollars to real estate in fiscal 2007. Disposition activity will be very limited
in the coming year. Any sales will be as a result of the regular culling of the portfolio, with possibly
selective sales due to capital market opportunities rather than for portfolio rebalancing as has been
the case the past few years. We expect the real estate weighting will remain below our new long-term
policy target of 9.5%.


Diversification
Public Investment (REITs)
   Our weighting in REITs is essentially at our neutral target of 10%. We anticipate maintaining the
weighting close to neutral due to our underweight on the private side.


Private Investment
   Geographic
        As shown in the table on Page 50, the portfolio is currently well diversified across regions with
   the East moving from an underweight to effectively neutral this year relative to the benchmark. This
   is due to the significant appreciation in the region, as the East has gained more than a 30% price
   appreciation for the fiscal year through March 2006. This is in addition to the 20% appreciation
   at this time last year. Both on an absolute and relative basis, the weightings in both the South and
   the West have declined, moving from overweight positions to slightly underweight. The weighting
   of the benchmark in the Midwest declined significantly, thereby causing a large increase in our
   relative weighting.
     Fiscal 2007 Investment Plan
50



                                         Geographic Diversification (Core Only)
                                               (estimate as of 06/30/05)


                                                STRS Ohio               STRS Ohio vs. NPI
                             East                   33%                         1.02X
                             Midwest                14%                         1.25X
                             South                  19%                          .90X
                             West                   34%                          .97X


                We will continue to focus our holdings in major metropolitan markets across the country to
            provide for diversification — both geographic and economic. Major markets are emphasized given
            the need to hold a mixed portfolio with critical mass to enable efficient asset management, as well
            as to benefit from the increased liquidity typically found in these markets.

        Property Type
                We have been working to rebalance our portfolio over the past several years. We have made
            significant progress and will be entering fiscal 2007 with a portfolio positioned almost exactly
            where we would like it. In fiscal 2006 we were able to acquire an existing portfolio of retail
            assets in the Midwest, which included a forward commitment for additional development for a
            total investment of $100 million between the two components. Additionally, we sold just over $800
            million gross assets in the office sector, bringing the total office sales over the last three fiscal years
            to $2.4 billion. These activities helped to bring the portfolio more in line with the benchmark and
            we are well positioned going forward. The following table details STRS Ohio’s weightings in the
            four property sectors, as well as the comparison to the index. The decline of the office weighting as
            compared to last fiscal year has resulted in an increase in the relative weighting to the benchmark
            in all three of the other property sectors.


                                         Property Type Diversification (Core Only)
                                                (estimate as of 06/30/06)
                                                   STRS Ohio        STRS Ohio vs. NPI
                                Apartment              23%                  1.17X
                                Industrial             17%                   .93X
                                Office                  43%                  1.15X
                                Retail                 17%                   .74X

                We will look to selectively add office property as we see strong potential in this sector in the
            coming year. Given the softening in the condominium market, apartments look relatively attrac-
            tive again and will be strongly considered this year, especially in the coastal markets where supply
            is more limited and housing affordability remains low. There is such strong investor demand for
            industrial investment that this is a very difficult sector to add substantial investment. Industrial is
            also the area for the greatest risk of overbuilding, which requires additional caution. Although the
            portfolio is underweight to the retail sector, its strong performance over the last several years will
            not provide as much growth as the other sectors, but is still considered attractive.
                                                                             Fiscal 2007 Investment Plan
                                                                                                           51



   Property Life Cycle
       We will consider new development opportunities in fiscal 2007 as appropriate. However, they
    will likely be much smaller, on average, than what we have done in the past given the smaller
    average property size of retail, industrial and multifamily. We will consider this alternative as a
    method for accessing these highly competitive property types. We expect to achieve higher returns
    with only slightly more risk compared to acquiring stabilized core properties.


Leverage
   As of March 31, 2006, our leverage ratio is 34%. Approximately 70% of the leverage is at the
individual asset level with almost all of it related to joint ventures. We have recently renewed our
credit facility of $400 million with a floating rate of 27 basis points over LIBOR (London Interbank
Offered Rate). We have fixed the rate on $200 million of the balance at 5.65%. The maturity date on
the facility is May 2008; however, we can prepay all or a portion at anytime with no penalty. We will
manage the use of leverage in the portfolio below the policy limit of 50%.


International
   During fiscal 2006 we made new commitments to three funds totaling $130 million. The total
program has investments in 13 funds with 10 managers, with the allocation approximately 70%
Europe/30% Asia. Nine funds have completed their investment programs and are actively selling
their portfolios. It is estimated that commitments outstanding for the four remaining funds will be
$165 million as of the end of fiscal 2006. The international portfolio currently stands at approxi-
mately 6.0% ($288 million) of total real estate, which is below the 10% maximum provided in the
Retirement Board’s Statement of Investment Objectives and Policy.
    The economic environments in Europe and Asia still favor an opportunistic investment strategy.
European markets continue to see corporations and governments divest of their real estate holdings
in an attempt to increase profitability and reduce deficits. The Asian property markets, spurred on by
China’s strong growth and the continued recovery of Japan, are exhibiting more favorable fundamentals.
Furthermore, the growth of the REIT industry in Europe and Asia will provide increased liquidity for
the commingled funds as they exit their investments. We will continue to evaluate new offerings and,
to the extent an appropriate opportunity arises, we may make commitments to additional funds.
     Fiscal 2007 Investment Plan
52



                          RETURN EXPECTATIONS FOR FISCAL 2007 ACQUISITIONS
                                                                                            5-Year
                                                                                            Holding-   Overall
                                                                               Stabilized   Period     Relative
           Property      Type               Strategy          Priority         Yield        Return     Risk

           Retail        Community Ctr      Stable            High             6 25%        7 25%      Moderate
                                            Value Add         Medium           7 00%        8 25%      Moderate to High
                                            New Development   Medium to High   7 50%*       8 75%      Moderate to High
                         Neighborhood Ctr   Stable            High             6 25%        7 25%      Moderate
                                            Value Add         Medium           7 00%        8 25%      Moderate to High
                                            New Development   Medium to High   7 50%*       8 75%      Moderate to High
           Multifamily                      Stable            Medium           5 5%         6 50%      Moderate
                                            Value Add         Medium           6 5%         8 00%      Moderate to High
                                            New Development   Medium           7 25%*       8 75%      Moderate to High
           Industrial                       Stable            High             6 0%         6 75%      Low
                                            New Development   Medium to High   7 00%*       8 00%      Moderate
           Office         Central Business   Stable            Low to Medium    5 50%        6 75%      Moderate
                         District (CBD)
                                            Value Add         Low to Medium    6 75%        8 00%      Moderate to High
                                            New Development   Low              6 75%*       8 00%      High
                         Suburban           Stable            Low              6 75%        8 00%      Moderate
                                            Value Add         Low              8 00%        9 25%      Moderate to High
                                            New Development   Low              8 00%*       9 25%      High

        *Denotes return on cost
                                                                             Fiscal 2007 Investment Plan
                                                                                                           53



IX. Alternative Investments
    Fiscal 2006 represents the 10th year of STRS Ohio’s current alternative investment program. In May
1997, after a statute revision allowed us to consider alternative investments located beyond our Ohio
borders, the Retirement Board approved a broad domestic and global investment plan for alternative
investments and established a 1% allocation for this asset class. Subsequently, in May 2000, a board-
directed Asset Allocation Study increased the allocation to 2%. Most recently, the Retirement Board
conducted an Asset/Liability Study and established a 3% allocation for alternative investments effec-
tive Jan. 1, 2006, with a target weighting range of 2% to 5%. The Annual Summary of Capital Commit-
ments (see Page 54) shows a higher level of activity in conjunction with each allocation increase.
    Last year’s Investment Plan projected new commitments ranging from $250 to $500 million.
However, fiscal 2006 commitments to date have reached almost $1.3 billion, all to existing managers.
This dramatic increase in activity reflects a conscious effort to make significantly larger commitments
to our top-performing private equity (buyout) managers, which has the added benefit of reducing our
weighting to venture capital. Fiscal 2006 was unprecedented with four of our five mega-buyout fund
managers raising a significantly larger new fund. With the alternative investments allocation increasing
to 3%, we were able to request $250 million commitments from each of these managers, as compared to
an average of $75 million for their previous funds. Even with significantly larger funds, all four funds
were oversubscribed and our commitment was reduced on two of these by a total of $55 million.
    For fiscal 2007, we are projecting that new commitments will be in the $400 to $700 million range.
This compares to an average of $485 million over the last 10 years. Although it is difficult to project
the pattern of disbursements to, distributions from and valuations of our alternative investments, this
commitment pace has gradually increased our invested level to 2.7% currently, compared to 2.4% at
the end of fiscal 2005. The impact of our fiscal 2006 commitments is yet to be felt as these funds are
just beginning to invest.
    The eight commitments that were made during fiscal 2006 were distributed among domestic pri-
vate equity funds — 83%; domestic venture capital funds — 8%; and “other” funds — 9%. The only
category without activity is global/international private equity. We are no longer investing with two
of our existing global managers, and the third is a fund-of-funds manager that is currently raising a
new international fund. We have not yet determined whether or not we will invest with this manager
over concerns regarding the fund-of-funds vehicle, i.e. the additional layer of fees and the potential
for performance to revert to the mean. This international fund-of-funds manager also has a direct
international fund that is more appealing, which we are actively considering. Although we have not
made a new commitment to this category since fiscal 2001, we are not concerned about underweight-
ing international private equity. During this period, our domestic private equity managers have been
investing an increasing percentage of each of their domestic private equity funds in non-U.S. com-
panies. This activity has grown to a 25% target level in most of these funds, which provides us with
meaningful international diversification. This method for gaining international private equity exposure
is attractive since our existing domestic private equity managers have experienced investment teams
in the United States, Europe and, in some cases, Asia, creating synergies that give them a competitive
advantage over funds that are dedicated to a single market.
     Fiscal 2007 Investment Plan
54



                             ANNUAL SUMMARY OF CAPITAL COMMITMENTS

                   Fiscal Year          $ Committed          New Managers    Existing Managers
                   1996 and Prior        $49 million                7                3
                   1997 (actual)         $139 million               4                2
                   1998 (actual)         $710 million               15               1
                   1999 (actual)         $160 million               4                1
                   2000 (actual)         $677 million               6                10
                   2001 (actual)         $580 million               7                9
                   2002 (actual)         $350 million               4                6
                   2003 (actual)         $145 million               3                1
                   2004 (actual)         $303 million               3                6
                   2005 (actual)         $490 million               1                8
                   2006 (actual)        $1,295 million              0                8
                   Total                $4,898 million              54               55

                   2007 (projected)     $400 to $700 million


           The alternative investment plan provides a framework for selecting appropriate investments. The
        categories that will be considered for new investments during fiscal 2007 are listed below.
           Domestic Private Equity Funds
             • General buyout funds
             • Industry-targeted buyout funds
             • Mezzanine debt funds
           Domestic Venture Capital Funds
             • General, early- to late-stage venture funds
             • Industry-targeted, early- to late-stage investment funds
             • Structured venture finance funds
           Global/International Private Equity Funds
             • Private equity funds in established emerging regions
             • Venture capital and other types of private capital
           Other
             • Energy/natural resources (private and public)
             • Distressed debt
             • Hedge funds
                                                                                 Fiscal 2007 Investment Plan
                                                                                                               55



    The primary vehicle for these investments will be commingled partnership funds. In addition,
fund-of-funds and separate account relationships may be considered. Direct investment in private
companies will not be considered due to the additional staffing and the industry-focused expertise that
would be required. Co-investment opportunities to invest in portfolio companies alongside existing
fund managers will be pursued on a case-by-case basis with the top-performing buyout fund managers
in our portfolio. Typically, this will be restricted to vehicles providing the general partner with com-
plete discretion. Conversely, co-investment vehicles requiring the active involvement of the limited
partner are not cost effective due to the additional staffing that is required to prudently evaluate such
investment opportunities.
    STRS Ohio has a modest exposure to hedge funds through a single commitment to one of our
top private equity managers. Additional hedge fund investments will be approached cautiously
because of concerns related to: (1) declining return expectations resulting from the amount of hedge
fund capital competing for investment ideas; (2) successful funds being closed to new investors; and
(3) challenges associated with the lack of transparent reporting. However, STRS Ohio will consider
hedge fund opportunities, especially those sponsored by our existing private equity managers. The
following investments will not be considered: micro-cap stock funds; seed or “angel” funds; economi-
cally targeted funds; or commodities. Also, we are unlikely to pursue first-time funds because of our
focus on team depth, track record and expertise.
    The purchase of secondary interests in existing partnerships is another method of investing in
alternative investments, either directly or through fund-of-funds. The latter is not attractive because of
the concerns we have regarding fund-of-funds in general. Direct secondaries can be useful for tactical
allocation purposes, but this would require additional staffing, and the timing of availability of good
opportunities is uncertain. Further, the portfolio is adequately diversified at this time. In selective situ-
ations, STRS Ohio will seek approval to purchase additional interests in existing funds occasioned by
other limited partners deciding to transfer their interests. This will typically involve oversubscribed
funds where STRS Ohio’s initial allocation request was not accepted in full by the general partner.
    STRS Ohio has been successful in gaining access to the top-tier, mega-buyout funds and will
endeavor to receive significant allocations as these managers raise new funds. In addition, there are a
handful of other mega-buyout fund managers that warrant our consideration as they raise new funds.
Our existing middle-market buyout managers will continue to earn our support as long as they can
continue to produce a compelling track record and value proposition. New relationships in this area
will be considered on a highly selective basis due to the challenge of evaluating the large number of
middle-market buyout fund managers that exist. The use of a separate account vehicle, i.e., a discre-
tionary fund-of-funds customized for STRS Ohio, will be considered as a means to leverage staff’s
ability to identify the best prospects.
    Access to top-tier, legacy venture capital funds continues to be a major problem for STRS Ohio.
This was recently exacerbated when the Ohio Attorney General (AG) decided to sue the general
partners of the Ohio Bureau of Workers’ Compensation’s (BWC) alternative investment portfolio.
The AG is seeking to release portfolio company-level data that was collected after concerns surfaced
regarding the BWC’s rare coin and hedge fund investments. Prior to the AG’s lawsuit, STRS Ohio had
been able to rely on the “trade secret” exceptions in the Ohio open records statutes to satisfy general
partners’ requirements that STRS Ohio not disclose portfolio company-level information that would
be harmful to these companies. Unfortunately, the AG decided that the public interest in disclosing
this information outweighed the potential negative economic impact on the underlying investments.
Knowledge of the AG’s lawsuit caused one of STRS Ohio’s top venture capital funds managers to
prohibit us from investing in its most recent fund, even though we had invested in its two previous
funds, both of which are generating top quartile returns.
     Fiscal 2007 Investment Plan
56



            As mentioned above, we are working to reduce our weighting in venture capital. This is appro-
        priate because of: (1) the difficulty accessing top venture funds; (2) the historical underperformance
        of this portion of the STRS Ohio portfolio; and (3) the relative venture overweight in the portfolio.
        From 1983 to 1997, STRS Ohio could only invest in Ohio-based venture capital. The results from our
        Ohio-based managers was a negative single-digit return that was below median during a period that
        produced some of the most attractive venture returns in history. With respect to the overweight issue,
        the appropriate neutral weighting in venture capital is generally considered to be approximately 25%,
        versus our current 30%. We have attempted to address this by increasing our emphasis on top buyout
        funds (discussed above) and by being highly selective when deciding which existing venture capital
        managers to support when they are back in the market to raise their next fund. New venture capital
        relationships will be added only if top-tier performance is a strong possibility.
            New capital commitments projected to be made during fiscal 2007 will be focused on top-
        performing or potentially top-performing successor funds for existing or new managers in all categories.
        The portfolio continues to be adequately diversified among these four categories. The emphasis on
        domestic private equity funds over the past year with new commitments totaling more than $1 billion
        has increased the percentage of total commitments to 57% from 47%. Since very little has been funded
        on these new commitments, the current market value of the venture capital portfolio has only dropped
        to 30% from 31%, but we expect this shift to accelerate during fiscal 2007. The commitments as of
        April 30, 2006, are shown below (current percentages shown in parentheses). We anticipate that the cate-
        gory allocations during fiscal 2007 will generally stay within the percentage ranges shown below.


                                     CAPITAL COMMITMENTS BY CATEGORY
                                                                  Actual                  Projected
                                                               Commitments            Allocation Ranges
                                                               April 30, 2006             Fiscal 2007
                Domestic Private Equity Funds                $2,780 million (57%)          55–65%
                Domestic Venture Capital Funds               $1,335 million (27%)          20–30%
                Global/International Private Equity Funds     $450 million (9%)             5–10%
                Other (Energy, Distressed & Hedge)            $333 million (7%)             5–10%
                TOTALS                                          $4,898 million              100%


            Most alternative investment opportunities involve a long-term investment horizon, illiquidity and
        a high volatility of returns. For these reasons, expected financial returns should, in theory, exceed
        those of other asset classes. Based on the Retirement Board’s Asset/Liability Study, alternative asset
        returns are expected to be 10.7% (net of fees) over the long term. Returns on individual funds generally
        follow a pattern referred to as the “J-curve,” which expects negative returns during the early years,
        followed by progressively increasing positive returns thereafter. Since more than 25% of our existing
        commitments were made during the last year, the “J-curve” effect can be expected to have an impact
        on near-term performance.
            The tech bubble, the burst of the bubble and the ensuing recovery defined alternative investment
        performance for STRS Ohio over the past six years. After a 31.4% return in fiscal 2000, the next
        three years produced negative returns that averaged –11% per annum. The public market recovery
        finally impacted our alternative investment portfolio in fiscal 2004 and 2005, producing a 19.7% and a
        21.3% return, respectively. The fiscal 2006 year-to-date return is 13.7%, and should be higher by fiscal
                                                                                Fiscal 2007 Investment Plan
                                                                                                              57



year-end. All categories produced positive returns year-to-date, with “other” private equity outper-
forming the other categories by producing almost one-third of the $214 million valuation increase
with strong performance in the energy and distressed debt sectors.
    The most important measure of performance for alternative investments is the cash-on-cash internal
rate of return (IRR) that limited partners receive from such investments. Unfortunately, these returns
cannot be calculated accurately until the gains and losses have been fully realized, which is closer
to the end of the usual 10-year term of such funds. Returns based on interim valuations that attempt
to calculate unrealized gains or losses are not reliable since there is not a uniform, industry-accepted
method for determining valuations on a mark-to-market basis. It is unlikely that this can ever be
addressed and, along with the problem of survivor bias, explains why there is not an accepted industry
benchmark for this asset class. Therefore, the 2007 Investment Plan is projecting alternative investment
returns to be below the 10.7% return established in the Asset/Liability Study.
    For the past two years, the Retirement Board’s consultant provided an informal evaluation of
alternative investment performance, including: (1) using IRRs to evaluate the more mature funds in the
portfolio in comparison to vintage-year, industry data; (2) comparisons to the Russell 3000 Index plus
300 basis points over rolling periods of not less than three years; and (3) comparisons to the absolute
return target of 10.7% using longer time periods of up to 10 years. This analysis generally shows lag-
ging, but improving asset class performance as the portfolio works through the periods when it was
being ramped up in response to allocation increases.
   During fiscal 2007, the alternative investments staff will:
   •    Continue to evaluate successor and new fund opportunities to improve the overall return
        potential of the portfolio;
   •    Continue to decline commitments to the follow-up funds being raised by existing managers whose
        track records cause us to believe that their next fund will not produce attractive returns;
   •    Continue to reduce our exposure to venture capital funds;
   •    Continue to opportunistically sell public shares distributed to us by the general partners;
   •    Evaluate hedge fund relationships with our existing managers that would meet our investment
        goals;
   •    Seek solutions to the problem of accessing top funds that was created by the AG’s lawsuit
        against BWC general partners;
   •    In response to our internal audit, determine if there are cost-effective software or services solu-
        tions that will assist in the measurement and attribution of performance, and the verification of
        capital calls, distributions, or management and other miscellaneous fees; and
    •   Hire a senior-level analyst to add to the alternative investments team.

				
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