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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.