ALA Endowment Trustees Report to Council
Sunday, January 13, 2008
This report provides information regarding the performance of the ALA Long Term Investment Fund (LTI) i.e. the Endowment Fund. It is provided as a supplement to the oral report given by the Chair of the ALA Endowment Trustees. This report also provides information on the general condition of the financial markets, the performance of the individual portfolio managers and other issues that impact the Endowment fund that are viewed as important to the membership. This report will be placed on the Treasurer’s web page after this Midwinter Meeting.
Attached for your review are charts ( Exhibits #1-7 and 8) detailing the value of the portfolio, the allocation of the assets by type, investment style and manager. Also included is a historical review, manager investment style/benchmark comparisons and other pertinent information related to the management of the Endowment Fund.
Financial Year in Review - 2007
Heading into 2007 volatility was the watch word of the day. Volatility did not disappoint. Few people remember that at the start of 2007 the talk of the town was falling oil prices when a barrel of oil was only $52. At the same time the Dow Jones Industrial average went over 12,500 for the first time ever. Technology stocks finally rebounded after years of lackluster performance and large cap company’s, i.e., large cap multinationals that supplied developing markets rode a global rebound, particularly in the emerging markets. Everything was rosy and climbing. Then on February 27th the world received a wake up call from China. China sneezed and the financial world received a shudder when speculative rumors resulted in a major sell-off in Shanghai that spilled over to the rest of the world’s financial markets, leading to the worse day of trading in four years. This gave pause to investors and was an indication they were at least considering a revaluation of their appetite for risk, particularly from emerging markets. Soon thereafter in March creditors for New Century Financial, a major sub-prime mortgage lender, was forced to stop making loans amid rising defaults. This was the first sign that a sub-prime problem was beginning to bubble to the top.
Because of easy credit, banks made funds available as quickly as possible. At the same time lending standards were diminishing and scrutiny transactions buyout firms used the cheap debt to fund ever bigger mergers and acquisitions. Private equity investment firms scoured the market for cheap stocks and the ability to generate cash—a critical factor since buyout firms layer their debt onto the companies they buy. Large buyers of these leverage pool of funds were hedge funds, as well as, mutual funds. By the time June rolled around defaults and foreclosures of mortgages were in the headlines and the prices of these securities were collapsing. At the same time Bear Stearns was forced to lend $3.2 billion to two of its hedge funds, which were heavily invested in sub-prime mortgage bonds. This move staved off a major spiral in the financial markets worldwide. The mortgage woes are now spilling over into the stock market, bring triple digit declines. As we rolled into the late summer and early fall, banks and securities firms were now reporting billion dollar losses. Hit hard were value stocks, value funds and financial stocks.
While all the above was going on, Federal Reserve was not just an innocent bystander. They moved from an attitude of vigilance about fighting the good fight against keeping inflation at bay, to one of providing liquidity and lowering rates to shore up the functioning of the credit markets. They had to constantly stick to the plan against calls from the market to move faster. When the market didn’t get from the Federal Reserve what they expected or wanted the market drop precipitously. patiently observing the situation and quietly put in place an interest rate reduction program designed to keep the economy from slipping into a recession.
All told there were four major corrections in the market during the year and a record number of ripple digit trading day declines.
Indeed, 2007 was quite a rollercoaster ride highlighted by extreme volatility.
Endowment Fund Performance
For the twelve months ended 12-31-07 the value in the ALA Endowment fund increased by approximately $2.2 million from $29.0 million to $31.2 million—see exhibit #2. This resulted in a return of 8.4% compared to the portfolio’s benchmark of 6.5%. As we can see from exhibit #5 most of the portfolio managers reported positive results and outperformed their respective benchmarks. Their results were as follows:
—Core manager—returned 14.3% compared to its benchmark of 5.5%. Alliance is the portfolio’s equity stabilizer with holdings in the growth and value categories, currently 70/30. They make investment decisions based on long-term secular market themes, along with some catalysts to provide support and short term economic trends. As noted in the last report Alliance Bernstein structured its portfolio to overweight technology and underweight energy eight months before the rest of the market. This hurt their 2006 results. Since the first quarter of 2007 the market has been bearing out their conviction and they have significantly outperformed their benchmark. In the last report management indicated their belief that they would make up the 2006 shortfall in 2007. They were correct.
Marsico —Large Cap Growth manager—returned 14.1% compared to its benchmark of 11.8%. Relative to the index Marsico is overweight in consumer discretionary’s, industrials and financials and underweight by a significant margin in information technology. Marsico runs a concentrated portfolio with approximately 30-50 securities.
Blackrock —Large Cap Value manager—returned 2.5% compared to is benchmark (S&P/Citigroup Value) of -0.4%. As a result of the deterioration in the economy i.e. subprime issues, credit liquidity concerns, weakening dollar etc. there was a rotation out of value stocks and into growth stocks, particularly large cap growth.
NFJ —Small Cap manager—returned 4.3% compared to its benchmark (Russell 2000 Value) of -9.8%. As there was a rotation out of value stocks to growth, there was also a rotation from small caps to growth. Coming into 2007 small cap stocks had outperformed large cap stocks for five consecutive years. Despite the rotational change, NFJ was able to significantly outperform its benchmark. This is a direct result of stock picking by the manager. This asset category typically performs well coming out of a recession. It is also one of the first categories to be hurt at the onset of a recession. In anticipation of the rotation out of small cap stocks exposure in this asset category was reduced during the year.
Lazard —International manager—returned 8.6% compared to its benchmark (MSCI EAFE) of 11.2%. There are 38 stock markets in developed and emerging countries around the world and all but nine reported positive gains. Lazard was helped by a strong showing in Europe and limited exposure in Asia. As a defensive manager they will typically not beat their benchmark in a growing mark, but offer down side protection.
Heitman —REIT manager—returned -16.8% compared to its benchmark (Wilshire Real Estate Securities) of -17.7%. Going into 2007 the expectation was that the REIT market was due for a slowdown as historical valuation levels were reached. Defaults on loans to less creditworthy borrowers created a broader credit squeeze. House prices fell, homeownership dropped, foreclosures soared and housing became the soft spot in the economy. Commercial real estate peaked in early 2007 when Blackstone Group LP paid $23.0 billion for office giant Equity Office Property Trust and immediately sold off pieces for record prices. As credit tightened throughout the economy and the economy shows signs of slowing growth, commercial property values titled downward. Despite the performance this asset category continues to spin off a significant amount of interest to the benefit of the association.
PIMCO —Fixed Income manager—returned 9.3% to its benchmark (ML US Bond Market) of 7.0%. 2007 was a year when investors sought safety from the volatility of the equity markets. It should be noted that this is the first time in five years that the fixed income portion of the portfolio outperformed the equity portion.
Ariel Capital —SRI manager—returned -1.4% compared to its primary benchmark (Russell 1000 Midcap Value) of -1.4%. Relative to its index Ariel’s performance was hurt by the fact that Because of Ariel’s unique standing in the investment community in that they are an SRI fund that compares itself to a more industry standard benchmark i.e. non-SRI (Russell 1000 Value), we have also provided two SRI specific indices, the Domini 400 and the KLD Social Select. These benchmarks returned 3.7% and 4.5% respectively.
Asset Allocation and Rebalancing
See exhibit #4 for details on the asset allocation strategy and current allocation. The practice of rebalancing is based on an assessment of the prevailing risks and opportunities in the market. The Trustees’, in conjunction with its investment advisor, continually monitor the portfolio and look for new opportunities to boost performance at appropriate levels of risk.
Based on prevailing market conditions the portfolio and the expectation of a slowing economy small cap stocks were underweighted. There has also been an under-weighting of the large cap value portion of the portfolio and a corresponding increase in the large cap growth portion as a result of the rotation by the market out of value stocks and into growth. As evidenced in exhibit #5 both the growth and core managers have benefited from the reallocation. The REIT weighting was reduced during the year as valuations reached historic levels and were not expected to be sustained, per the recommendation of the portfolio manager. The weighting in the fixed income portion of the portfolio continues to increase to its target weighting of 32% as the Federal Reserve has suspended its program of interest rates hikes.
Note: The Trustees meet on a monthly basis via telephone, with ALA staff and Merrill Lynch—ALA’s Investment Advisor—to review the Endowments’ investment performance, asset allocation and other matters. As a result of this practice and asset allocation decisions made by the Trustees’ during the course of the year, based on prevailing market conditions.
Future Outlook in 2008
What challenges await investors as we approach 2008? Clearly volatility will continue and be a constant companion. The market is still faced with the prospect of rising oil prices and its potential impact on the economy. At the current level of interest rates (5.25%) the Federal Reserve has little wiggle room to positively impact the economy, particularly with inflation showing signs of being rekindled. The medicine needed to battle a weak economy and to fight rising inflation work against each other i.e. raising rates for inflation, reducing rates to keep the economy growing. Some tough decisions await the Federal Reserve. Housing has not yet quite reached its bottom or the spill over effect to other parts of the economy. The current administration, with the specter of a presidential election looming, is making rumblings of a possible fiscal stimulus package.
As the Trustees have stated on many occasions in the past, no one can accurately predict the future. In a worse case scenario the price of oil sprints past $100 a barrel. Emerging markets such as China and India overheat and collapse. Housing issues continue to accelerate the decline in home values and increased foreclosures. Inflation gets serious. In the best case the current five year “Bull” market finds a second wind and keeps moving forward, thus avoiding a recession. The global boom continues its torrid pace serving as an outlet for the products and services of large US multinationals. Lowering interest rates have the intended positive impact on the financial markets as the credit market disruption corrects itself, while housing finds a bottom.
All told, all we do know is that we can expect more volatility.
Investment Policy Review
As part of the Trustees’ regular business, an annual review is made of the ALA investment policy. During their fall meeting in November a review was made with the ALA investment advisor—Merrill Lynch—and ALA’s finance staff. As a result a number of changes were made and recommended to the ALA Executive Board. The recommended changes will enable the individual portfolio mangers an opportunity to better meet and outperform their benchmarks.
On behalf of the Trustees I would like to thank the ALA Finance staff who assists the Endowment Trustees in carrying out our duties. We continue to be especially well served by Greg Calloway, Keith Brown and Elaine Klimek of the ALA financial staff. They have been very dependable, reliable and thorough in assisting the Trustees in our financial oversight responsibilities.
Robert Newlen—Chair (2008)
Dan Bradbury—Trustee (2009)
John Vitali—Trustee (2010)
Rod Hersberger—ALA Treasurer, Ex Officio (2010)