Legislature(2003 - 2004)
02/24/2004 03:37 PM Senate STA
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* first hearing in first committee of referral
+ teleconferenced
= bill was previously heard/scheduled
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SB 326-PERMANENT FUND INVESTMENTS
CHAIR GARY STEVENS announced SB 326 to be up for consideration.
He asked Mr. Storer to step forward.
ROBERT STORER, executive director of the Alaska Permanent Fund
Corporation sat down and introduced himself and Ron Lorenson who
is outside counsel to the permanent fund.
MR. STORER described the request to increase the investment
flexibility of the permanent fund as a timely and important
issue. As background he reported that AS 37.13.120 sets out
statutory investing guidelines for the board to follow including
adherence to the prudent-investor rule. He noted that the
permanent fund is one of the last public funds, including those
managed by the Department of Revenue, that is guided by statute.
He maintained that, "The challenges for managers of the
permanent fund are to be able to manage the fund in a
contemporary way in what is in fact a very dynamic industry, and
deal with legislative changes that allow us to meet that
challenge."
MR. STORER noted that he would address his comments to the
Investment Flexibility handout that members had in their
packets. The following is his verbatim testimony.
Over the next couple of pages you'll see the history
of some of the legislative changes that the permanent
fund has asked for and received support for. The
bottom of page 3, which was SB 156, was approved in
1999. In 1999 the Permanent Fund Board of Trustees
were allowed one exemption from the statutory list and
it's what we call the "basket clause."
SB 156 actually did a couple of things. One was
increase our statutory limitation investing in the
stock market from 50 to 55 percent. But it also
allowed the administrators of the permanent fund to
make investments outside of the statutory list, but
still following the prudent investor rule. The prudent
investor rule really defines a process that allows one
to make an informed decision. That's the criteria that
is involved in the prudent investor rule.
The permanent fund was given permission to invest up
to 5 percent of the fund outside of the statutory
list. To suggest that we took this ability and ran out
and got into all kinds of investments is not so. In
fact, we are just now four years later, after a lot of
evaluation of different opportunities; we are just
about to implement some of the strategies that are
embedded in the basket clause. I think that is an
important issue. When we ask for permission, we still
approach our responsibility prudently.
Page 4 simply shows if you look at the statutes - and
I call it the maturation of the permanent fund - the
permissible list. You'll see how the asset allocation
of the Alaska Permanent Fund has changed over years. I
actually started work ... at the permanent fund in May
of 1983. Why do I say that? One, I do have a sense of
history and the other is I arrived in May of 1983 and
the permanent fund had just received permission to
invest in the U.S. stock market and, in fact, they
funded their first equity managers in June or July of
1983. You can see the non-U.S. investments occurred in
the late 1980s etc.
Why are we proposing - and Ron will tell you the
technical aspects - we're proposing a couple of
things. The essence and the most important thing may
be increasing the "basket clause" from 5 to 15
percent. That is to allow future administrations of
the permanent fund to meet what is a very dynamic
industry changing its investment options to have the
latitude to address a changing investment world as
they occur.
Another [reason] is potentially to allow different
instruments that will allow us to increase our return
objective over some time. Another one - and it's not
necessarily contradictory - is the more investment
options you have, the more you can diversify your
portfolio or reduce your risk. In a conversation I had
with Senator Stedman I believe if you asked us do we
have all the diversification we need right now the
answer is yes. And we had that conversation. But if
you ask me what do we need in the future, we need the
flexibility to respond to changing financial markets.
To address them in a contemporary manner so we cannot
ignore the need for potential expanded diversification
in the future.
Last item and it's not on this list but it's a
management tool. There are certain things that we
could do in the course of business that are not
incurring more risk. It's sort of the arcane or
complexity of investment management, but it would be
ways to implement strategies in a low cost way that we
are precluded from currently because of the
limitations on the statutory list.
I've added a list of the asset allocation. Every year
we visit our asset allocation and we adopt it by
resolution. Our March 10 and 11 board meeting we will
be making a recommendation for some adjustments to the
asset allocations. What you see is our current asset
allocation. You'll see it broken down between domestic
equities, U.S. stocks; international equities, foreign
stocks; U.S. bonds and I would note that the U.S.
bonds are all investment grade. Either all U.S.
treasuries [which are] agencies of the U.S. government
or high grade corporate debt, and then non-dollar
bonds, which are mostly sovereign issues by Japan,
England etc. and 10 percent allocation to real estate.
I'll use domestic equities as an example. Our target
is 37 percent, but we create bands around it. You'll
see on domestic equities it's plus or minus 7 percent.
Our goal is to create a discipline, that when you
reach a certain point - hopefully through appreciation
- you automatically rebalance closer to target. By the
same token, when our equity investments go down there
is an inflection point where we must rebalance closer
to target. That's a tough one because usually it's a
lot harder to put new money in a declining stock
market because it takes a real discipline. It occurred
in October of 2002. No great insight other than the
fund went outside its bands, but it turns out we
missed the bottom of the bear market by about four
days. It was a superb piece of timing, but that was
more discipline than it was a particular skill.
The point is we try to have bands that are reasonable
but not get into a lot of rebalancing because there
are a lot of transaction costs that one occurs when
you rebalance so we try to have some reasonable bands
around our target.
Why am I noting that? I'm noting that because on the
current statutory limitations, we will be - if the
board adopts the recommended asset allocation - up
near our statutory limitations in both the "basket
clause" and equities. What does that mean? That means
that our investment managers in the board will not be
deciding our asset allocation. Statutes will be
deciding our asset allocation. It suggests that right
now our stock - our managers - decide when we'd
maximize our return. They will then sell that stock
and buy other stock, but we will be forced by
statutory limitations to limit the upside potential on
stocks. Of course, risk is not symmetrical because the
stock market can go down so we have some statutory
controls on how much we can gain on appreciation, but
not so on the down side.
That is another reason why I think it is a compelling
argument and I hope you will agree that we need to
expand our flexibility. Not in terms of making pure
decisions, but simply to let the permanent fund take
advantage of the appreciation in the financial markets
when they occur.
This is the first opportunity I've had to address the
Legislature on this issue. On the last page I tried to
think of what would be some of your questions,
criticisms - whatever you want to call it - and I came
up with three.
The first thing I would ask if I was scrutinizing this
is would the fund be taking too much risk if they were
given this latitude. Of course we can't speak for
future administrators of the fund, but I can give you
a history lesson. I've had the privilege of working
with all but four trustees of the Alaska Permanent
Fund Corporation. I have worked for, been or known
every executive director of the Alaska Permanent Fund
Corporation and I have worked for or with every chief
investment officer in the history of the Alaska
Permanent Fund Corporation.
What I have observed is the corporate culture of the
administrators of the fund - they have always used
this investment privilege very prudently and very
conservatively. We have always spent time trying to
ferret out fads from real contemporary issues and we
are more than content to watch and learn from others'
mistakes. If history is a lesson of this, I would say
that we've used our privilege of expanded investment
flexibility judiciously, carefully and I think the
fund has benefited from that.
How will the board of trustees use this flexibility?
That's a key issue that I would ask and one of the
main things, as I've noted, is to allow future
administrators the flexibility to address contemporary
investment management issues. So to some degree I
don't know. I can identify some sort of cornucopia of
options or the myriad of options that are available.
Clearly one use, and the immediate use would be to not
have the statutory constraints if the funds assets
appreciate and we would hope that they would. We are
currently using a bit of the statutory "basket clause"
or the outside of the statutory identifications to
invest in private equities. [It would be a] small
weighting - no more than 3 percent and [we would]
probably take several years to implement. We probably
won't start investing our first dollars until late
spring, early June. That alone, if we're successful -
and of course we spent a lot of time studying it -
success actually will take that 3 percent over a 5
percent limit because of appreciation right there. We
are going to propose to the board something that I
think is unique.
The term of art right now is called an absolute return
strategy. You see it in the papers a lot - it's called
a hedge fund. Sometimes you see negative press on
hedge funds. You always see the headlines in the
negative. It's not necessarily bad, but what we're
doing in the first time of the permanent fund is we're
recommending a pilot program - a program that will be
small enough so that if there are problems it will
have, we hope, virtually no impact on the performance
of the fund. By the same token, if it's successful it
will have virtually no impact on the permanent fund.
These are sophisticated investment philosophies and we
want to learn from the live experience. The other
thing that is unique in this proposal is we're going
to have a sunset clause. The contracts will be good
for up to 36 months and then that investment strategy
will die as a matter of course. We're not saying we
want this flexibility in perpetuity. We think it has
merit, but we want to learn more from it.
The last one is derivatives. That was a more
pejorative word in the '80s and earlier '90s and less
so now. What are derivatives? The simplest definition
- it is an investment instrument that derives its
return from some other investment. An example would be
hedging your equity exposure using an equity contract
- either a forward or a futures contract. That's not
investing in the stock market, but the returns on that
contract will be derived by the reality of what
happens in the stock market. That's called a
derivative - people use derivatives to hedge their
exposure. You can use a derivative to gain exposure in
a certain market - immediately while you invest then
systematically in the stocks you want as an example.
Would there potentially be derivatives? The answer is
yes, hopefully in a very deliberate manner.
CHAIR GARY STEVENS asked Mr. Lorenson for his comments.
RON LORENSON, outside counsel for the Alaska Permanent Fund
Corporation, walked members through the bill and gave an
explanation of the recommended changes.
He suggested focusing on Section 2 first because that contains
the "basket clause." The provision begins on page 1, line 14 and
continues through line 10 on page 2. He explained that
subsection (g) is what Mr. Storer referred to as the legal list.
It describes the investment forms that the Permanent Fund
Corporation is authorized to invest in with the exception of the
basket clause.
He continued to say that in addition to (g), there are other
provisions under [AS] 37.13.120 that provide a restriction on
investments under certain circumstances.
That's what has raised the concern or the interest of
the Permanent Fund Corporation in terms of making some
adjustments in the way the basket clause would
operate. Right now, under the basket clause provision,
it says, 'Notwithstanding (g)' and that means even
though there is this legal list, you don't have to
follow the legal list for up to 5 percent of the value
of the assets of the fund. You can go outside the
legal list as long as the other investments satisfy
the prudent investor rule.
With respect to that 5 percent, it's okay to go
outside that legal list. There are, however, under (h)
and (i), which are the two provisions you'll see at
the bottom of page 1 in section 2 that are proposed to
be added to the language authorizing the 'basket
clause' - there are some additional restrictions in
(h) and (i), which by a legal interpretation, if they
aren't specifically acknowledged, would continue to
operate to restrict the use of the 'basket clause.'
I was involved in 1999 when the bill was presented to
the Legislature and passed, it wasn't the intention of
the drafters or ever in discussion with the
Legislature that those two provisions operate to act
as restrictions on the 'basket clause.'
What (h) does is say that futures contracts can only
be used under certain very restricted circumstances.
Overall it makes sense in terms of a conservative
approach to investment, but in terms of the prudent
investor rule and flexibility under the basket clause,
applying that limitation on futures has the effect of
potentially limiting various kinds - particularly
hedge funds - that the permanent fund might otherwise
be able to invest in as a result of the basket clause.
(i) says that the permanent fund cannot invest in any
fixed income asset bond - essentially - where there
has been a default on the interest payment in the last
5 years. It makes a lot of sense as a general
investment guideline, but to the extent that you want
to be able to take advantage of the 'basket clause'
and use various funds of alternative investments such
as some of the high yield bond type products that
might be available. It acts as a restriction and
limitation that again, wasn't intended when people
were visualizing what the basket clause might be used
for.
He pointed out the other change on page 2 increases the size of
the basket clause from a maximum of 5 percent to a maximum of 15
percent.
Subsection (e) in section 1 says the corporation can't borrow
money as part of its investment strategy. The second sentence
was then added to permit investments that the corporation was
involved in - and at that time the only focus was on real
property investments - to permit real property investments of
the fund - to borrow money is a way of leverage potentially as
part of the investment in a particular piece of real estate.
What (e) does is say the permanent fund corporation
can't borrow money as part of its investment strategy.
It makes a lot of sense and no one has suggested that
the permanent fund should borrow money as part of its
strategy. But the second sentence was then added to
permit investments that the corporation was involved
in - and at that time the only focus was on real
property investments - to permit real property
investments of the fund - to borrow money is a way of
leverage potentially as part of the investment in a
particular piece of real estate.
When the permanent fund invested in real estate, it
always does it through a holding company - an LLC or a
limited partnership. It doesn't do it directly and
that's what this language authorizes. The holding
company can borrow money as part of its investment
strategy with respect to an asset as long as there is
no recourse back against the permanent fund
corporation. In other words, as long as the only
reliable entity is the holding company and there is no
ability to go back and sue or pursue a claim for
default against the corporation.
That's the way it's set up for real estate. There's no
reason not to provide the same flexibility for other
forms of holding entities - limited partnerships in
the area affirmative investments - private equity for
instance. We're just recommending there, that the
restriction for real property be taken out, but the
limitation remains. That is that the corporation
cannot borrow money directly. If money is going to be
borrowed, it is part of the investment strategy of the
corporation. It has to be through some other legal
entity that isolates the corporation from liability if
things don't go right.
SENATOR JOHN COWDERY asked how many dollars 15 percent might
represent at today's value.
MR. STORER answered 10 percent would represent $4.2 billion.
SENATOR COWDERY inquired about the type of investments that are
considered.
TAPE 04-9, SIDE B
4:22 pm
MR. STORER replied there are numerous options most of which he
wouldn't support, but an example of investment expansion could
be private equity buyouts. Some hedge funds have absolute return
strategies and there are a myriad of sophisticated approaches.
An obvious approach would be high yield debt, which can be a
speculative investment. Another category of high yield debt is a
company that has fallen out of investment grade and is
restructuring. The latter doesn't offer as much investment
opportunity as the more speculative type, but it is a way of
increasing fixed income returns beyond investment grade. He
suggested that is a standard tool that deserves consideration.
Some funds are looking at timber, agriculture and commodity
based investments. He wasn't endorsing those, but they do fall
within investment grade.
He noted that many funds are diversifying and some endowments
and foundations are becoming more aggressive on the absolute
return strategies.
SENATOR COWDERY mused the corporation must support the concept
and a number of desirable options must be unavailable currently.
MR. STORER maintained the options are numerous and some are
worthy of evaluation. He asked members to remember that it took
more than two years of study before they concluded that they
wanted to invest in the private equity market. When he
identifies the options as worthy of consideration, he assured
members that a lengthy and in depth study is part of the
process. Certainly, he wouldn't support some of the options he
mentioned.
SENATOR COWDERY asked if new investment managers would be
selected or guidelines changed.
MR. STORER replied nothing like that would change. He noted that
the corporation manages quite a lot of money internally and the
staff does very well. However, "These, by and large, are more
sophisticated investments that require more personnel, more
analysis etc. So the answer is we would most clearly seek
outside expertise to assist us in managing those assets."
To do that, he said, they establish criteria, which might
include expected returns, types of options, and benchmarks and
standards. The consultant would be told to review peer groups
that have expertise in that area. They look at performance as
well as how long they have managed that type of discipline. They
look at the depth of the organization and an analysis of whether
or not repeated success is likely. After that, three prospects
are brought in for interview and the board makes a selection
from there.
He advised that any time they make an investment policy it is
posted on the web site. There are resolutions for every asset
class or discipline that managers must follow broadly and then
contracts further tighten the guidelines.
SENATOR COWDERY asked if a manager had ever underperformed and
had to be changed.
MR. STORER replied they try to stay with a manager as long as
their discipline works because there are transaction costs
associated with change. Although there are a number of issues,
one is whether the assets are managed as represented and another
questions whether they are managing it well. They look at
whether the management style is out of favor or whether the job
is simply done poorly.
He pointed out that one equity manager they selected in 1983
still has "a substantial relationship with the permanent fund
and the others have not so they have been fired for performance,
for personnel turnover or for mergers...or simply we have
decided that we need to implement different strategies."
SENATOR HOFFMAN noted he was around in 1999 when the Legislature
made the last change. Although he doesn't have any reservations
about adding (h) and (i), the request also triples the amount of
funds that wouldn't be restricted by the investment rule. To put
$4.2 billion into perspective, he called it $4,200 million.
Although they are the same, the latter sounds like a larger
number. "You're asking for a lot more flexibility" and he
questioned whether that might not be too much risk.
He reminded members that the POMV (percent of market value)
question was also before legislators. Currently the state
doesn't use the earnings from the permanent fund, but that could
change if POMV passes and a percentage of the earnings is
allotted to government and the state comes to rely on that
income. When you become dependent upon your earnings, it's
natural that you become less willing to assume risk, he
reasoned.
MR. STORER agreed with the last statement saying that, "The
sooner you need the money, the more conservative you should be."
SENATOR HOFFMAN interjected, "The more you're dependent on it."
MR. STORER agreed adding that stock market investment is for the
long term. He confirmed that Senator Hoffman correctly
identified the two issues. He called the first issue house
cleaning related to the original intent and the other issue is
potentially expanding the risk from 5 to 15 percent. However, as
he identified earlier,
As a management tool, one of the things that we will
be doing right now is restricting ourselves because of
the statutory limitations so it actually could work -
we wouldn't have to change our asset allocation - and
the current statutes would be an inhibitor on our
return simply because we would be forced to liquidate
assets because of statutory limitations, not what the
market and asset allocation tells you.
He also made the point that even at 15 percent, the permanent
fund is probably the most restrictive and conservative public
funds in the country. It is far more restrictive than the state
retirement system, he said.
They are not cavalier when it comes to large numbers, but they
are used to managing money and the implications of large
numbers. He said, "I'm not prepared to suggest that the future
managers of the fund would put all their eggs in a $4.2 billion
basket. I don't know, but I think the opposite would occur." He
agreed that Senator Hoffman's concern is valid, but he
maintained that the increased investment latitude would be
diversified and they would continue to follow the rules of
prudent investing.
SENATOR HOFFMAN recalled that in the early '90s, the fund
managers asked to invest in foreign stocks and that wasn't a
very good decision for the first several years.
He then asked where the sunset clause was referenced.
MR. STORER explained that it related to just the one issue and
they intend to impose the sunset clause in their investment
policies and not statute. That one investment strategy will be a
very small component, he said.
SENATOR HOFFMAN said, "You're not saying that that should be
considered in this legislation and the Legislature should look
at it in three years and see how the fund is doing."
MR. STORER maintained that a statutory sunset on the investment
strategy would not be a good idea, but frequent performance
evaluation is always a good idea.
SENATOR BERT STEDMAN said he understood private placements but
he needed further clarification on increasing the basket from 5
to 15 percent. He questioned whether future markets might be
used and if so, how much and where would they be used.
MR. STORER replied they would be used. Future markets are
currently used to a small degree and he could see a day when
they would be used more. Although they have never done so, they
can use futures to hedge a long position. Fund managers use the
futures market on currency on international investments because
they tend to have longer settlement dates. When you make an
international investment, you invest in the company and in the
currency. Managers use futures to lock in the currency rate at
the time.
He said more and more often, managers are employed to use
futures in more sophisticated ways. There is danger in that
though because a residual futures contract is potential
leverage. They aren't suggesting such use and are very mindful
of that issue.
However, using futures as a management tool to mitigate
transaction costs can be worthwhile. For example,
We have a significant payout annually to - for the
dividend payout and one could take their cash flow and
instead of investing in - and it would be a small
component - the stock market and incurring a
transaction cost and then selling it later and
incurring another transaction cost. One could use
either future or forward contract that expires - that
takes the cash and commits that to a future so that it
expires right on that date to reduce transaction
costs. My guess is that the dividend costs right about
2 to $5 million in transaction costs. So that's one
type of tool, but there are a myriad of ways one could
use them. I would assume they would be used not now,
not next year, but maybe five years down the road. I
would expect to see more use of futures contracts -
forward contracts, but I can't tell you the magnitude.
SENATOR STEDMAN said they would use short-term futures to bridge
a settlement timeframe versus hedging the currency on the
portfolio.
MR. STORER replied that would be one way and another would be to
mitigate transaction costs for funding the dividend.
SENATOR STEDMAN viewed it differently. He said, "If you're going
to access the futures market for short timeframes to mitigate
your calendar on your settlement versus using futures to hedge
currency in your international portfolio - particularly your
international bond portfolio. So there's no intent to do that?"
MR. STORER replied, "No, not right now."
SENATOR STEDMAN said, "So there's no intent to use the basket
move from 5 to 15 [percent] - where you can actually start
getting a fairly good chunk of leverage on your portfolio - to
go in and speculate or leverage up your equities portfolio. It
would always be used as a hedge?"
MR. STORER replied they weren't discussing that use right now
and although he couldn't say it would never happen, he couldn't
envision that the board would leverage their equity portfolio in
the foreseeable future.
With regard to increasing the flexibility now and the reference
to the ability to invest in the international equity markets, he
said, "There seems to be a classic event that occurs when the
permanent fund is trying to increase their investment
capabilities. What happened during that period [1999] is that it
was only through the success of the international equity markets
- and specifically in Japan - that we were able to get
legislative ability to make international investments."
The point Senator Hoffman made was correct, he said; their
initial investment in the international equities market went
down. Fortunately they didn't invest a great deal of money, but
since that time the international market returns have been
significant. In fact, international equity markets have
outperformed the domestic equity market in the last several
years.
He concluded, "You have to justify your ability by showing how
these high returns occur and it's like all things, you overshoot
in both directions. That is the point of getting flexibility
now."
4:50 pm
CHAIR GARY STEVENS noted that it was getting late and the
members had a number of questions on the issue. Furthermore, 35
people were waiting to speak on the next bill. He stated he
would like to return to this at a later date.
MR. STORER replied, "We would be delighted Mr. Chair. It's an
important issue and we want to make everybody comfortable."
CHAIR GARY STEVENS held SB 326 in committee.
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