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.