SB 326-PERMANENT FUND INVESTMENTS    CHAIR GARY STEVENS announced SB 326 to be up for consideration and asked Mr. Storer to identify himself for the record. ROBERT STORER, executive director, Alaska Permanent Fund Corporation, introduced himself and advised members that Ron Lorenson, outside counsel, was on line to answer questions. To address the discussion about how the corporation would use the increased investment flexibility, he distributed a chart outlining how they would use the basket clause over the next several years. He said: We are in the late stages of implementing a private equity program ... and that takes several years to get it up to the 3 percent target. Then we're also recommending a pilot program that will be - we call it alternative investments - that's the sort of contemporary term - many people call it hedge funds. Hedge funds have some notoriety in the sense that they use a lot of leverage and when they don't work they get a lot of headlines. This proposal that we are suggesting will not be that kind of hedge fund. We're suggesting a pilot program to learn with no more than 1 percent. It will expire within 3 years, but I think the key is that it is not going to be risky. We're going to have a targeted, expected risk of equal to or less than the fixed income market - a bond market. It's not going to be leveraged up to get excess returns over the equity market. It'll be structured in a very conservative manner and we hope to learn from this program, but it will not be designed as a risky investment. One of the problems with where we are right now is that we are close to our statutory limitations. We hope we have a wonderful problem, which is what happens if it all works. If it all works, the fund will increase - these target allocations will increase, but we're also going to have a problem, which means statutes not the markets will define when we must liquidate the assets. That, Mr. Chair, is why we're asking for increased flexibility in the basket clause. CHAIR GARY STEVENS referred to the new chart and asked for verification that the traditional asset class [gray bar] is not part of the basket clause. MR. STORER said, the blue bar represents the unused portion in the '03 bar chart. He then pointed out that as the 5 percent is implemented there would be a 1 percent target to hedge funds and 1.5 to 2 percent in private equities. Moving out to '05, there will be 3 percent private equity investment and over that time, the basket clause will essentially be used up on a cost basis so with appreciation there will be problems. SENATOR BERT STEDMAN asked Mr. Storer to go over the effects of the leverage when it moves from 5 to 15 percent. MR. STORER said he would answer the question at the extreme, but because they are driven by diversification, the probability of placing all the eggs in one basket is extremely unlikely. He continued to say that if they increased risk for dramatically higher returns they could only use the full 15 percent. He said he wasn't prepared to suggest they do that, but even that is low versus some real estate portfolios that are leveraged to 50 percent. "That would probably be the most volatile scenario that I could think of in terms of using all the investment." SENATOR STEDMAN used the example of putting $100 down to control $1,000 of some entity and said, "I assume then that you're looking at the weighting effect of the $1,000; you're not counting the $100." MR. STORER replied that is correct. In that example, they would use the basket clause and count the leverage and not just the $100 investment. SENATOR STEDMAN asked if there is a diversification gain by targeting a return that would be about equal to the bond market return. MR. STORER said that's true, but you can gain diversification in far more ways than just more equities or more return. The corporation is working to develop a conservative instrument such as the targeted risk of a bond market or less as opposed to the more volatile equity market. At present the corporation is looking for alternatives to fixed income, not increasing their equity exposure so the 1 percent target would reduce the fixed income exposure. They expect to get some additional incremental return greater than the fixed income market. SENATOR STEDMAN asked Mr. Storer to explain the effect that interest rates have on their bond portfolio. MR. STORER explained: The major component of a fixed income security is the yield of the security and when you buy it, you will buy that security to yield X. That's a snapshot in time, but during that whole period you will earn that yield. Let's just say that the environment is 5 percent so that means that if you earn that security for life, you get a 5 percent yield. But every time interest rates change, the price of that security changes to reflect the changing interest rate environment. So what will happen in a rising interest rate environment is we will continue to get that 5 percent yield, but that security that we paid $100 for will become worth $99 become worth $98 so that diminishes the value of the investment. Of those two components, historically the yield has been the largest contributor of return, but in a lower interest rate environment you get greater profits from the principal and in a rising interest rate environment you will end up losing some principal. SENATOR STEDMAN opined that the concept is important because "the impression I'm getting is that you want to broaden out this asset class and you want to target that bond - roughly the return you would get in a normal bond environment - and there probably will not be a normal bond environment coming at you - and you want to have some diversification for that area to hopefully give you an incremental, if not a positive rate of return, at least pushing in that direction." MR. STORER agreed with the assessment. If interest rates stay stable or rise they would expect the 1 percent allocation to have a higher return plus some diversification from a volatility factor, but part of our goal is to have a higher return than the bond option. SENATOR STEDMAN noted that historically returns are yield rate averaged over the years. He then brought up a previous discussion regarding reducing the request from 15 percent to 10 percent. If that change were made, he questioned how long it might be before the corporation would return to the Legislature and ask for a review of the basket clause limit. MR. STORER said it would depend on need and the financial markets, but he estimated that they would be back within two years. SENATOR COWDERY asked about the reason for the request. MR. STORER replied there are two basic reasons for the request. The immediate one is to address that there are arbitrary constraints on the successful management of the fund. The corporation could be forced to liquidate assets because of statutory constraints rather than due to market conditions. The other more long-range reason is to create flexibility to meet the ever-changing financial markets. CHAIR GARY STEVENS asked Mr. Lorenson whether he had anything to add. MR. LORENSON told him that he was listening and available to answer questions from a legal standpoint. SENATOR STEDMAN offered an amendment to change the request from 15 percent to 10 percent [page 2, line 3]. CHAIR GARY STEVENS asked if there was any objection to the amendment and there was none. He asked for a motion to pass the bill from committee. SENATOR COWDERY made a motion to move CSSB 326(STA) from committee with individual recommendations and the attached fiscal note. There being no objection, it was so ordered.