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Nebraska Investment CouncilBlank Sheet Equity Review – Summary of Activity to Date and Current Thinking

June 2017

Aon Hewitt | Retirement and InvestmentProprietary & Confidential Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. 2

The Domestic / International Blank Sheet review started in June 2016– Managers were chosen from a combination of top managers in Pension and Investments as well

as managers participating in the Global Equity Review– Joe & Jeremiah contacted 23 managers and met with 21 managers. These 2 hour meetings took

place from June 30th through September 12th

During the manager meetings a few common themes kept coming up– The Investment Staff met a couple of times during November and early December to discuss

themes and develop questions for Aon. Joe & Jeremiah sent Aon 15 questions regarding these themes along with 3-4 pages from each manager’s presentation that best described their solution.

– In January 2017 the Investment Staff met to discuss Aon’s responses. On March 2nd Aon presented their own blank sheet review, taking into consideration the common themes that we identified. The Investment Staff met again on March 7th to discuss Aon’s blank sheet review.

Common themes:– Reduce / Eliminate Home Country Bias

• We had 9 managers come in and make this recommendation; this was the most common theme we heard

– Use a Global Mandate / Passive International• There were 5 managers that made this recommendation

– Leave Currencies Unhedged• We had 3 managers make this recommendation, but we originally told the managers to

ignore the issue of hedging since historically the portfolio has been unhedged

NIC Investment Staff – Summary of Process


While the original focus of this review was the optimal implementation of the U.S. and Non-U.S. Equity components, we are generally of the view that public equity sub-asset classes should be viewed holistically

As such, this review focuses on the optimal implementation of the total allocation to public equities

Overview

Long-Term Target AllocationU.S. Equity 29.0%

Non U.S. Equity 13.5

Global Equity 15.0

Total Public Equity 57.5%

Real Estate 7.5%

Private Equity 5.0

Fixed Income 30.0

Total Portfolio 100.0%

DB/CBB Plans


Above (right) we illustrate what our “blank sheet” approach to equities would like for NIC– Cap-weighted approach (i.e., no home country bias)– Current ≈1/3 active / ≈2/3 passive split is maintained; however, all active exposure is now obtained

via global equity mandates• The size of the allocation to active global mandates increases by roughly 1.7X

– Active risk level (i.e., the degree to which the return of the total equity allocation is expected to deviate from its benchmark) increases slightly, but remains similar to existing structure

IronBridge is replaced with Dodge & Cox; global manager relative weightings adjusted modestly

Current Equity Structure vs. Pro-Forma “Blank Sheet” Equity Structure

MFS, 10% Ironbridge Dodge & Cox,

7%

Arrowstreet, 11%

Wellington, 5%Passive Global Equity, 67%

DFA (U.S.), 5%

BlackRock Russell 1000 Index (U.S.),

45%

MFS (Global), 5%

Ironbridge (Global), 4%

Arrowstreet (Global), 8%

Wellington (Global), 3%

BlackRock ACW IMI (Global), 7%

BlackRock World ex‐U.S. IMI (Non‐

U.S.), 14%

Baillie Gifford (Non‐U.S.), 4%

Gryphon (Non‐U.S.), 6%

Current Structure “Blank Sheet”


Current Structure vs. Pro-Forma “Blank Sheet” Equity Structure (Cont’d)

Relative to the existing structure, we think the pro-forma “Blank Sheet” equity structure has the following advantages:

1) Cap-weighting improves diversification, maximizing long-term risk-adjusted returns of the equity allocation

2) Active management is deployed only in mandates where we think the odds of success are greatest (i.e., global)

3) Reduction in number of active managers increases “active share” (i.e., reduces the potential for closet indexation), and should lead to reduction in investment management fees• Larger mandates increase negotiating power

In order for the “Blank Sheet” structure to be considered superior to the current equity structure, one needs to believe the following:

1) Broader mandates (e.g., global) give a manager a better chance for success than narrower, region specific mandates

2) A cap-weighted approach to the equity market has better risk-adjusted return prospects than an approach that is biased towards U.S. equities


The table above illustrates the percentage of active managers that have outperformed their respective benchmarks net of fees across various categories over the last one, three, and five years

– As shown, only a small percentage of active managers have had success adding value in recent years

– International mandates appear most attractive (or “least unattractive”), followed by global mandates and U.S. mandates

– We believe there is a fair amount of noise in that International fund data, however • i.e., structural differences between international managers and the benchmarks they are being

measured against (USD hedging, exposure to U.S. domiciled companies, lack of exposure to EM, etc.)

Our “house view” is that 1) equity markets are hard to beat, and 2) broader mandates like global give skilled active managers the best chance to add value

Active Management – The Case for Global Mandates

Percentage of Funds Outperforming their Benchmarks – Periods Ending 6/30/2016*

Trailing 1 Year Trailing 3 Years Trailing 5 Years5 Year Average Value Added

Large-Cap U.S. Funds 15.4% 18.7% 8.1% -2.5%

Mid-Cap U.S. Funds 12.1% 16.2% 12.1% -2.5%

Small-Cap U.S. Funds 11.2% 5.9% 2.4% -3.9%

Global Funds 24.7% 23.0% 17.6% -1.9%

International Funds 45.1% 45.5% 39.6% -0.3%

*S&P Indices vs. Active (SPIVA) U.S. Scorecard – Mid-Year 2016


Active Management – The Case for Global Mandates (Cont’d)

Arguments for global mandates include:– Markets around the world have become more integrated

• Increasing cross-border M&A activity, expansion of domestic corporations sales’ overseas, increasingly common accounting standards, etc.

– Correlations between U.S. and Non-U.S. markets have risen– Global mandates allow for wider opportunity sets and “best in class” stock selection

NIC’s own experience with actively managed U.S., Non-U.S., and Global Equities provides support to the notion that global mandates offer the best active management prospects

Trailing 1 Year

Trailing 3 Years

Trailing 5 Years

Trailing 10 Years

Since Inception

Inception Date

Total U.S. Equity 13.3% 8.6% 14.8% 7.1% 9.6% 7/1/1983

Custom Benchmark 12.6 8.4 14.6 7.2 10.5

Total Non-U.S. Equity 2.6% -1.0% 5.8% 0.5% 5.2% 10/1/1991

Custom Benchmark 4.4 -1.4 5.3 1.3 5.6

Total Global Equity 7.7% 3.1% 9.9% 4.2% 6.5% 9/1/2005

Custom Benchmark 8.4 3.2 9.6 3.7 5.6

Cumulative Periods Ending 12/31/2016


Home Country Bias

Most institutional investors forecast long-term returns for non-U.S. markets to be at least as good as those that can be earned in the U.S.

Finance theory suggests holding an equity portfolio in market proportions is optimal But institutional investors have always invested a substantially greater proportion of equity in their

home countries It has been described as one of the puzzles of modern finance; possible explanations:

– Greater optimism regarding home market; greater perceived risk in non-domestic markets– Greater fees and costs in non-domestic markets– Less information/transparency in non-domestic markets– Liabilities denominated in home currency– Sensitivity to peer comparisons

AHIC Long-Term Return

Forecast

AHIC Forecasted

Volatility

Horizon Survey* Avg

Return Forecast

Horizon Survey* Avg

Volatility Forecast

U.S. Stocks (Large-Cap) 6.4% 17.0% 6.6% 16.9%

U.S. Stocks (Small Cap) 6.6 23.0 7.0 21.0

Non-U.S. Stocks (Developed) 7.3 20.0 7.1 19.5

Emerging Market Stocks 7.5 30.0 8.5 26.4*Horizon Actuarial survey of 2016 capital market assumptions from 35 independent investment advisorsExpected returns of the survey are annualized over 10-years (geometric).


Public Funds’ Movement Towards a Cap-Weighted Equity Allocation Over the Past Decade

56.7%

43.3%

0%10%20%30%40%50%60%70%80%90%

100%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

U.S. Stocks Non‐U.S. Stocks

Composition of Equity Allocation: Public Funds >$5 Billion*

Composition of Equity Allocation: Public Funds $1-$5 Billion*

59.1%

40.9%

0%10%20%30%40%50%60%70%80%90%

100%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

U.S. Stocks Non‐U.S. Stocks*Greenwich Associates – Institutional Investors Market Trends 2007-2016

The Council currently targets a split of approximately 65% U.S. Stocks / 35% Non-U.S. Stocks within the DB Plans’ equity allocation

– This represents a home country bias of ≈10%-15%

In recent years, peer public funds have sought to reduce their equity exposure’s home country bias

U.S. equities have produced stellar returns over the past several years, dramatically outpacing their non-U.S. counterparts

– Equity market valuation levels (please see next slide) suggest now might not be a bad time to move closer to a cap-weighted approach


Equity Market Valuations Levels – U.S. vs. Non-U.S. Markets

Russell 1000 Forward P/E Ratio (Large-Cap U.S. Stocks)

Russell 2000 Forward P/E Ratio (Small-Cap U.S. Stocks)

MSCI EAFE Forward P/E Ratio (Developed Market International Stocks) MSCI Emerging Markets Forward P/E Ratio


Why Move to a Capitalization Weighted Portfolio?

A capitalization weighted portfolio approach places the global market as the natural starting point It acknowledges that deviations from market weights of regions are active investment decisions Geographical constraints limit investors’ ability to capture growth opportunities For passive investors, a capitalization weighted portfolio captures the global investable opportunity

set and provides for efficient market beta exposure For active investors, a capitalization weighted portfolio provides the freedom to select the best

stocks and leads to higher potential to generate alpha

6.4%

6.6%

6.8%

7.0%

7.2%

7.4%

7.6%

17.0% 18.0% 19.0% 20.0% 21.0% 22.0%Exp

ecte

d N

omin

al

Geo

met

ric R

etur

n

Expected Risk (Volatility)U.S. Equity Non-U.S. Equity Cap-Weighted

Current NIC Equity


Reducing home country bias means increasing exposure to other currencies– The Council’s liabilities are denominated in US dollars; exposure to other currencies is an uncompensated risk

Exposure to other currencies could be hedged but:– There is a cost associated with hedging– Currency fluctuations tend to wash over time– Human nature often leads to sub-optimal decisions from a timing perspective

A Few Comments on Currency

Why Hedge Currency? Why Not?

Returns are difficult to forecast Currency exposure is a relatively small proportion of the overall portfolio

Risk is likely to be unrewarded Implementation is deemed too costly and/or complex

Will likely reduce overall equity volatility Cash flow volatility is undesirable

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