fresno county employees’ retirement association asset allocation study march 1, 2006
DESCRIPTION
Fresno County Employees’ Retirement Association Asset Allocation Study March 1, 2006. Jeffrey MacLean Chief Executive Officer. SEATTLE 999 Third Avenue Suite 3650 Seattle, Washington 98104 206.622.3700 telephone 206.622.0548 facsimile. LOS ANGELES 2321 Rosecrans Avenue Suite 2250 - PowerPoint PPT PresentationTRANSCRIPT
Fresno County Employees’ Retirement Association Asset Allocation StudyMarch 1, 2006
Jeffrey MacLeanChief Executive Officer
LOS ANGELES2321 Rosecrans AvenueSuite 2250El Segundo, California 90245310.297.1777 telephone310.297.0878 facsimile
SEATTLE999 Third AvenueSuite 3650Seattle, Washington 98104206.622.3700 telephone
206.622.0548 facsimile
WURTS & ASSOCIATESPAGE 2
Overview of Presentation
I. Inputs & Assumptions
II. Analysis & Results
WURTS & ASSOCIATESPAGE 3
SECTION I
Inputs & Assumptions
WURTS & ASSOCIATESPAGE 4
Consensus Expectations - Returns
Notes: Compound Returns. Investment Consultant 1, 2, & 3 were provided by Ennis Knupp, whom performed the survey.
Asset ClassConsultant
1Consultant
2 Consultant 3Consultant
4Consultant
5Consultant
6Consultant
7
Goldman
Sachs SSGA
Large Cap U.S. Equity 7.70% 8.50% 8.70% 8.50% 8.00% 8.85% 8.40% 8.00% 7.50%
Small/Mid Cap U.S. Equity 9.85% 9.00% 7.70%
International Large 7.70% 8.50% 8.70% 8.80% 8.00% 9.25% 9.50% 8.00% 9.10%
International Small 10.00%
Emerging Markets 9.80% 10.50% 8.00% 9.90%
U.S. Core Fixed Income 5.00% 4.80% 6.10% 5.25% 5.40% 4.75% 4.50% 5.00% 4.50%
High Yield Fixed Income 6.80%
TIPS 4.40%
Foreign bonds 5.10% 4.70%
Real Estate 7.30% 7.30% 7.00% 7.50% 7.60% 7.20% 6.00%
REIT's 7.10% 7.10% 7.50% 7.20% 6.80% 5.80%
Hedge Funds/Abs Return 8.50% 6.50% 7.00%
Timber 9.40%
Commodities 4.5-7.0% 7.30%
Private Equity / Venture Capital 10.60% 11.70% 11.70% 12.80% 11.00% 11.00%
Cash 3.10% 4.20% 3.25% 3.50%
Inflation 3.00% 3.10% 2.90% 2.60% 2.90% 2.50%
WURTS & ASSOCIATESPAGE 5
Expected Rate of Inflation
Cash Bonds
U.S. Stocks
InternationalStocks
Wurts & Associates utilizes a combination of fundamental analysis and a building block approach to construct projected returns for key asset classes.
International Stocks: The historical relationship between returns for international and U.S. stocks is examined to determine if a premium should exist for international stocks. An overlay of fundamental analysis is applied for minor adjustments.
U.S. Stocks: We estimate an Equity Risk Premium based upon the historic range of premia. This is fine-tuned with fundamental returns decomposition.
Bonds: We believe that a bond’s yield is an unbiased measure of market expectations regarding future returns. Given historically low rates and the high level of fiscal and monetary stimulus, we believe rates will rise over time, and the current yield should be adjusted as a predictor of future returns.Cash: We examine the historic premium of cash instruments to inflation and compare to the current yield and inflation rate. A qualitative judgment is made about the size and sustainability of the premium given today’s environment.Inflation: We utilize the break-even inflation rate between the ten-year TIPS and conventional Treasuries as a starting point. Adjustments are made based upon our view of the macroeconomic environment.
Building Block Approach: Description
WURTS & ASSOCIATESPAGE 6
Market Implied 10 Year Inflation Estimate:
• Market expects inflation of
2.4% over next ten years.
• We believe that this
measure is too low:
•Fiscal and monetary
stimulus
•Need to “reflate away”
large public and private
debt levels.
• We leave the inflation
forecast unchanged of
2.70%.As of January 3, 2006.
Market Implied 10 Year Inflation Estimate
4.4%
2.0%
2.4%
0%
1%
2%
3%
4%
5%
Nominal Yield TIPS Yield
10 Year Yield Implied Market Inflation
Return Assumptions: Inflation
WURTS & ASSOCIATESPAGE 7
Source: Ibbotson. Data ending 12/31/2005. Current Yield on T-bill matures Feb 3, 2006: WSJ.
Compound Annual Average 1926-2005
3.73.0
0.0
1.0
2.0
3.0
4.0
5.0
30 Day T-Bill US Inflation (CPI)
Return Assumptions: Cash
Current Yield as of January 5, 2006 & 2005 Inflation
3.93.5
0.0
1.0
2.0
3.0
4.0
5.0
30 Day T-Bill 2005 US Inflation (CPI)
WURTS & ASSOCIATESPAGE 8
Starting bond yield is an excellent predictor of subsequent ten-year performance:
Source: Ibbotson. Data ending 12/31/2004. 10 Year Govt Bond Return: 50% Intermediate Gov’t & 50 LT Gov’t. Starting 10 Year Govt Bond Yield: 50% Int Govt Yield & 50% LT Govt Yield.
Rolling 10 Year Return vs. Starting 10 Year Yield
0.0
3.0
6.0
9.0
12.0
15.0
1926 - 1935 1936 - 1945 1946 - 1955 1956 - 1965 1966 - 1975 1976 - 1985 1986 - 1995 1996 - 2005
10 Year Govt Bond Return Starting 10 Year Govt Bond Yield
Source: Ibbotson. Data ending 12/31/2005. 10 Year Govt Bond Return: 50% Intermediate Gov’t & 50 LT Gov’t. Starting 10 Year Govt Bond Yield: 50% Int Govt Yield & 50% LT Govt Yield.
Return Assumptions: Bonds
WURTS & ASSOCIATESPAGE 9
Relationship also holds for Lehman Aggregate Index over shorter time period:
Source: Ibbotson. Data ending 12/31/2005.
Rolling 10 Year Return vs. Starting Yield
0.0
3.0
6.0
9.0
12.0
15.0
1976 - 1985 1980 - 1989 1984 - 1993 1988 - 1997 1992 - 2001 1996 - 2005
LB Aggregate Bond LB Aggregate Bond Yield
Return Assumptions: Bonds
WURTS & ASSOCIATESPAGE 10
Yield to Maturity:
• We believe the yields will
rise moderately in response
to inflation.
• Higher reinvestment rate
will, over latter portion of
next ten years, compensate
for shorter-term price
losses.
• We estimate a 5.25% return
for (Lehman Aggregate
Index) core bonds.
Return Assumptions - Bonds
Source: Ibbotson. Data as of 12/30/2005.
Yield to Maturity
4.45.1
4.14.8
0.0
1.0
2.0
3.0
4.0
5.0
6.0
December 2004 December 2005
LB Aggregate LB Govt/Credit
WURTS & ASSOCIATESPAGE 11
The equity risk premium is the most important number in investing.
• Stocks are inherently more risky than bonds. In order to be a valid investment choice, stocks must offer a higher rate of return than bonds to attract investor capital.
• This demanded incremental difference in return is the equity risk premium and is typically defined as the long run (ten years in this case ) return difference between US equities and US government bonds.
• Since 1926, this number has averaged approximately 6.0%.
• We begin our 2006 estimate with a historic look at the premium over time. The following chart displays the starting yield of a ten-year government bond and the subsequent ten years of stock performance as measured by the S & P 500:
Return Assumptions - Equity
WURTS & ASSOCIATESPAGE 12
We estimate a 7.9% nominal return for stocks. This implies an equity risk premium of about 3.5% over a starting 10-Year Treasury bond yield¹.
• About 200 basis points less than 6.0% average of last 76 years.
• Lower end of historical risk premium distribution.
Return Assumptions - Equity
Breakdown of the Return Composition:
Dividends: Our total dividend estimate is 2.7% - 1.8% current yield, 0.3% “repurchase yield”, and 0.6% for a rising payout ratio.
Real Earnings Growth: over the 1990’s averaged 5.5% and 2.5% from 1950-2000. We feel the moderately higher 3.0% is appropriate and in line with a reasonable rate of real GDP growth.
P/E Contraction: Ratios increased from 10 to 30 over the last 76 years. Most of the increase occurred in the last 20 years. Last year, we assumed no change in valuation levels over the next ten years. P/E’s have subsequently risen causing us to project some contraction in equity prices. Therefore, we assume a contraction of -0.5% which we feel will be cushioned by lower tax rates and inflation levels.1. 10-Year Yield as of 12/30/05 was 4.4%.
WURTS & ASSOCIATESPAGE 13
Stocks usually (but not always) reward investors for their greater volatility:
Return Assumptions - Equity
Rolling 10 Year Return vs. Starting 10 Year Yield
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
1926 - 1935 1936 - 1945 1946 - 1955 1956 - 1965 1966 - 1975 1976 - 1985 1986 - 1995 1996 - 2005
10 Year S&P 500 Return Starting 10 Year Govt Bond Yield
Source: Ibbotson. Data ending 12/31/2005. Starting 10 Year Govt Bond Yield: 50% Int Govt Yield & 50% LT Govt Yield.
WURTS & ASSOCIATESPAGE 14
The distribution of the ten-year equity risk premium around a starting government bond yield can vary widely. Valuations, dividend yields, investor behavior and a number of other factors can cause the number over any ten-year period to dramatically deviate from the 6% average.
Our preference over the next ten years is towards the lower end of the distribution due to high valuations and low dividend yields. However, we need a more precise estimate to model. Therefore, we will look at key fundamental components of long run stock returns.
Return Assumptions - Equity
Equity Risk Premium: Is the arithmetic difference of the S&P 500 10 year return and the 10 year starting yield.
Distribution of Equity Risk Premium 1926-2004
9.8
6.2 6.0
2.5
0.0
2.0
4.0
6.0
8.0
10.0
12.0
75th Percentile mean median 25th Percentile
Distribution of Equity Risk Premium 1926-2004
1%
6% 6% 6%
19%
14%
19%
7%6%
3%
14%
0%
5%
10%
15%
20%
25%
-4 -2 0 2 4 6 8 10 12 14 More
WURTS & ASSOCIATESPAGE 15
To better understand where the risk premium will fall over the next ten years, it is important to decompose the average return of the stock market over the last 78 years:
1926-2003 1950’s 1960’s 1970’s
1980’s 1990’s2006-2014 Est.
Dividends 4.3% 5.3% 3.3 % 4.0 % 4.6 % 2.7 % 2.7%
Real Earnings Growth
2.0% 1.7 % 2.9 % 2.3 % 0.2 % 5.2 % 3.0%
P/E Expansion/Contraction
0.9% 9.4 % -1.0 % -7.7 % 7.6 % 7.3 % -0.5%
Inflation 3.0% 2.2 % 2.5 % 7.4 % 5.1 % 2.9 % 2.7%
Total 10.4% 19.4% 7.8 % 5.9 % 17.6 % 18.2 % 7.9%
Source: Ibbotson, Standard & Poor’s, Haver, Robert Shiller, and Morgan Stanley Research. Historical data is rounded.
Return Assumptions – Equity
WURTS & ASSOCIATESPAGE 16
Small stocks have historically displayed a risk premium of their own to large cap stocks given their historical higher volatility.
Return Assumptions – Small Stocks
Source: Ibbotson. Data ending 12/31/2005.U.S. Small Stock Premium: The historical small stock premium is derived as the geometric difference between U.S. Small Stocks total returns and S&P 500 total returns.US Small Stock index: The Small Company Stock return series is the total return achieved by the Dimensional Fund Advisors (DFA) Small Company 9/10 (for ninth and tenth deciles) Fund. The Fund invests in a broadly diversified cross section of small companies.
Premium 1926-2005
12.6%10.4%
2.3%
0%
5%
10%
15%
U.S. Small Stock S&P 500
Annual Return Premium
Rolling 10 Year Return
-10%
-5%
0%
5%
10%
15%
20%
1926 - 1935 1938 - 1947 1950 - 1959 1962 - 1971 1974 - 1983 1986 - 1995
US Small Stock Premium Average
WURTS & ASSOCIATESPAGE 17
Small stocks have historically displayed a risk premium of their own to large cap stocks given their historical higher volatility.
Return Assumptions – Small Stocks
Source: Ibbotson. Data ending 12/31/2005. Table was derived using quarterly observations. U.S. Small Stock Premium: The historical small stock premium is derived as the geometric difference between U.S. Small Stocks total returns and S&P 500 total returns.
5 Year Compound
Average Small Stock Premium
Small Stock Subsequent
10 Year Compound Average Performance
Quartiles Range Low
Median Max
1st -19.6 to -4.6 -6.4 3.7 16.6
2nd -4.5 to 1.5 -2.9 4.6 12.0
3rd 1.5 to 8.5 -3.8 4.2 13.3
4th 8.9 to 26.2 -5.8 -0.9 10.9
5 Year Compound Average for Small Stock Premium ending
12/31/05 = 15.8%
Rolling 3 Year Return
-30.0
-20.0
-10.0
0.0
10.0
20.0
30.0
40.0
1926 - 1928 1938 - 1940 1950 - 1952 1962 - 1964 1974 - 1976 1986 - 1988 1998 - 2000
US Small Stock Premium Average
WURTS & ASSOCIATESPAGE 18
Previously, we examined long term (20 years) results of international and domestic stocks that showed no distinct premium. However, when measured in 10-year periods, international stocks and U.S. stocks show shifting leadership characteristics.
Return Assumptions – International Large
Source: Ibbotson. Data ending 12/31/2005.
Compound Average 1970-2005
11.1% 11.1%
0%
5%
10%
15%
MSCI EAFE S&P 500
Rolling 10 Year Return
0%
5%
10%
15%
20%
25%
30%
1970 - 1979 1975 - 1984 1980 - 1989 1985 - 1994 1990 - 1999 1995 - 2004
S&P 500 MSCI EAFE
WURTS & ASSOCIATESPAGE 19
Return Assumptions – International Large
We begin our assessment of relative performance differential over the next ten years by looking at the difference in dividend yields. Beginning in the late 90’s, international stocks began to show a distinct premium in annual dividend yields.
Source: GMO
Dividend Yield DifferentialMSCI EAFE minus S&P 500
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05
Dividemd Yield December 2005
2.4
1.8
0.0
1.0
2.0
3.0
4.0
5.0
MSCI EAFE S&P 500
WURTS & ASSOCIATESPAGE 20
What impact does a starting dividend premium have on the next ten years of performance? We compared the 10-year performance ( between the MSCI EAFE and S&P 500) and the starting dividend yield differential (EAFE dividend yield minus S&P 500 dividend yield). The table below summarizes:
Return Assumptions – International Large
Dividend Advantage (EAFE over S&P)
% Time EAFE Outperformed the
S&P 500
Average Return Differential
Over .75% 100% 4.6%
.74% to .25% 88% 2.9%
.24% to (-.25%) 48%
(-.26%) to (-.75%) 54%
(-.76%) to (-1.25%) 48%
(-1.26%) to (1.75%) 37%
Under (-1.76%) 52%
Notes: The first observation compared the 10 year, January 1970 to December 1979, annualized return differential (MSCI EAFE minus S&P 500) with the 12/31/1969 dividend yield differential (EAFE dividend yield minus S&P 500 dividend yield). The second observation compared the 10 year performance, February 1970 to January 1980, with the 1/31/70 dividend yield differential. Data as of 12/31/2005.
For the next ten years, we believe it will be in the 0.7% ballpark translating to a nominal return expectation of 8.6%.
WURTS & ASSOCIATESPAGE 21
Given the lack of historical data for emerging markets, we measured rolling 5-year periods. Emerging markets and U.S. stocks show shifting leadership characteristics.
Return Assumptions – Emerging Markets
Source: Ibbotson and MSCI. Data ending 12/31/2005.
Rolling 5 Year Return
-20.0
-10.0
0.0
10.0
20.0
30.0
40.0
Jan-88 - Dec-92 Mar-90 - Feb-95 May-92 - Apr-97 Jul-94 - Jun-99 Sep-96 - Aug-01 Nov-98 - Oct-03 Jan-01 - Dec-05
S&P 500 MSCI Emerging
Average Compound Return 1988-2005
14.3%12.0%
2.3%
0%
5%
10%
15%
MSCI Emerging S&P 500
Annual Return Premium
WURTS & ASSOCIATESPAGE 22
• Majority of real estate returns come from income return.– NCREIF income return stood at
8.0% ending June 2005• Price appreciation of properties
roughly lags the inflation rate.– U.S. Inflation averaged 4.2%
from 1978 – 2005 (ending June)
• We estimate a 6.1% ten-year return for private, core real estate portfolios.– Pricing risk caused by
continued low interest rates and increased institutional demand for that asset class will lead to values appreciating slower than our inflation estimate – 2.7%
– Leading to a realized income return from real estate in the 4.5% range
Source: SSR Realty Advisors, NCREIF
Return Assumptions – Real Estate
NCREIF Propery ReturnJanuary 1978 - June 2005
1.6%
8.0%
4.2%
0%
2%
4%
6%
8%
10%
12%
14%
NCREIF PropertyReturn
Inflation
Price Appreciation Income Return
WURTS & ASSOCIATESPAGE 23
Asset Class Proxy PeriodStandard
DeviationWurts’ 2006Assumptions
Large Cap U.S. Equity S&P 500 1945-2004 16.8% 16.0%
Small / Mid Cap U.S. EquityIbbotson U.S. Small Stock 1945- 2004 26.6%
22.0%Russell 2000 1979-2004 24.5%
International Large MSCI EAFE 1970-2004 20.7% 19.0%
International Small MSCI EAFE Small Cap 1993-2004 20.1% 28.0%
Emerging Markets MSCI Emerging 1988-2004 30.8% 35.0%
U.S. Core Fixed Income
Ibbotson U.S. LT Corporates
1945-2004 9.1%6.0%
LB Aggregate 1970-2004 7.5%
High Yield Fixed Income LB High Yield 1983-2004 8.9% 10.0%
TIPSML Inflation-linked Securities
1998-2004 4.6% 5.0%
Real Estate NCREIF Property 1978-2003 6.2% 12.0%
REIT’s NAREIT 1972-2003 18.7% 15.0%
Liquid Alternatives / Hedge Funds
HFRI Fund of Funds Composite
1990-2004 9.5% 8.0%
Private Equity / Venture Capital
Cambridge Private Equity 1987-2003 12.9% 35.0%
Cash U.S. 30 day T-Bill 1945-2004 1.5% 1.50%
Inflation U.S. Inflation (CPI) 1945-2004 2.3% 2.0%
Source: Ibbotson, Hedge Fund Research, and Cambridge. Return observations are annual.
Historical Risk
WURTS & ASSOCIATESPAGE 24
Historical Correlations
Large US Equity 1.00
Small/Mid US Equity 0.79 1.00
International Large 0.69 0.54 1.00
International Small 0.52 0.61 0.83 1.00
Emerging Markets 0.61 0.70 0.56 0.62 1.00
US Core Fixed Income 0.25 0.15 0.23 -0.30 -0.17 1.00
High Yield Fixed Income 0.53 0.54 0.42 0.34 0.50 0.37 1.00
TIPS -0.60 -0.34 -0.49 -0.25 -0.31 0.72 -0.24 1.00
Real Estate -0.03 -0.08 0.04 -0.23 -0.23 -0.16 -0.15 -0.20 1.00
REITs 0.59 0.71 0.49 0.39 0.32 0.43 0.55 0.13 -0.071.00
Hedge Funds 0.45 0.55 0.36 0.41 0.59 -0.09 0.24 -0.18 -0.220.20
1.00
Private Equity/Venture 0.66 0.60 0.48 0.42 0.40 -0.13 0.28 -0.38 0.090.25
0.60 1.00
Cash -0.08 -0.06 -0.11 -0.38 -0.10 0.12 -0.06 -0.06 0.43
-0.10
0.11
-0.04 1.00
Inflation (CPI) -0.23 -0.14 -0.25 0.02 -0.15 -0.19 -0.19 0.24 0.33
-0.19
0.10
-0.12 0.33
1.00
Note: The history used to calculate correlation is the common date range between the pair of asset classes. (The previous page shows date ranges for all asset classes.). Correlation is calculated using quarterly returns.
Larg
e U
S
Smal
l/Mid
US
Inte
rnat
iona
l
Emer
ging
Mkt
sU
S Cor
e FI
Hig
h Yi
eld
FI
TIPS
Rea
l Est
ate
REIT
sH
edge
Fun
dsPr
ivat
e E
quity
Cas
h
(CPI
)
Int’l
Sm
all
WURTS & ASSOCIATESPAGE 25
Consensus Expectations - Returns
Notes: Compound Returns. Investment Consultant 1, 2, & 3 were provided by Ennis Knupp, whom performed the survey.
Asset ClassHistorical Returns
(Period)
10 Year Estimates
Avg. ConsensusReturns
2006 Wurts’Returns
2006 Wurts’ Standard
Deviation
Large Cap U.S. Equity 10.4% (1926-2005) 8.24% 7.90% 16.0%
Small/Mid Cap U.S. Equity 12.6% (1926-2005) 8.85% 8.50% 22.0%
International Large 11.2% (1970-2005) 8.62% 8.60% 19.0%
International Small 7.0% (1993-2005) n/a 9.10% 28.0%
Emerging Markets 14.3% (1988-2005) 9.55% 9.60% 35.0%
U.S. Core Fixed Income 5.3% (1926-2005) 5.03% 5.30% 6.0%
High Yield Fixed Income 9.6% (1984-2005) n/a 6.50% 10.0%
TIPS 7.9% (1998-2005) n/a 4.70% 5.0%
Real Estate 9.5% (1978-2004) 7.13% 6.10% 12.0%
REIT’s 10.7% (1972-2004) 6.92% 6.60% 15.0%
Liquid Alternatives/Hedge Funds 9.9% (1990-2005)
7.33% 7.50% 8.0%
Private Equity/Venture Capital 13.7% (1987-2004)
11.47% 10.90% 35.0%
Timber 15.4% (1991-2005) n/a 8.30% 14.0%
Commodities 7.8% (1991-2005) n/a 6.50% 12.5%
Cash 3.7% (1926-2004) 3.51% 3.50% 1.5%
Inflation 3.0% (1926-2004) 2.83% 2.70% 2.0%
WURTS & ASSOCIATESPAGE 26
Wurts’ Expected Correlation Assumptions
Large US Equity 1.00
Small/Mid US Equity 0.80 1.00
International Large 0.70 0.55 1.00
International Small 0.55 0.60 0.85 1.00
Emerging Markets 0.65 0.70 0.55 0.60 1.00
US Core Fixed Income 0.25 0.10 0.20 0.00 0.00 1.00
High Yield Fixed Income 0.55 0.55 0.40 0.35 0.50 0.30 1.00
TIPS 0.00 0.00 0.00 0.00 0.00 0.70 -0.10 1.00
Real Estate -0.05 -0.10 0.05 -0.25 -0.25 -0.15 -0.15 -0.20 1.00
REITs 0.60 0.70 0.50 0.40 0.30 0.45 0.55 0.15 -0.101.00
Liquid Alts / Hedge Funds 0.45 0.55 0.35 0.40 0.60 -0.10 0.25 -0.20 -0.20
0.20
1.00
Private Equity/Venture 0.70 0.60 0.50 0.40 0.40 -0.20 0.30 -0.30 0.100.25
0.60
1.00
Cash -0.10 -0.10 -0.15 -0.40 -0.10 0.15 -0.10 -0.10 0.45
-0.10
0.10
-0.05 1.00
Inflation (CPI) -0.25 -0.15 -0.25 -0.15 -0.30 -0.20 -0.20 0.25 0.35
-0.20
0.10
-0.15 0.35
1.00
Note: The history used to calculate correlation is the common date range between the pair of asset classes. (The previous page shows date ranges for all asset classes.). Correlation is calculated using quarterly returns.
Larg
e U
S
Smal
l/Mid
US
Inte
rnat
iona
l
Emer
ging
Mkt
sU
S Cor
e FI
Hig
h Yi
eld
FI
TIPS
Rea
l Est
ate
REIT
s
Liqu
id A
lts
Priv
ate
Equ
ity
Cas
h
(CPI
)
Int’l
Sm
all
WURTS & ASSOCIATESPAGE 27
Wurts’ Expected Alpha Assumptions
Data as of 12/31/2005.1.Alpha is the excess return of a portfolio calculated as Portfolio Return – Benchmark Return. For this analysis, Small/Mid Cap Equity and International Equity alpha figures adjusted to 1.50% and 1.00%, respectively, to match assumptions of other Avista Corp. benefit plans.2.International small cap is over 5 years. International small universe data is from eVestment Alliance. 3.Fund of funds level. Excess net return is not applicable since the index return and median return are the same.
Asset Class
Ten Year ICC Universe
Median Return (A)
Ten Year Benchmark
Return (B)
Average Mgmt. Fee
(C)
Alpha¹ = Excess Net
Return (=A-B-C)
Ten Year Forecasts of Active Mgmt.
Alpha
Large Core US Equity 9.19% 9.28% 0.60% -0.69% 0.50%
Small/Mid Core US Equity 15.22% 9.26% 0.85% 5.11% 2.00%
International Equity 11.05% 6.18% 0.75% 4.12% 1.25%
Emerging Markets 8.10% 6.98% 1.25% -0.13% 2.50%
International Small Cap² 14.50% 5.10% 1.25% 8.15% 2.00%
US Core Fixed Income 6.50% 6.16% 0.35% -0.01% 0.25%
Real Estate 12.11% 12.09% 1.00% -0.98% 0.00%
Hedge Funds³ n/a n/a 1.0 -2.0% n/a 0.00%
Private Equity³ n/a n/a 1.0 -2.0% n/a 0.00%
WURTS & ASSOCIATESPAGE 28
Wurts’ Expected Alpha Assumptions
*Independent Consultants Cooperative Universe Median net of expected fees versus comparable index - a result above 0.00% indicates the median manager in the asset class added value. Data for small cap equity goes back to 1990.
Rolling 10 Year Excess Net Return
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
1997 1998 1999 2000 2001 2002 2003 2004 2005
Large Core Large Value Large Growth
Small Core International Core Bonds
WURTS & ASSOCIATESPAGE 29
SECTION II
Analysis & Results
WURTS & ASSOCIATESPAGE 30
Allocation
Market Value: $2.479 Billion
Investment Policy Manager Allocation
As of 12/31/05
Artisan 2.4%
S&P Flagship 6.2%
INTECH 5.9%
TCW 4.4%
A.J.O. L.P. 7.3%
Wellington 6.4%
Kalmar Investments 2.3%
Blackrock 8.6%
Bradford 6.8%Loomis Sayles 5.4%
WAMCO 8.1%
Brandywine Funds 5.2%
Mondrian Investments 4.9%
Oechsle 6.5%
Franklin 7.8%
Other 11.8%
Active Large Cap US Equity
22%
Passive Large Cap US Equity
6%
Small/Mid Cap US Equity 10%
International Large 12%
Emerging Markets 6%
US Core Fixed Income 30%
Global Fixed Income 3%
Private Equity/VC 6%
Real Estate 5%
WURTS & ASSOCIATESPAGE 31
Projected Return:10 Year Forecast
Asset Class Policy
Large Cap U.S. Equity 28%
Small/Mid Cap U.S. Equity 10%
International Large Cap Equity 12%
Emerging Markets Equity 6%
U.S. Core Fixed Income 30%
Global Fixed Income 3%
Private Equity 6%
Real Estate 5%
Expected Return 8.15%
Standard Deviation 11.53%
Sharpe Ratio 0.40
Active Alpha¹ 0.69%
Return with Active Alpha 8.84%
I. Active Alpha (0.69%) = (22% x 0.50%) (Large Cap U.S. Active) + (10% x 2.0%) (Small Cap U.S. Active) + (12% x 1.25%) (Int’l. Large Cap) + (6% x 2.5%) (Emerging Mkts.) + (30% x 0.25%) (U.S. Core Fixed Income). 0% Active Alpha for Global Fixed Income, Private Equity, and Real Estate.
WURTS & ASSOCIATESPAGE 32
Best/Worst Case Scenarios
Percentile
1 Year 3 Year 5 Year 10 Year
5th 28.7% 19.58% 16.90% 14.27%
25th 16.15% 12.70% 11.66% 10.62%
50th 8.15% 8.15% 8.15% 8.15%
75th 0.71% 3.79% 4.76% 5.74%
95th -9.11% -2.18% 0.06% 2.37%