Fiscal impact
reports (FIRs) are prepared by the Legislative
Finance Committee (LFC) for standing finance committees of the NM Legislature. The
LFC does not assume responsibility for the accuracy of these reports if they
are used for other purposes.
Current FIRs (in HTML & Adobe PDF formats) are available on the
NM Legislative Website (legis.state.nm.us). Adobe PDF versions include all attachments,
whereas HTML versions may not.
Previously issued FIRs and attachments may
also be obtained from the LFC in
F I S C A
L I M P A
C T R E P O R T
|
SPONSOR |
HAFC |
DATE TYPED |
|
HB |
209/HAFCS |
||
|
SHORT
TITLE |
Permanent Funds Investment In Real Estate |
SB |
|
||||
|
|
ANALYST |
Garcia |
|||||
REVENUE
|
Estimated Revenue |
Subsequent Years Impact |
Recurring or
Non-Rec |
Fund Affected |
|
|
FY04 |
FY05 |
|||
|
|
|
FY06:
$70.0; FY07: $135.0; FY08: $271.0 |
Recurring |
General
Fund |
|
$7,400.0
(increase in market value) |
$14,400.0
(increase in market value) |
Greater
Than $14,400.0 (increase in market value) |
Recurring |
Severance
Tax Permanent Fund |
|
|
|
|
|
|
(Parenthesis ( ) Indicate Revenue Decreases)
Synopsis of Bill
The bill
allows a 10 percent allocation from the Severance Tax Permanent Fund (STPF) only
for real estate investments and investments in hedge funds. The bill does not reference the Land Grant
Permanent Fund (LGPF), and thus none of the new allocations will be made from
the LGPF and will not require a ¾ vote for passage. The bill does not allow direct investment in
derivatives and short-selling from the State Investment Office, but does allow
the investment office to invest in hedge funds.
The bill will
allow the State Investment Council to invest up $360 million of the market
value of the STPF (as of the
Significant Issues
1) Background of Investments: Currently, the State Investment Council (SIC)
is not authorized to invest in hedge funds and is limited to invest only 3
percent of the market value of the land grant permanent fund in real estate
assets. Consequently, the bill will allow the investment agency the ability to
invest in hedge funds and10 percent of the STPF in real estate.
Hedging
is the practice of buying and selling a particular asset to offset an otherwise
risky position. For example, if a company
knows its going to gain $1,000 for each 1 cent increase in the price of an
asset, but also knows it will lose $1,000 for each 1 cent decrease in the price
of the asset; the company can hedge by taking a short futures position on the
asset. If the asset decreases, the short position makes up for the decrease in
the prices of the asset to net the investment loss at zero. On the other hand,
if the price of the asset goes up, the loss to the company is only the price of
buying the short position, thus resulting in a net investment gain.
Hedging
is a common practice among institutional investors and is a strategy that
attempts to protect a portfolio against market downturns. Moreover, the
derivative market, otherwise known as hedging, is a huge market
internationally. The futures, options, and forwards markets dwarf the equity
markets in size and are growing rapidly.
Real Estate
investments do not include speculation in raw land (which are prohibited by SIC
policy). The classic core investment is an office building that is almost
completely leased to an investment grade (BBB or greater by Standard &
Poor’s) tenant for longer than 5 years.
Real estate behaves differently than other
financial assets. The very nature of
real property makes these investments illiquid and unique. Unlike stocks, cash
flow to tax exempt investors is not reduced by income tax. Although real estate equity and stocks both
represent ownership interest, real estate has many characteristics that provide
stable income. Like bonds, the majority
of returns from real estate are generated from cash distributions. Unlike bonds, property values are not
adversely affected by inflation.
2) SIC contends the ability to use the
additional investment strategies will provide added diversification effects
that will (1) reduce or maintain the same level of risk of the portfolio; and
(2) increase the expected return of the portfolio. Specifically, investments in
hedge funds are regarded by the SIC advisor to typically have higher
risk-adjusted returns.
3) According to SIC’s
advisor, New England Pension Consultants (NEPC), the additions of hedge funds
and real estate add no economic risk, as measured by standard deviation, to the
portfolio. However, an implicit risk does exist to the portfolio. The risk lies
in oversight of the hedge funds.
·
Risk
lies in the ability of the SIC to develop a comprehensive due diligence process
that chooses sound hedge funds and monitors them extensively.
·
The
success of the asset relies on investment fund manager skill
Without
a well structured management and implementation plan that adequately oversees
the hedge fund asset class, the portfolio return is at risk due to the
complexity of the asset. Thus far, SIC has not provided a management or
implementation plan of how the organization will oversee this new asset class.
4) The
FISCAL IMPLICATIONS
The fiscal impact research
was conducted by New England Pension Consultants (NEPC), the SIC investment
consultant. NEPC included a 10 percent asset allocation in real estate investments
and hedge funds in its projections and concluded the proposed changes would
increase the total return to the STPF by 0.40 percent without increasing risk.
For FY04, the increase in allocation to the two asset classes would result in
an estimated increase in the STPF market value of $7.4 million (from the 4.7
percent distribution from the STPF). The estimated increase in the market value
of the STPF for FY05 from an increase in these investment classes would amount
to roughly $14.4 million. Because the distribution formula for the STPF is
determined on December 31 of each year for the next fiscal year, the FY05
distribution has already been determined and the bill will not affect FY05
distribution but will increase the FY06 distribution. The estimated increased
general fund revenue from the increase in market value of the STPF from the
bill is $70 thousand for FY06, $135 thousand for FY07, and $271 thousand for
FY08.
The first year estimate assumes that only
one-third of the real estate will be placed in FY05. The SIC’s real
estate policy anticipates that this minimum will be invested in publicly traded
real estate investment trusts (REITs) and real estate
“mutual funds” for institutional investors that are easily placed and
redeemed. Finally, the out-year estimates
for all these proposals assume no growth or compounding in permanent fund
market values; they are all based on the
As of December
31, 2004
the severance tax permanent fund market value was roughly $3.6 billion. The
additional allocations from the bill will not affect the Land Grant Permanent
Fund and will only affect the Severance Tax Permanent Fund.
ADMINISTRATIVE IMPLICATIONS
Although
the SIC proposal raises the expected return of the portfolio and does not raise
the standard deviation (risk), there are still risks to using the new asset
classes. Chief among the risks is the ability of SIC to implement and
adequately administer the assets. For instance, successful investments in hedge
funds are dependent on investment manager skill and a mechanism that properly
monitors investment fund managers. SIC has experienced problems in its due
diligence mechanism in another asset class, private equity, that resulted in
the investment council back-tracking on approval of a few deals. As a result,
it is necessary for SIC to present a plan on how the investment agency will
implement and oversee this possible new and complex asset class and the fund
managers in order to establish the program on good footing from the start.
OTHER SUBSTANTIVE ISSUES
The
figure below provides a long-term comparison of one-year, two-year, three-year,
five-year, and ten-year returns of the Land Grant Permanent Fund (LGPF),
Severance Tax Permanent Fund (STPF), the ERB Fund, and the PERA Fund versus the
median public fund return in the Wilshire universe. The figure shows that for
10 years ended
Risk Adjusted Return
- The historical average return of an asset or
portfolio can be extremely misleading and should not be considered alone when
selecting assets or comparing the performance of portfolios. One also has
to take into account the historical variability or riskiness
of return. The following table shows the return of different assets per unit of
risk; the statistic is known as a “Sharpe ratio”.
|
|
Sharpe Ratios by Asset Class
|
|
|
|
|
Asset
Class |
Ratio |
|
|
|
Core
Bonds |
0.15 |
|
|
|
Mortgages |
0.17 |
|
|
|
Mid
Cap Equities |
0.29 |
|
|
|
Large
Cap Equities |
0.33 |
|
|
|
Int'l
Equities |
0.33 |
|
|
|
Real
Estate |
0.34 |
|
|
|
Hedge
Funds |
0.43 |
|
|
|
Source: NEPC |
|
|
As the table shows,
hedge funds currently have the highest risk adjusted return of any major asset
class. The second highest level of risk
adjusted return is found in real estate. This result drives a considerable part
of the fiscal impact shown above.
POSSIBLE QUESTIONS
Is this a proposal that needs further study and possibly referred to the
DG/lg:yr:dm