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.
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in
F I S C A
L I M P A
C T R E P O R T
|
SPONSOR |
Smith |
DATE TYPED |
|
HB |
|
||
|
SHORT
TITLE |
Permanent Fund Investments in Real Estate |
SB |
316/aSCORC/aSFC/aSFl#1/aSFl#2/aSFL#3/aHTRC |
||||
|
|
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)
HB 209 is the companion bill.
SOURCES
OF INFORMATION
Response
Received From
State
Investment Council
SUMMARY
Synopsis of HTRC Amendment
The
House Taxation and Revenue Committee Amendment to SB 316, as amended, removes previous amendments and adds language to duplicate
HB 209. The following are the HTRC changes:
(1) The HTRC Amendment
removes the Senate Finance Committee Amendment Item 5 which stipulates requirements
for real estate investment trusts. The removed language required that any real
estate investment trusts the SIC invests in must have a minimum of $50 million
already invested, a three-year performance record, and provide reports detailing
underlying assets.
(2) The HTRC Amendment
strikes Senate Floor Amendment #2 which added a sunset provision to the bill.
(3) The HTRC Amendment
strikes Items 3 and 4 of Senate Floor Amendment #3. The Senate Floor Amendment #3
reduced the allocation from the Severance Tax Permanent Fund from “ten” percent to “five” percent. The HTRC Amendment reinstates the “ten” percent
allocation from the Severance Tax Permanent Fund.
(4) The HTRC Amendment strikes
the word derivatives and short-selling, eliminating the ability of the SIC to
invest directly in derivatives and conduct short-selling. The bill still allows
for the ability to invest in hedge funds.
(5) The HTRC Amendment strikes
all authorization allowing the SIC to invest directly in derivatives and
conduct short-selling.
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.
Synopsis
of SFl Amendment #3
The
Senate Floor Amendment #3 to SB 316 strikes any reference to “ten” percent allocation
from the permanent funds to “five” percent. Consequently, the amendment only
allows a “five” percent allocation of real estate and hedge funds from the
Severance Tax Permanent Fund. The amendment still allows the SIC to directly
invest in derivative investment instruments.
Fiscal
Implications
The
amendment and consequently the entire bill will only be referenced to the
Severance Tax Permanent Fund (STPF) since a ¾ vote on the Land Grant Permanent
Fund investments failed. The result of the decrease in allocation from ten
percent to five percent will reduce the fiscal impact on the market value of
the STPF and revenue to the general fund from the 4.7 percent distribution of
the STPF.
The
State Investment Council’s investment advisor, New England Pension Consultant
(NEPC), estimates that allowing the SIC to invest 5 percent of the STPF in real
estate and hedge funds and allowing direct investment in derivatives will
increase the STPF market value by roughly $4.4 million in FY04. The resulting
revenue to the general fund from the increase in market value (based on a 4.7
percent distribution formula) will be an additional $41 thousand. For FY05,
NEPC estimates the market value of the STPF will increase to around $7.9
million and revenue to the general fund (based on a 4.7 percent distribution
formula) will be roughly $74.5 thousand. Moreover, in FY06, NEPC estimates the
general fund revenue increase will jump to $149 thousand and will move up to
$223 thousand in FY07 and beyond.
Synopsis
of SFl Amendment #2
The
Senate Floor Amendment #2 adds a sunset provision on page 17, line 17 that
states: “this bill shall sunset on
Synopsis of SFl Amendment #1
The Senate Floor Amendment #1
reinstates the word “first” on page 4, line 1. Section 1 (7) now reads: “real
estate investments, including real property and undivided interests in real
property, debt instruments secured by first liens on real property or limited
partnership interests….”
Synopsis of SFC
Amendment
The Senate Finance Committee amendments repeal
the SCORC amendment and emergency clause.
The SFC amendments add the following language for administering investments
in real estate trusts: “investments in hedge funds that invest primarily in
real estate investment trusts may be made pursuant to this paragraph only if
the fund advisors: 1) provide audited financial statements to the state
investment officer; 2) agree to provide regular reports detailing underlying
fund investment holdings and transactions to the state investment officer and a
third party risk assessment firm designated by the state investment officer; 3)
possess a three-year performance record that has been reviewed by the state
investment officer; and 4) manage a minimum of fifty million dollars
($50,000,000) of investments in the investment strategy to be used for the investment
made pursuant to this subparagraph.”
The amendments also add the following language
to for administering investments in hedge funds: “the hedge fund advisors: 1)
provide audited financial statements to the state investment officer; 2) agree
to provide regular reports detailing underlying fund investment holdings and
transactions to the state investment officer and a third party risk assessment
firm designated by the state investment officer; 3) possess a three-year
performance record that has been reviewed by the state investment officer; and
4) manage a minimum of one hundred million dollars ($100,000,000) of
investments in the investment strategy used.”
Significant Issues of
SFC Amendments
The
Senate Finance Committee amendments resolve concerns about the execution of the
State Investment Council’s proposed hedge fund allocation. Besides mandating transparent reporting, the
amendments require that stock and bond hedge fund managers possess a three year
track record managing at least $100 million; the requirement is reduced to $50
million for hedge fund managers specializing in real estate investment trusts
(REIT’s). The amendments strengthen the bill for SIC administering of hedge
funds and higher real estate allocations.
The
lowered threshold for REIT hedge funds was recommended by the SIC’s real estate
consultant, Courtland Partners. REIT’s
are not like other stocks; they are securities real estate holdings and hedge
fund managers that specialize in public equity real estate have only recently
evolved. Courtland believes that the
hedge fund strategies might be an appropriate response to recent REIT market
performance; the one year increase in the NAREIT equity index is almost 40 percent.
Synopsis of SCORC Amendment
The Senate Corporations and Transportation
Committee Amendment adds an emergency clause.
Synopsis
of Original Bill
The bill allows the SIC to invest in
additional alternative asset classes and allows a higher allocation of real
estate investments in the portfolio.
Specifically, the bill allows:
- A
10% allocation for real estate (currently 3% of the permanent funds’ market
value).
- A
10% allocation for hedge funds (currently not allowed).
- The
use of forward contracts such as options, interest rate swaps, and short
selling arrangements for the purposes of hedging and asset reallocation.
Significant Issues
1) Background of Investments: Currently, the State Investment Council (SIC)
is not authorized to invest in derivatives, conduct short-selling, 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 derivative instruments, conduct short-selling,
and invest more of the permanent fund’s portfolio (up to 10 percent) in real
estate.
Derivatives
are assets such as futures, forwards, and options, assets that are derived from
an underlying asset. Instead of directly
buying and selling an asset, an investor who invests in derivatives pays a premium
for the opportunity to buy an underlying asset with features. For instance,
with a future, an investor is obtaining a contract to buy or sell an asset
(such as: wheat, corn, gold, silver, etc.) at a certain time in the future at
an agreed upon price. A forward is the same type of contract as a future;
however, a forward contract is traded over-the-counter whereas a future is
traded in an open market such as the Chicago Board of Trade. Lastly, an option
contract gives the investor a right to do something. For example, in a call
option, the holder has a right to buy an asset by a certain date at an agreed
upon price. A put option gives the holder a right to sell an asset by a certain
date for an agreed upon price.
Short-selling
is the opposite of regular stock or other securities purchases. An investor who short-sells will profit when the stock price falls
and will lose when the stock price rises. For example, an investor will
make an order with a broker to buy ‘short’ on a given stock, that current stock
price, say $30, is then recorded and any price decline from the stock say to
$25, is a $5 gain to the investor and is charged to the investor’s account.
The
use of derivatives and short-selling enable the portfolio to hedge its assets.
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, the ability to
invest in derivatives and short-sell allows the investment agency to invest in
hedge funds. These types of funds and investments are regarded by the SIC
advisor to typically have higher risk-adjusted returns.
3) According to SIC’s advisor, New England
Pension Consultants, 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 management and
structure of the new program.
·
Risk
lies in the ability of the SIC to develop a comprehensive due diligence process
that chooses competent managers and monitors them extensively.
·
The
success of the asset relies on investment 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
following table is a breakdown of the current portfolio target mix, and the
additional columns show the portfolio asset allocation with the addition of 8
percent in hedge funds as well as 8 percent in real estate (5 percent above the
current real estate allocation). This is used just to illustrate the possible
new asset mixes of the portfolio with the additions of the new asset classes
and the impact the assets would have on expected return and risk of the whole
portfolio.
|
|
Current
Target Allocation |
Hedge
Funds Addition |
Hedge
Funds + Real Estate |
|
Equity |
61% |
58% |
59% |
|
Fixed Income |
31% |
27% |
21% |
|
Alternatives Private Equity
Market Neutral Hedge Funds
Mkt. Directional Hedge Funds
Real Estate |
7% 4% 0% 0% 3% |
14% 3% 4% 4% 3% |
19% 3% 4% 4% 8% |
|
Cash |
1% |
1% |
1% |
|
Expected
Long-term Compound Return |
8.32% |
8.43% |
8.63% |
|
Expected
Risk (standard deviation) |
11.46% |
11.46% |
11.46% |
|
Additional
Return (%) |
n/a |
0.11% |
0.31% |
Source:
The fiscal impact research
was conducted by NEPC. NEPC included a 10 percent asset allocation in real
estate investments in its projections and concluded the proposed changes would
increase the total return to the funds by 0.43 percent without increasing risk.
For FY05 the estimated additional distribution out of the permanent funds due
to higher returns would amount to $285 thousand. This would increase to $668
thousand in FY06 and is estimated to increase into the future.
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
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 short-selling and
buying of hedge funds is dependent on investment manager skill and a mechanism
that properly monitors investment 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 administer this possible new and complex asset class in order to
establish the program on good footing from the start.
OTHER SUBSTANTIVE ISSUES
The following graph is
a 5 year history of the returns of the LGPF versus its benchmark.
As the table shows, SIC met or exceeded its
benchmarks for each of the past five years. However, these benchmarks are set
at a lower standard as compared with other endowment funds. The numbers in the
parenthesis represent SIC benchmark and actual return rankings (in percentile)
in a universe of approximately 1,800 endowment funds. As the peer ranking shows, the majority of
endowment funds in the universe had more aggressive benchmarks than SIC and
nearly half of the endowment funds had higher returns for FY03.
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
Does the SIC have an adequate plan to implement this asset class and
avoid the due diligence problems the agency encountered with private equity?
Is this a proposal that needs further study and possibly referred to the
DG/lg:yr:dm