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Home My WebLink About03.b. Info from HighMark Capital Management re Underperforming FundsCentral Contra • District • ,, TO: FINANCE COMMITTEE VIA: ROGER S. BAILEY, GENERAL MANAGER DAVID HEATH, DIRECTOR OF ADMINISTRATION FROM: THEA VASSALLO, FINANCE MANAGE SUBJECT: INFORMATION REQUESTED FROM HIGHMARK CAPITAL MANAGEMENT REGARDING UNDERPERFORMING FUNDS At the May 5, 2014 Finance Committee meeting, Member Pilecki (Alternate for Chair Causey) asked that more information be provided on the investments in MFS International Growth Fund (MQGIX) and Nationwide Geneva Mid Cap Growth Fund (NWHYX), which seemed to be performing below index. Attached is a memo provided by Andrew Brown, CFA, Vice President and Senior Portfolio Manager of HighMark Capital Management, which provides overviews and commentary on the underperforming funds noted by Member Pilecki, as well as on the T. Rowe Price Growth Stock (PRGFX), an additional fund Mr. Brown felt was worth highlighting. Staff can relay any additional questions the Committee may have to Mr. Brown. Attachment IGH K@ CAPITAL MANAGEMENT May 7, 2014 Thea Vassallo Finance Manager Central Contra Costa Sanitary District 5019 Imhoff Place Martinez, CA 94553 -4392 Dear Thea, Market Overview Fourth quarter Gross Domestic Product (GDP) slowed to an estimated 2.6% annualized rate, when compared to 4.1 % for the third quarter of last year. Continued slowing to 2.9% is expected for the first quarter of 2014, as difficult weather conditions impacted consumers and business in the first two months of the year. Job growth improved modestly while unemployment remained stable. Non -farm payrolls expanded by 533,000 over the quarter, with month -to -month growth ranging between 144,000 and 197,000. Unemployment ended the quarter at 6.7 %, unchanged from year -end 2013. Rates in the long -end of the curve fell throughout January before trading in a relatively narrow band during the quarter. The ten -year Treasury yield which entered the quarter at a rate of 3.04 %, dipped slightly to 2.73% at quarter -end. Concerns about issues surrounding Ukraine /Crimea as well as concerns surrounding global growth played a role in money flowing into the Treasury market. With short-term yields remaining fairly unchanged, the yield curve flattened somewhat in the quarter. Performance Review The Central Contra Costa Sanitary District OPEB Plan returned 1.28 %, gross of investment management fees for the quarter. Our fixed income investments posted a 1.48% return, which slightly underperformed the Barclays Aggregate return of 1.84 %. The tilt towards shorter duration investments was the primary detractor for performance in the quarter. Our equity funds returned 1.14 %. Small cap equities were the source of strength in the quarter, while domestic large cap and mid -cap equities lagged the benchmark. International equities lagged somewhat in the quarter as well, due primarily to emerging market equity exposure. Fund Commentary Per the District's request, we wish to provide commentary on three of the Fund's in the Plan. MFS_International Growth Fund (MQGIX) The fund beat its MSCI ACWI ex US Growth index in 2010 (35th percentile), 2011 (40th percentile) and 2012 (31St percentile). The fund trailed slightly in 2009, but still finished in the 38th percentile versus its category peers. The fund is in the 50th percentile for 3- years, the 45th percentile for 5 years and the 21St percentile for 10 years. More recently, the fund trailed its benchmark by 164 bps in 2013 (it trailed by 20 bps in 1Q13, trailed by 57 bps in 2Q13, beat by 80 bps in 3Q13, and trailed by 140 bps in 4Q13). The fund trailed the index by 120 bps in 1Q 2014, which is what has skewed performance for the 1 year period, and filtered through to the 3- year and the 5 -year number. The source of recent underperformance was a combination of the portfolio's higher quality bent at a time when the market favored lower quality, higher beta names. Also, the fund's EM weighting, which was 12% at year end, impacted them negatively. Over the course of 2013, the fund was hurt by its positioning in autos, housing and health care. We have no material concerns about the fund at this time, since the struggles have been during a period of heightened market volatility. This fund is not on our watch list. Nationwide Geneva Mid Cap Growth Fund (NWHYX) This fund is currently on our watch list due to performance. Quality has been the main culprit behind the fund's struggles, as they emphasize high quality at a time when lower quality, higher beta, low earnings companies have led the market. The fund manager believes that the Fed's easy money policies have caused this lower - quality outperformance to run longer than normal (in the past when low quality rallies have occurred, they have not had the tailwind that Fed easing has provided this time around); they believe that Fed policy has pushed investors into higher beta type names. The fund is on our watch list and if it doesn't turn around at some point in the near future, we will likely make a switch. T. Rowe Price Growth Stock (PRGFX) While you didn't ask about this particular fund, we wanted to highlight another fund on our watch list. The fund had a return of -1.24% for the quarter, underperforming the S &P 500( +1.81) by over 300 bps and finishing in the 87th percentile versus its category peers. On the surface, this wouldn't be too troubling as the fund's performance still ranks in first quartile on a one year, three year, five year and ten year basis. That said, longtime manager Rob Bartoio left the firm and was replaced by Joe Fath on January 16th of this year so it's natural to wonder just why the new PM struggled in the first few months of his stewardship. When dissecting the fund's performance for the quarter, the fund actually beat both the S &P and the Russell 1000 Growth index in both January and February of this year. Unfortunately, March saw a sharp stylistic shift in the market, resulting in a reversal of some of the gains posted by all of T. Rowe's large growth strategies. T. Rowe attributed their struggles to four drivers: • First, the situation in the Ukraine reintroduced investors to geopolitical tail risk, affecting global travel and gaming stocks • Second, new Fed Chairman, Janet Yellen suggested in her mid -March congressional testimony that rate increases would come sooner rather than later causing investors to re- evaluate the relative merits of the type of secular growth stocks that T. Rowe tends to own • Third, several congressional Democrats wrote a letter to Gilead Sciences asking about the rationale behind the pricing of their Hepatitis C drug creating another reminder to investors of the potential for policy risk • And finally, Chinese economic data was mixed, dampening the picture for global economic growth Simply put, company- specific fundamentals were overwhelmed by the stylistic shift in the market. This resulted in investors selling both growth and momentum stocks (which had outperformed in 2013) while also taking profits in themes that had worked in 2013 (including biotech, internet and social media companies, along with cloud computing plays). As a result, Joe Fath and the other growth PMs at T. Rowe responded to the market sentiment shift in a very limited fashion since that shift was not the result of any meaningful shift in in fundamentals or the growth prospects in the companies owned in the portfolio. T. Rowe believes that long term results for clients are driven by the firm's collective ability to identify companies with solid management teams and strong financial positions that can grow their earnings and free cash flow at above market rates over a multi -year time horizon. As such, we will continue monitoring this fund due to the new PM, but at this time are not overly concerned by the recent underperformance. Asset Allocation /Strategy Positioning U.S. market valuations remain high, complemented by record margins and moderate revenue growth expectations. We remain slightly cautious in our equity market positioning, maintaining a slight underweight to stocks (-2.5%). That said, we did increase our investments in international equities during the quarter, as we view international equities as slightly more attractive from a valuation standpoint versus domestic stocks. We are underweight as well fixed income, as we are concerned about the risks of a rise in interest rates. We ended the quarter with an asset allocation of 47.5% stocks, 48.75% bonds, and 3.75% cash/money market. Best regards, Andrew Brown