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SFERS

City and County of San Francisco

Employees' Retirement System

San Francisco Employees' Retirement System

RETIREMENT BOARD CALENDAR SHEET

Retirement Board Meeting of April 8, 2015
To:

Retirement Board

Through:

Jay Huish)fij (
Executive Director

From:

William J. Coaker, Jr., - CFA, MBA

Chief Investment Officer

Date:

April 8, 2015

Agenda Item:
Possible Action to Authorize Staff to Conduct Due Diligence on Ex-Fossil Fuels Indices and to Invest up to
$100 Million in One or More Ex-Fossil Fuels Passive Index Funds.
Background:
Investment Staff has undertaken a survey of the potential for investing in passive investment vehicles (either
commingled funds or separate accounts) that are designed to exclude investments in companies involved in
the extraction of fossil fuels (Coal, Oil and Natural Gas).
Although three of the major index providers have launched indices that exclude fossil fuels, the perfoimance
history is very short. Additionally, the leading providers of passive investment management services have only
a very limited number of fossil fuel free investment funds.
Recommendation:
Authorize Investment Staff to enter into discussions and to negotiate with SFERS' approved passive
investment manager services providers to evaluate and select a passive investment vehicle that specifically
excludes fossil fuels. Should the Retirement Board agree, the following motion is required:
Move that the Retirement Board authorize Investment Staff to pursue implementation of Level ll.0
of SFERS' Social investment Procedures and Policies and authorize Staff to conduct due diligence
on Ex-Fossil Fuels Indices and to invest up to $100 million in one or more Ex-Fossil Fuel Passive
Index Funds, or take other action related to investing in Ex-Fossil Fuel Passive Index Funds.
Attachment:
Staff Memorandum
Consultant Presentation

SFERS

City and County of San Francisco

Employees' Retirement System

San Francisco Emp!oyees' Retirement System

RETIREMENT BOARD CALENDAR SHEET

Retirement Board Meeting

To:

Retirement Board

Through:

Jay Huish4g
Executive Director

of April 8,2015

qlliam J. Coaker, Jr., - CFA, MBA\\\\\J

chief Investment Officer
From:

Robert L. Shaw, CFA

Managing Director, Public Mfk

Date:

AphI 8, 2015

Re:

Possible Action to Authorize Staff to Conduct Due Diligence on Ex-Fossil Fuels Indices
and to Invest up to $100 Million in One or More Ex-Fossil Fuels Passive Index Funds.

Background:
Investment Staff ("Staff) has been asked to evaluate investment in a passively managed equity index fund that
excludes fossil fuels for the Board's consideration. Under Section ll.0 of the Board's Social Investment Policies
and Procedures, at a Level II engagement, the Board may consider "specific investment programs that benefit
the Participants white aiding other persons or entities ... provided that expected returns are at least equivalent to
available alternatives of similar risk."
Staff contacted MSCI (one of (he major providers of equity index information) to obtain historical performance
data on MSCI's ex fossil fuel index (The MSCI ACWI ex Fossil Fuels). MSCI launched the MSC! series of
Global Fossil Fuel Exclusion Indexes in October 2014. The performance sedes in this memorandum goes back
to 1995 and represents a "back-tested' return series created by MSCI that follows MSCI's indexing
methodology. 1
As SFERS is a long-term investor, the analysis in this memorandum is focused on 10 year rolling performance
data from January 1995 to December 2014.
Historical Performance:
Staff evaluated a number of absolute and risk-adjusted performance metrics to determine if MSCI ACWI ex
fossil fuel index ("XFF") would produce consistently better performance than the MSCI ACWI:

I.

iscl, in their materials, notes There are frequently material differences between back-tested pertorniance and actual results."

Excess Return (Chart A). Excess Return looks at the performance difference between XFF and MSCIACWI. Over the full span of the 20 years of performance data evaluated, only the 10 years ended
November2014 (+0.05%) and December 2014 (+0.02%) have outperformed MSCI ACWI;
Alpha (Chart B). Using Rolling 10-year time periods (through December 31,2014), XFF produces
negative Alpha for all 10-year time periods with the exception of the 10-year time periods ended
October (+0.03%), November (+0.11%) and December 2014 (+0.08%);
Information Ratio (Chart C). As with Alpha, the Information Ratio turns positive in November (+0.04%)
and December (+0.02%) of 2014;
Sharpe Ratio (Chart D). Over the full 20-year performance periods evaluated, MSCI-ACWI maintained
a marginally higher Sharpe Ratio (mostly by 1-2 basis points) for each 10-year rolling period - with the
exception of the 10 years ended December31, 2014; and
S. Standard Deviation (Chart E). For most of the rolling 10-year time periods evaluated, the Standard
Deviation (Return Volatility) of the MSCI-ACWI has been consistently lower than XFF. This reversed in
2012 as the impact of rapidly changing energy prices resulted in higher volatility for MSCI-ACWI. This
shift, combined with higher absolute returns for XFF, is a key driver behind the strong risk-adjusted
returns realized by XFF over the past 3-5 years.

Over shorter time periods (ended December31, 2014) XXF has outperformed MSCI ACWI on both an absolute
and risk-adjusted basis:

Quarter

Ex Fossil Fuels
1.94%

FYID

0.42%

1 Year
3 Years

6.50%
16.35%

5 Years

10.69%

MSCI ACWI

Excess
Return

Alpha

0.52%
-1.69%

1.42%
2.11%

NA
NA

4.71%

1.79%

1.86%

NA
1.58

14.72%
9.74%

1.63%
0.94%

1.77%
1.11%

1.88
1.04

Information
Ratio
NA

This trend, which is also seen in the attached charts, may be unsustainable as markets tend to be long-term
mean reverting.
Based on the long-term excess return and commonly employed risk-adjusted performance statistics, the usage
of the MSCI ACWI ex Fossil Fuels Index as a replacement for the standard MSCI ACWI index is not justified.
There is anecdotal evidence, from more recent time periods, that XFF indices may show excess returns on a go
forward basis. This may not be sustainable as the outperformance coincides with the recent decline in the price
of oil.
Index Providers -Availability:
Three of the major index data providers (MSCI, Standard & Poor's and FISE) have launched competing series
of indices that exclude Fossil Fuels - although the length of the live performance records is somewhat limited.

S&P started back in 2009 while MSCI and FTSE launched their indices in 2014. The approaches being
employed for constructing Low, Carbon (or Ex Fossil Fuel) benchmarks come from several perspectives:
Low Carbon Footprint. Utilized by MSCI and S&P. This approach employs quantitative analysis
to assess the carbon footprint of each company in the benchmark and then, using specific
construction rules, reduces the carbon footprint of the benchmark while maintaining minimum
sector weights and limiting tracking error; and
Exclusion of Fossil Fuels. Utilized by MSCI and FTSE. This approach targets companies within
specific industries (Coal Mining, Integrated Oil and Gas, etc.) and then evaluates the sources of
revenue and/or sources of reserves of each company to determine if it should be excluded.
Asset Managers - Market Depth:
Through discussions with a number of the major passive investment organizations (Blackrock, Northern Trust
and State Street), Staff has determined that the current universe of investible funds is small. The largest fund
($550 million managed by Northern Trust) is focused on emerging markets and is not available to US investors.
Blackrock manages the second largest fund ($113 million), which in addition to fossil fuels, also precludes
investment in Korea.
The index providers are continuing to actively develop indices that exclude fossil fuels, but there remains a lack
of 'turn-key" investment funds for the institutional investor.
Despite these issues, Investment Staff believes that the market has developed to the point that there exist
viable Low Carbon or Ex-Fossil Fuels indices that can be implemented and managed on an institutional basis.
Asset Managers - Fee Structures:
Existing Funds:
As noted above, there is limited market depth in terms of available institutional index funds that exclude fossil
fuels:
iShares: MSCI ACWI Low Carbon Target:
Exchange Traded Fund, $144 Million AUM, Fee: 33 basis points
Blackrock FISE Developed ex Korea & ex Fossil Fuels:
Commingled Trust, $113 Million AUM, FeeS basis points;
Northern Trust: MSCI Emerging Markets Low Carbon:
Commingled Trust, $550 million ALJM, Fee 30 basis points.
Not available to US based investors.
Fee estimates from index providers:
Staff has contacted each of the major index providers. The following are representative fee quotes for different
benchmarks:
MSCI ACWI ex Fossil Fuels:
5.5 basis points for first $260 million;
4 basis points thereafter; and
$300,000 fee minimum (30.0 basis points on $100 million)
MSCI US ex Fossil fuels:

First $50 million: 5 basis points;

Next $50 million: 4 basis points;
2 basis points thereafter
$125,000 fee minimum (12.5 basis points on $100 million)
I basis point license fee + $30,000 index setup
3. MSCI Emerging Markets ex Fossil fuels:
First $50 million: 5 basis points;
Next $50 million: 4 basis points;
2 basis points thereafter
$125000 fee minimum (12.5 basis points on $100 million)
1 basis point license fee + $30,000 index setup
Each of these fee quotes

are preliminary and will likely change based upon final negotiations.

Energy Sector, Crude Oil and CPI - Inflation Protection:

Staff has been asked to evaluate the relationship between Energy and Inflation and more specifically, how
Energy reacted during periods of rising rates of inflation.
First, Angeles Investment Advisors evaluated the correlation of the Energy Sector (and Crude Oil) to full market
benchmarks and a copy of this analysis is attached. The high-level conclusion:
The average correlation between CPI and ACWI (or ACWI-ex fossil fuels) is essentially zero - ranging
between 40.30 and -0.40 (vs. MSCI ACWI). This implies that owning the Energy Sector is a good
diversitier to the full benchmark.
Given this information, Staff evaluated the performance data for Standard & Poor's S&P 500 Energy Sector,
which has data going back to 1990, Crude Oil price data as well as information on the Consumer Price Index to
determine if there would be performance differences during periods of rising (of falling inflation).
Analysis #1: S&P 500 Energy Sector (non-lagged). Over the past 25 calendar years (1990.2014), the rate of
inflation increased in ten years, declined in 14 and was flat (1994) in one:
1990-2014:
Consumer Price Index:
S&P 500 Energy:
S&P 500:

+2.52% (Annualized, 2.7% median)

+10.54%
+9.49%

Rising Rate of Inflation Years:

CPI:
S&P 500 Energy Sector:
S&P 500:

+3.44%
+15.91%
+4,93%

Falling Rate of Inflation Years:

CPI:
S&P 500 Energy Sector:
S&P 500:

+1.86%
+7,54%
+ 13.73%

This base model shows strong predictive powers and an investor that could consistently anticipate the rate of
growth in inflation would have added significant value by knowing when to over- (or under-weight) the 5SF 500
Energy sector.
Analysis #2: S&P 500 Energy Sector (1 year lag). This model applied a lagged approach. An investor will
be over-weighted the S&P 500 Energy Sector if the rate of inflation had risen in the prior year:
Rising Rate of Inflation Years:
S&P 500 Energy Sector:
5SF 500:

+8.85%
6.24%

Falling Rate of Inflation Years:

S&P 500 Energy Sector:
S&P 500:

+11.24%
+11.40%

The lagged model shows strong predictive powers in years of rising inflation, but fails (by a small margin) to
keep up when inflation has been falling.
Analysis #3. Crude Oil (non-lagged). The S&P 500 Energy Sector includes both energy produces (such as
Exxon) as well as service providers (Schiumberger, Halliburton, etc.). To provide a more clean energy vs
inflation evaluation, Staff looking at Cwde Oil prices using a common benchmark, West Texas Intermediate (or
Wil) - for which there is reliable data going back to 1986(29 years):
Rising Rate of Inflation Years:
CPI:
WTI:
S&P 500:

+3.61%
+18.14%
6.95%

Falling Rate of Inflation Years:

CPI:
WTI:
S&P 500:

+1.86%
-3.39%
+13.73%

As with the S&P 500 Energy Sector analysis, the WTI model shows strong predictive powers and an investor
that could consistently anticipate the rate of growth in inflation would have added significant value by knowing
when to over- (or under-weight) Crude Oil relative to the S&P 500 Index.
Analysis #4 Crude Oil (1-year lagged). Staff employed the same lagging methodology used in Analysis #2
(above):
a) Rising Rate of Inflation Years:
CPI:
WTI:
S&P 500:

+3.61%
+11.72%
+6.24%

b) Falling Rate of Inflation Years:

CPI:
WTI:
S&P 500:

+1.86%
+6.24%
+10.94%

This model also shows strong results during both rising and falling rates of inflation.
Staff evaluated two different approaches to investing in Energy (S&P 500 Energy Sector and WTI) as well as
two separate investment models (lagged and un-lagged). The overall results indicate that being over-weight
energy during periods of rising inflation (or under-weight during times of declining rates of inflation) produces
returns superior to just holding the S&P 500 index. This indicates a strong correlation between energy and
inflation.
Constituents Excluded:
At this point of the analysis, Staff does not have a recommendation as to which benhmark to employ for the
potential passive mandate. As a result, the following analysis looks at MSCI ACWI, which is a broad
benchmark and includes both developed market and emerging market equities:
Names in Benchmark:
Names excluded:

2,470 ($37.7 trillion in market capitalization)

123 ($2.6 trillion or 6.9%)

Largest exclusion:
Smallest exclusion:

Exxon Mobil $357.4 billion)

Indo Tambangraya ($516.5 million)

A list of the excluded securities can be found in the attached Appendix F.

Analysis:
The MSCI ACWI and the MSCI ACWI ex fossil fuel index have had similar levels of risk over the long term.
Regarding historical returns, the ex-fossil fuel index has outperformed the MSCI ACWI over the past several
years, while over the longer periods of time the MSCI ACWI has edged the ex-fossil fuel index.
A key question is whether the recent outperformance of the ex-fossil fuel index will be sustained over the long
term.
On the one hand, the performance of the ex-fossil fuel index over the past 3-5 years has been aided by the
following factors: the significant drop in the price of oil in recent years and the underperforrnance of energy
companies, which since March 2009 have returned 114% while the S&P 500 has soared by 244%.
As of December 31,2014 the trailing price-earnings ratio of energy companies in the S&P 500 and for the index
was 12.8 and 18.6, respectively. Energy companies are currently trading at a 31% discount to the overall
market. Over the past 20 years, the average price-earnings ratio of energy companies and the index has been
17.1 and 19.5, respectively. In other words, over the past 20 years energy companies have traded on average
at a 12% discount to the overall market. Since energy companies are currently trading at nearly 20% greater
discount to the overall market as compared to their long-term average, energy appears to be cheap on the
basis of valuation.

It should also be noted that some companies with large amounts of fossil fuel reserves may be making
structural changes toward greater use of renewables and cleaner forms of energy.
Lastly, markets will mean revert over the long-term. However, individual companies may not. A potentially
better approach is to maintain benchmark exposure, but allow active managers to evaluate and select
companies for investment.
In summary, low valuations have been a strong predictor of long-term returns and currently energy companies
are characterized by low valuations.
On the other hand, the outperformance of the ex-fossil fuel index recently may be due to longer term forces in
favor of greater use of renewables and clean energy and less demand for traditional sources of energy. These
forces may still have many years to play out.
Recommendation:
Section II.0 of SFERS' Social In vestment Pfocedures and Policies states that:
Specific investment programs that benefit Participants while aiding other persons or entities may be
considered provided that expected investment returns are at least equivalent to available alternatives of
similar risk.
In studying this issue Staff was able to determine that the two indices have similar levels of risk while it is less
clear whether the ex-fossil fuel index will provide equivalent returns to the MSCI ACWI over the long term due
to the conflicting forces described above. That said, due to the potential for long-term structural forces affecting
the investment returns for energy companies, Staff is comfortable recommending a modest investment of up to
$100 million (0.5% of SFERS' current total assets) in a separate account or commingled fund that excludes
fossil fuel securities or reduces the carbon footprint of the index. At the same time, Staff is unable to
recommend a larger investment based on the factors noted in the previous section.
Should the Retirement Board determine that the MSCI ACWI ex-fossil fuel index and the MSCI ACWI are likely
to earn equivalent returns with similar risk, the following motion is required:
Move that the Retirement Board authorize Investment Staff to pursue implementation of Level II.0 of
SIERS' Social Investment Procedures and Policies and authorize Staff to conduct due diligence on ExFossil Fuels Indices and to invest up to 5100 million in one or more Ex-Fossil Fuel Passive Index
Funds, or take other action related to investing in Ex-Fossil Fuel Passive Index Funds.

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