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‘THOMAS P. DiNAPOLI STATE COMPTROLLER 10 STATE STREET ALBANY, NEW YORK. 12236 STATE OF NEW YORK OFFICE OF THE STATE COMPTROLLER December 9, 2016 Daniel Sanjeap Director & Deputy Counsel, Capital Markets Division ‘New York State Department of Financial Services 1 State Street ‘New York, NY 10004 Dear Mr. Sanjeap: Lam writing to convey the response of the New York State and Local Retirement System (the Retirement System) to the Report of the Department of Financial Services (DFS) published ‘on October 17, 2016, entitled “State Comptroller-Managed Common Retirement Fund Pays High Fees Year After Year for Poor Hedge Fund Performance and Lacks Transparency on Costs of Other Alternative Investments” (the DFS Report or Report). The Retirement System strongly disagrees with the Report’s findings and conclusions. DES prepared and published the Report with virtually no notice to or meaningful input from the State Comptroller, the administrative head of the Retirement System and trustee of the ‘New York State Common Retirement Fund (CRF or the Fund), or his staff ~ a process that is at ‘odds with the law applicable to preparing such reports.’ As a result, there are multiple instances where DFS relies on inaccurate or incomplete data to make claims that are unsupported, wrong or inappropriate. While the motivation behind the DFS Report is unclear, the Retirement System has a duty, to taxpayers and to the 1.1 million individuals who rely on the CRF for theit retirement security, to highlight and correct the errors and false assumptions it contains. Going forward, the Retirement System is more than willing to provide DFS with information on the Fund’s investment processes and strategy, as has always been the case with prior reviews. The Retirement System values independent oversight in the interest of good government and accountability. The Retirement System and the CRF are known for adhering to high professional standards, which have been praised by independent industry experts, and we ‘rust that in the future DFS will return to the standards expected of a regulator of a large public pension fund. * Sco Insurance Law §§311(b) (1) (“Before adopting any such report and filing for public inspection, the ‘superintendent shall notify the insurer or other person examined of its contents and shall afford such insurer or other person a reasonable opportunity to obtain further details ...”); and 314(b) (2) (“Notwithstanding eny other provision of law to the contrary, the superintendent shall have ... the following authority with respect to any system: ... (3) 0 ‘make an examination into the affairs of every system, atleast once in every five years in accordance with the provisions of sections ... three hundred ten, three hundred eleven and three hundred twelve of this article....”) Department of Financial Services December 9, 2016 Page 2 ‘The issues raised by the Report — hedge fund performance and fees, private equity fees, and transparency regarding private equity fees and expenses ~ are not unique to the CRF, but rather are issues confronting all sophisticated institutional investors. As explained in detail below, the ‘CRF has been actively addressing these issues. We begin, however, by highlighting these key facts: © The CRF is a sophisticated long-term investor with a diversified portfolio, valued at an estimated $184.5 billion as of September 30, 2016, that prudently includes absolute retum strategies (ARS) as a defense-minded strategy that emphasizes risk-adjusted returns and downside protection during volatile market conditions. * Asof June 30, 2016, the CRF’s ARS portfolio (which excludes equity-oriented long-only global funds that by design are correlated to the public equity markets) has outperformed its benchmark on a 1-year, 3-year, 5-year and 10-year basis. ‘In comparison to the other pension funds mentioned in the DFS Report, the CRF’s ARS portfolio is, and always has been, modest. As of June 30, 2016, the long-term target allocation for ARS (excluding equity-oriented long-only global funds) is only 2 percent of the overall portfolio, The CRF is a disciplined long-term investor that does not act rashly, rush to follow the pack or try to time the market. © Asa result of the CRF's standard internal portfolio review process, the CRF has not made any new ARS investments since January 2015, and has processed over $1 billion in redemptions since October 2015. ¢ The CRF has been an investor in Private Equity (PE) since 1983 and has significant experience in this area. The PE portfolio has consistently outperformed its 10-year benchmark, net of all fees, expenses and incentive compensation, © The CRF is a recognized leader with respect to the transparency of fees. For instance: ‘© The Retirement System's Comprehensive Annual Financial Report (CAFR) has received the Government Finance Officers Association's Certificate of Achievement for Excelience in Financial Reporting annually for the past twelve years. © The DFS-mandated Fiduciary and Conflict of Interest reviews of the CRF conducted by an independent entity in 2013 and 2016 have found that the CRF ‘maintains “a high level of operational transparency” that “compares well with other large peer funds,” and that the CRF’s “expense recording and transparency provide a leading practice for peers in regard to level of detail disclosed.” © The CRF staff who manage the PE portfolio are active members in the Institutional Limited Partners Association (ILPA) and were involved in the creation of the ILPA fee reporting Department of Financial Services December 9, 2016 Page 3 template, which is designed to increase transparency industry-wide on the reporting of PE fees and expenses. © The CRF was an initial endorser of the ILPA fee reporting template and since the template’s release in late January 2016, the CRF has required its use for all new commitments, and will not invest in a PE fund if the manager does not agree to comply with ILPA fee reporting standards. Understanding the Importance of Diversification and Asset Allocation ‘The CRF, with an estimated value of $184.5 billion as of September 30, 2016, holds and invests the assets of the Retirement System on behalf of over one million members, retirees, and beneficiaries of the Retirement System. The Fund’s goal is to provide pensioners who are entitled to a constitutionally-guaranteed defined pension benefit with a secure pension through prudent management of the Fund’s assets, As such, the CRF isa long-term investor and, like all long-term investors, regards diversification — the practice of spreading money among different types of investments to reduce risk and generate return ~as a cornerstone of its prudent investment strategy. ‘Thus, the CRF invests in many different classes of assets, including global public equity (stocks), fixed income (notes and bonds), and several alternative investments, such as private equity, real estate, ARS (hedge funds), opportunistic investments, and real assets. By including within the portfolio a variety of asset categories with projected investment returns that behave differently in different market conditions and that do not move in tandem, the CRF is seeking to generate strong retums while reducing the risk of loss and minimizing the volatility of its portfolio. ‘The DFS Report fails to acknowledge the role of alternative investments within the CRF’ overall portfolio, and instead characterizes the Fund’s prudent actions as “chasing returns.” (Report, p.1.) Like many other major institutional investors, the CRF considers the single largest driver of the Fund’s performance and risk profile to be the asset allocation of its investments, Asset allocation is important because it has a significant impact on whether the Fund will be able to meet its performance goals. Essentially, the objective of asset allocation is to select a mix of assets that has the highest probability of meeting the Fund’s goals with an acceptable level of risk. Determining the appropriate asset allocation for the CRF is an essential component of the CRF’s work. As of June 30, 2016, following the annual review of the portfolio by the Comptroller's Investment Advisory Committee (IAC) at its June 2016 meeting, the CRF’s long-term target asset, allocation was: Department of Financial Services December 9, 2016 Page 4 Asset Class Target Allocation Global Equity Domestic Equity 36.0% International Equit 14.0% Alternative Investments [Private Equity 10.0% [Real Estate ‘Absolute Return Bonds & Mortgages Cash Inflation-Indexed Bonds Understanding Why Different Asset Classes Have Different Fees A majority of the CRF portfolio is invested in public equity and fixed income securities. ‘The DFS Report correctly notes that the fees paid in connection with the CRF’s domestic equity portfolio are relatively low in comparison to the fees paid for certain alternative investments (Report, p. 3.) The reason management fees for CRF’s domestic public equity portfolio are lower than fees for alternative investments is because the majority of the CRF’s domestie public equity holdings are passively managed.” Currently, 86 percent of the domestic equities portfolio is passively managed. In addition, 90 percent of the fixed income portfolio is internally managed at very low cost. The remainder of the portfolio is managed actively by outside managers. The purpose of the CRF’s passively managed domestic equity portfolio is to generate a return that mirrors a chosen benchmark (ie., the Russell 3000). Because this investment strategy does not require discretionary judgments, the management fees assessed on passive portfolios are far lower than those on actively managed portfolios. Fees for alternative investments such as hedge funds and private equity are typically higher than the fees for traditional investments (e.g., stocks and bonds), because the fees pay for active management, provide access to a class of investments that offer advantages over traditional investments, and are intended to align manager and investor interests. For example, hedge funds often seek a high level of absolute returns that require a greater degree of managerial attention and skill than traditional portfolios, In addition, the returns from alternative investments may have different or enhanced risk characteristics when compared with traditional portfolios, such as achieving meaningful returns with a lower level of risk or helping to diversify a portfolio of traditional assets by bringing down overall portfolio tisk, ‘The DFS Report concludes that the “[CRF] is paying excessive hedge fund fees” (Report, p. 2) based on the assumption that “the hedge find managers’ services cost the CRF the same as that paid for domestic equities....” (Report, p. 3). Plainly, the Report’s conclusion is * Passive management isan investment strategy that tracks a market-weighted index or portfolio. Passive management {s the opposite of active management, in which a manager attempts to beat the market with various investing strategies and decisions about buying and selling of a portfolio's securities. Department of Financial Services December 9, 2016 Page 5 fundamentally flawed because it expressly ignores the fact that there is a reason the fees for actively managed investments are greater than the fees for passively managed investments. Understanding the Role of the CRF’s ARS Portfolio For a pension fund such as the CRF, which strives to generate long-term returns to ensure adequate funding for a defined benefit pension plan, more sophisticated, actively managed alternative investments that deliver risk-adjusted returns have become increasingly important to the overall portfolio. This is because the CRF, like other large long-term investors, by and large has relied on equities and equity-like instruments to drive its returns, However, to protect the portfolio against bearish (declining) equity markets, the CRF, like other pension funds, looks for diversifying asset classes that can generate attractive returns during these times. Traditionally, fixed income assets have provided good diversification benefits with attractive retums; however, because global fixed income securities have been trading at or near all-time lows, it has become increasingly important for the CRF to find other asset classes that can provide similar

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