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Four finalists from Institutional Investor's annual investment awards offer a candid assessment of the investment risks and opportunities ahead.

For the stewards of pension funds, endowments and foundations, finding new sources of alpha is a relentless challenge. Another year of solid returns from equities has helped the cause, but share valuations in many markets now look rich, leaving little margin for error. The interest rate outlook for the U.S. remains uncertain. And a flood of capital is rushing into hedge funds, private equity and real estate, squeezing the return potential and heightening the already stiff competition for allocations to top managers.

What's a forward-thinking investor to do? To find out, Institutional Investor invited four of the most respected names in the business to participate in a roundtable discussion. Three joined us at our Manhattan offices last month: Ralph Egizi, director of benefits finance and foreign exchange at Eastman Chemical Co.; Andrew Golden, president of Princeton University Investment Co.; and D. Ellen Shuman, vice president and chief investment officer of Carnegie Corp. of New York. Ronald Schmitz, director of the Oregon State Treasury's investment division and director of investments at the Oregon Public Employees Retirement Fund, participated in the discussion by teleconference.

All four have stellar track records and were finalists in II's 2006 Awards for Excellence in Investment Management. Schmitz and Egizi, who oversee $57 billion and $1.1 billion, respectively, have aggressively allocated to alternative asset classes. Although Golden, who runs about $14 billion, and Shuman, who manages $2.5 billion, are also big believers in alternatives, they are scouring the globe in search of the next generation of pioneering portfolio managers. Both were among the award winners, announced by II in November (see page 40).

In a lively conversation the panelists offered their views on a range of investment issues, including the allure of emerging markets, the challenges of assembling an optimal number of manager relationships and the attractiveness of specialist, long-only mandates in a potentially lower-return world. The discussion was moderated by Senior Editor Loch Adamson and Assistant Managing Editor Len Costa. Excerpts follow.

Institutional Investor: How aggressively are you allocating overseas? Does the debate about Sarbanes-Oxley and the competitiveness of U.S. capital markets play into your decision making?

Golden: A couple of years ago, we articulated a grand, unifying theme for our behavior moving forward that involved directing a lot of effort to bringing up the quality of our network of relationships. That meant deploying more capital with local foreign investors. That has nothing to do with the competitiveness of U.S. markets. We're doing it because we see an opportunity. The quality of investment management overseas has improved tremendously over the past decade. But it was only two, three, four years ago that we really saw that local investors were able to capitalize on their information edge in a way that was competitive with U.S.-based investment managers. We now have 33 local foreign relationships; two years ago we had 11.

Shuman: There is a trend in institutional investment management toward more-global portfolios, and certainly, we have a much higher equity allocation outside the U.S. than we have in the U.S. There's an argument to be made that markets outside the U.S. are less efficient, so there is a greater opportunity for active managers to add value, and I've certainly seen that. But I don't think Sarbanes-Oxley is affecting us directly in our manager selection.

Schmitz: Not too many years ago, Oregon's 20 percent target allocation to international investments was high in the public fund universe. It's probably about average now, and we're in fact looking at eliminating the home-country bias that we do have. We have a lot of exposure to private equity, and we view Sarbanes-Oxley as a great thing. It creates some good opportunity in the private equity world.

Given your increasingly global orientation, do you have any concerns with emerging markets, which are having a big run?

Egizi: You have to be very selective. We're looking at Russia: Its debt is now investment grade, and it looks like the country is much more stable. But the political environment is still a big question. Some other countries have political issues that come into play too. As far as growth is concerned, India and China are a phenomenal opportunity.

Shuman: The earnings growth is very powerful in emerging markets -- that's a new phenomenon. The condition of these countries is completely different than it was ten years ago in terms of their reserves and their relative stability. I'm still pretty bullish, but investors have to be ready for a volatile ride.

Ralph, what's your outlook for the U.S. stock market?

Egizi: Any time you've had a four-year run, I think you worry about when the trend will turn. When is that going to happen in the U.S.? How long can you continue to outperform general long-term returns? You've got an inverted yield curve -- what impact will that have, and how long will it last? Look at what's happening in housing markets and high prices in crude oil. None of that seems to have affected the overall economy to any great degree so far. But at some point in time, it's got to.

Golden: It's pretty apparent that corporate profit margins are really high, perhaps historically high, and the one thing we know about capitalism is that, all things being equal, profit margins do retreat. That tends to cause some issues for financial markets.

Shuman: Ron mentioned private equity. There have been massive amounts of leverage employed, and you're seeing that debt-to-ebitda multiples of these buyout deals are now what the purchase multiples used to be. We are also seeing a lot of triple-C debt issuance. People have forgotten that 50 percent of triple-C debt defaults over a ten-year period, at least historically.

Golden: Creditors have forgotten that. I'm not sure debtors have!

Shuman: I think a lot of these things are priced to perfection. I would not expect our returns next year to be as robust as they have been.

Ralph, how serious is the retirement crisis?

Egizi: I don't think it's a crisis. If you look back, all of this started two or three years ago because two things happened simultaneously: We had interest rates and returns on assets both decreasing. It was a double whammy, and so all of a sudden you had these plan deficits. Unfunded liabilities grew to fairly significant amounts, and people thought, "Well, that's a crisis." You have a long-term expected rate of return, but cyclical changes are going to occur. Interest rates and discount rates are going to go up and down over time. Asset returns are going to go up and down over time. The markets have now had a wonderful four-year run. You will see at the end of 2006, I think, a significant reduction in corporate pension plans' unfunded liabilities. What's changed? Nothing has changed. We're continuing to invest the way we should. The crisis, which was a huge crisis for some people, is now significantly muted.

What's your take on the Pension Protection Act?

Egizi: I think the act was a good thing. It tried to establish some kind of consistency of reporting. The problem is that there are too many ways to look at the value of your pension fund and your deficit, or unfunded liability. You had different calculations for different purposes. It got ridiculous. I think coming to a more consistent set of assumptions to use across the board is a good thing for all of us, and it will make financial statements in the long run clearer and more understandable.

Are you contemplating freezing or terminating your plan -- or moving toward an investment strategy that matches assets to liabilities?

Egizi: I won't comment on freezing or not freezing plans. Liability-driven investing is certainly the flavor of the day. It existed many years ago under different terms and was called portfolio immunization. I'm not convinced of the economics.

Schmitz: There aren't any! It's a bad economic decision for solving an accounting problem. In the corporate world you are trying to control the annual pension expense number by liability-matching your portfolio. For different reasons, this is a bit of an issue for public funds as well. We have pressure to control contribution volatility. Twenty years ago immunization maybe made some sense because interest rates were in the double digits. But when interest rates are at 5 percent and a long-term investment strategy can earn you about 8 percent -- not necessarily over the next three or four years, but over the long term -- [with liability-driven investing] you're solving a short-term accounting issue by forcing a bad economic decision, one that you'll pay for over time.

What is the outlook for the traditional long-only active manager?

Golden: We think there's still a lot of opportunity with long-only managers. It's about getting money into the hands of players who, through specialization and concentration, can gain an edge.

Shuman: In a lower-return environment, which I think we're entering, long-only looks more and more attractive, partly given the fee burden of alternatives options. With the hedge funds at 2 and 20, you have to do so much better just to break even compared with an index investment. I'm really starting to think that long-only could maybe play a greater role in our portfolio. It's very hard to identify new absolute-return managers given the kind of fee structures that are prevalent today. They have to be pretty special for us to give them an allocation, and they are pretty few and far between.

So one of the ways to get more bang for your buck is to invest in a specialist long-only structure?

Shuman: Yes, I think it is. We just heard from a manager that I think has only five or six stocks. It's tiny and concentrated, but I think that's great.

Speaking of concentration, how many managers is too many?

Shuman: Manager proliferation is a huge issue. We all have way too many managers, but it's hard to stop it.

Golden: The definition of "too many" depends on what the managers are doing. I actually don't think we have too many. We can put together a roster of 120-plus really important relationships, and while that may sound like a lot, it's not, as the roster is covering a very large number of niches and strategies. On the other hand, more than two managers would probably be too many if they ran highly diversified portfolios in large-cap U.S. equities.

Egizi: We take a slightly different approach. Our portfolio of about $1.1 billion is largely passively invested on the stocks and bonds side through indexation and enhanced indexation. We use our risk budget, if you want to use the term, in the alternative space, where we spend our time and effort trying to find those areas where we think we have an advantage. The number of managers is quite small on the stocks and bonds side of the portfolio, but we have a fairly large allocation to alternatives compared to other funds our size.

Schmitz: I was struck by the comment that Andy made, that you are probably overdiversified in your number of managers if you have more than two in the U.S. large-cap equity space. I don't know if I would go quite that far. But we do think very carefully about how managers fit together when we're assembling our U.S. and international portfolios. We're very comfortable that there is not a great deal of overlap in terms of what they're trying to do even within, say, large-cap growth or large-cap value, where we do have multiple managers in each bucket. Where I think there's a lot of overdiversification isn't necessarily in the number of managers but in managers trying to control their business risk by overdiversifying their portfolios. I would love to see them run portfolios of 20 or 30 names instead of 50, 80, 100 or 150 names. Even nonenhanced-index managers are running 100-plus holdings in their portfolios these days. That's where the real rub is and where I'd like to see us start pushing back.

Golden: That's a great point. A lot of what we're trying to achieve is optimizing the sharing of risk among our managers, including their business risk. From a manager's perspective, to finish first you have to first finish. We work with our managers to make sure that our dollars are flowing to those who are currently in a high confidence state and are concentrating on just a few issues. But we let them know that they aren't going to get penalized when their style is out of favor. We'll stick with them. In roughly 12 years the number of managers we've both hired and terminated can be counted on two hands. That's how you deal with a portfolio being managed suboptimally to control business risk.

Given some of the megabillion-dollar LBO funds that are being raised and deployed, is there a concern that people might be destined for disappointment? Or do opportunities remain?

Shuman: In addition to the very high use of leverage, fees are extraordinarily high. That never ends up well. General partners are getting paid monitoring fees; I always thought that was what the carried interest was supposed to be for. Also, expenses that were formerly absorbed by the management fee are now being passed on to investors. I think these issues are going to cause some stress on the system, and they are creating an asymmetry between the risk to the investor and the risk to the manager, which is very worrisome to me.

Ron, any thoughts given your big allocation to private equity?

Schmitz: Our allocation is north of 10 percent right now and going higher. If you think the next five years are going to be like the past five years, with returns of 20, 25 or 30 percent, you're going to be disappointed. But if your expectation going in is that you can still get a 300-to-500-basis-point premium over the public markets, I don't think you will be. Ellen mentioned fees. Most of the funds that we're in have the limited partners taking 80 percent of the profits. So to me, deal fees, monitoring fees, investment banking fees or director fees aren't really an issue. The factors that drove private equity market returns in the past five years haven't all gone away. Certainly, prices being paid today are higher than they used to be, but debt is still cheap. There is still in many cases a tremendous advantage given the way private equity firms have morphed over the past ten years. It's no longer a financial engineering game. Most of the top private equity firms have good operators as well as good financial people. So I still think there's a lot of wind at the back of the private equity world.

Golden: I think it's interesting that it seemed natural to clarify that the 80 percent goes to the LP -- that in the day and age we're living in, we have to make sure that we're all on the same page on that point.

What is your outlook for venture capital?

Shuman: It's harder and harder for institutions to invest in venture. If you knew going in that you would receive the median return, you would never do it, because the median return is unacceptable on a risk-adjusted basis. We all want to be above average and top quartile, but the size of those funds, in general, is small. We're often getting cut back. I suspect that it's even harder for the larger endowments, and certainly for a public pension fund, because there just aren't that many managers who are in that top quartile and the fund sizes by definition are relatively small. So I think we're going to see a shift in venture allocations. I'm very happy with our asset base because we can get a $5 million or $10 million allocation to a fund. I honestly think that larger funds probably shouldn't go there because the allocation is going to be meaningless to them if it's just 1 or 2 percent.

Golden: Venture capital is part of the motivation behind our grand, unifying theme. The reason we are spending so much time overseas is to identify earlier where we think the next great local venture capitalists will be and to develop a true partnership with them. Not only do we get a large allocation, but we also can help them develop their firms in a way that tilts the odds in favor of a very sustainable business. That's part of the relationship aspect of it.

Some funds of funds that avoided the blowup at Amaranth Advisors say the protection they provided to investors proves the value of that extra layer of fees. Do you agree?

Golden: There's no question that one should not invest in these highly inefficient areas without expertise. You can buy a wealth of that expertise through a fund of funds, although that raises the question of whether the fear level takes out the advantage. If you have to have an intermediary to provide guidance, maybe you can't afford to be in that area.

Do you view hedge funds as their own asset class or as the asset class of the underlying securities? Does it matter?

Golden: The hedge fund format is a structure in which the general partner invests assets alongside those of the limited partners and charges an incentive fee. That format can be applied to a variety of investment strategies and many different asset categories. But there's a whole collection of strategies in which we describe the driver of return as being highly independent of major markets -- that's a category we call independent returns. People say, "That's your hedge fund program." Thank you, I don't think so. It's a subsegment of the hedge fund universe. We've got hedge funds throughout the portfolio. For example, we have managers who invest long-only in domestic equities via a hedge fund format; those managers are classified in our domestic equity allocation. Conversely, managers that are doing a good amount of short-selling, as well as investing in long positions, would fall into the independent return category.

Shuman: We have a very loose definition of a hedge fund. We have some long-only managers that we pay hedge-fund-like fees to; we have some in a category we call absolute return and some in emerging markets, where they've got a partnership structure with a broad investment mandate. In general, we define a hedge fund manager as one with superior expertise and a flexible investment mandate. We allocate to managers based on their underlying strategy and security exposures, not according to whether they charge a performance fee. If a long-short manager has a consistent net long exposure, they may very well go in our marketable equity portfolio and not in our absolute-return portfolio. But we may also categorize a manager with a large net long exposure in the absolute-return portfolio if we know that they are willing to change that exposure significantly based on fundamental, bottom-up securities analysis and opportunities they see in the marketplace.

Are you allocating to real estate? And if so, do you have any concerns in this asset class going forward?

Shuman: We love real estate because it's wildly inefficient and we've been able to find managers that are very, very disciplined and have done a tremendous job. But there's no doubt that valuations are astronomical right now. You have to invest with local sharpshooters because they know that this side of the street is better than that side of the street, that this floor plan is more functional -- those kinds of things. We don't invest globally, and one of the reasons is that private foundations have unrelated business income tax issues that pension funds do not have. So unless we can utilize a private real estate investment trust structure, we have a much harder time investing tax-efficiently -- and globally, it gets even more complicated.

Ron, tell us about your real estate program.

Schmitz: Real estate professionals are properly a lot more pessimistic than I am. But I keep pointing out to them that all my asset classes are overpriced. We have not reduced our allocation; it's about 8 percent of the portfolio. We've taken some money off the table in low-risk core investments because we see tremendous capitalization rate risk there, and we've shifted about 30 percent of the portfolio primarily into value-added real estate, where the buy going in is cheaper. It's higher risk. But by diversifying the types of risk we're taking, we're comfortable that we're actually reducing the overall risk in the portfolio. We've also added to our international positions, again primarily in value-added and opportunistic strategies.

Thank you all very much.

Commanding performance

Money managers who deliver exemplary results deserve special recognition -- especially those who are charged with a public trust. That's why we at Institutional Investor magazine decided to honor outstanding achievement at endowments, foundations and public and corporate pension funds with our annual Awards for Excellence in Investment Management. The editors of II chose the 2006 winners from a list of 16 finalists and announced the awards at a gala dinner held at Chicago's Ritz-Carlton hotel in November.

In making their final selections, editors weighed the nominees' investment performance records, asset allocation skills and innovativeness, among other factors. Below are profiles of the four winners: Gary Bruebaker, chief investment officer, Washington State Investment Board; Andrew Golden, president, Princeton University Investment Co.; Michael O'Donnell, chief financial officer, NiSource; and D. Ellen Shuman, vice president and chief investment officer, Carnegie Corp. of New York.

BRUEBAKER: Testing new alternatives

Gary Bruebaker is used to outdoing his peers in the public fund world, but he doesn't let good numbers get to his head. "I have absolutely no ego," says the 51-year-old CIO of the Washington State Investment Board, which oversees $55.7 billion. "There are going to be years when you look different from everybody else and your returns don't look so good."

If the first nine months of last year are any guide, 2006 isn't likely to be one of them. Through September 30 the state's main retirement fund had returned 15.76 percent, well above the 10.61 percent median return for public funds with more than $1 billion in assets, according to Wilshire Associates.

A generous allocation to alternatives helped power those returns: Private equity, which makes up 17 percent of the fund, earned 33 percent. Real estate, 11 percent of the portfolio, was up 23 percent. The combination has helped the fund stay on top over longer periods too. In the three years ended September 30, Bruebaker returned an annual average of 15.67 percent, compared with 12.38 percent for the median public fund; over five years his fund earned an annualized 10.81 percent, versus the median of 9.20 percent.

WSIB helped pioneer public fund investing in private equity 25 years ago. Now Bruebaker is seeking new alternatives. This year he will begin investing in what he calls an innovation portfolio, which will make up as much as 5 percent of the fund. The goal is to experiment with new asset classes.

"It used to drive me nuts when a really good idea came in that didn't fit neatly into any particular space," says Bruebaker. On the list: commodities, infrastructure funds and active currency management. "If these work out, they could graduate to be their own asset classes."

Bruebaker says he's committed to staying in the public sector, in part because his mother, Helen, worked for 29 years as head of central payroll for the state of Oregon before retiring in 1987. After earning a bachelor's degree in business administration from Oregon State University and an MBA from the University of Oregon, Bruebaker worked for his home state for 22 years, the last eight as deputy state treasurer, before moving to WSIB to become CIO in 2001.

"Yes, I could make more in the private sector," says Bruebaker, who has received lucrative offers. "But it's not who I am on the inside." -- Steven Brull

GOLDEN: Building global relationships

Andrew Golden, president of Princeton University Investment Co., got his start in endowment management in 1988 as a graduate student intern at Yale University's investment office, working for renowned CIO David Swensen. After receiving a master's degree in public and private management from Yale in 1989, Golden joined the investment office full-time but left after only four years. Why? The lousy salary. "The job was great, but the pay scale at Yale was horrible," says the genial 47-year-old.

Golden nearly doubled his income when he moved to his undergraduate alma mater, Duke University, to become a director of investments. But he spent even less time at Duke -- just 18 months -- before Princeton recruited him to take charge of its then-$3.5 billion endowment. Golden began his job at Princo in January 1995; in the 12 years since, the endowment has quadrupled, to about $14 billion. Performance has been stellar: In the ten fiscal years ended June 30, 2006, Golden delivered annualized returns of 15.5 percent, compared with an average of 11.4 percent for endowments greater than $1 billion, according to preliminary data from the National Association of College and University Business Officers. In fiscal 2006 the fund was up 19.5 percent, versus an average of 15.2 percent for $1 billion-plus endowments.

Although Golden was an early adopter of the highly diversified style of portfolio management pioneered by Swensen at Yale, transforming Princeton's endowment took some effort. In his first two years on the job, he spent much of his time working with Princo's powerful board chairman, Richard Fisher, then chairman of Morgan Stanley, to revamp the investment office; Golden wanted greater authority to hire and fire external managers.

The CIO began with a portfolio that was divided among just a few external managers; now he has a deeply diversified roster of more than 120 active relationships spanning all asset categories, including a growing global presence.

"We went from having 11 or so foreign local managers overseeing about $500 million to three times as many overseeing about $3 billion," he says.

Today his team includes 14 investment professionals, and he is quick to share credit for Princo's success with his two lieutenants, Daniel Feder, 43, who oversees the private equity program, and Jon Erickson, 40, who "oversees everything else," Golden says.

In an effort to spur creative thinking and valuation-independent portfolio design, Princo's chief encourages his team to focus ten to 20 years in the future. The goal is not only to deliver solid returns in the near term but also to ensure that the portfolio is optimally positioned to support future generations of Princetonians. -- Loch Adamson

O'DONNELL: Applying a steady hand

As an infantryman in Vietnam in 1968­'69, Michael O'Donnell saw short bursts of combat interspersed with long stretches of boredom. Now CFO of NiSource, a distributor and generator of gas and electricity based in Merrillville, Indiana, O'Donnell says his wartime experience provided a salutary lesson for managing the company's pension fund.

"Like battle situations, returns in the marketplace come in very short periods," he says. "That taught me to stay away from market timing."

O'Donnell, 62, joined NiSource in 2000 when it acquired Columbia Energy Group, where he had served as CFO since 1993. Despite pressure from company executives to cut and run from equities during the market's 2001­'02 decline, he stayed the course, helping NiSource's $2.05 billion pension fund outperform despite a conventional asset mix of 65 percent in stocks, 30 percent in bonds and 5 percent in alternatives. In the 12 months ended September 30, 2006, the fund returned 9.6 percent, compared with a median 9.55 for corporate plans, according to Wilshire. For the three- and five-year periods ended September 30, the fund delivered average annualized returns of 12.4 percent and 10.4 percent, respectively, outpacing the 11.84 and 8.67 percent medians. Thanks to those solid returns, O'Donnell has lowered NiSource's pension contributions over the past five years by about $300 million.

As CFO, O'Donnell's duties encompass more than just the pension fund, and he praises Stephen Gallas, NiSource's manager of benefit plan investments, and Richard Babcock of NiSource's Atlanta-based investment consultant, LCG Associates, for helping to deliver strong results. Key return drivers include a large-cap value allocation managed by San Francisco­based Dodge & Cox that earned 14.9 percent in the 12 months ended September 30, compared with 10.7 for its benchmark, the Russell 1000 index; and an international equity allocation to Boston-based GMO that returned an average of 18.7 percent annually in the five years ended September, versus 14.3 for the MSCI EAFE index.

O'Donnell, who earned a bachelor's degree in economics from Temple University, plans to boost his plan's exposure to alternatives from 5 percent to 10 percent over the next two years, mostly through private equity, funds of hedge funds and other absolute-return strategies. In 2006, NiSource made its first foray into fixed-income arbitrage when it hired Legg Mason subsidiary Western Asset Management Co. -- S.B.

SHUMAN: Emphasizing focused mandates

D. Ellen Shuman, the first-ever chief investment officer of Carnegie Corp. of New York, knows a thing or two about forging her own path. As an undergraduate in the class of 1976 at Bowdoin College, she wanted to compete in her chosen sport, springboard diving, but the college had only recently become co-ed and didn't have a women's swim team. So the petite, outspoken athlete joined the men's team instead.

"At the time, I really didn't think it was odd," says Shuman, 51, who has overseen Carnegie's $2.5 billion portfolio since January 1999. "That's just how it was, and I wanted to compete."

The CIO no longer performs front two-and-a-half somersaults -- "diving is definitely not a life sport," she says wryly -- but her willingness to take calculated risks is a hallmark of her tenure at Carnegie. For the five years ended September 30, 2006, her portfolio delivered annualized returns of 13.7 percent, compared with a median return of 11.1 percent for a composite of large nontaxable funds with $1 billion or more in assets, as measured by Cambridge Associates; in the fiscal year ended September 30, the endowment was up 18.5 percent, versus a median of 12.0 percent.

Shuman has achieved exceptional returns by implementing high hurdles for prospective managers and playing to strengths she developed while working at Yale University's investment office. She earned a master's in public and private management from the Yale School of Management in 1984 and spent the next two years performing budgeting and financial planning for the university's administration. She went to work for David Swensen in 1986, a year after he came in as Yale's CIO, and eventually took responsibility for all capital markets and real estate activities. Shuman stayed at Yale for 13 years, overlapping with Princeton's Andrew Golden, before leaving for Carnegie.

As the foundation's first CIO, her initial challenge had less to do with overhauling the portfolio than with building an investment team and fine-tuning asset allocation. She now has three senior investment professionals working alongside her, overseeing a broadly diversified portfolio with asset allocation targets of 32 percent in global developed equity; 10 percent in emerging-markets equity; 10 percent in fixed income; 21.5 percent in absolute-return funds; 13.5 percent in private equity; 11.5 percent in real estate and natural resources; and 1.5 percent in cash.

Shuman's exposure to emerging markets, while volatile, has been a strong contributor to performance. So has her recent shift from core managers to local managers with narrow specialties. "In real estate we tend to look for managers who focus on a specific property type or market," she says. "In emerging markets we look for managers who have a very specific regional or country focus."

Despite the demands of her job, Shuman serves as a trustee of Bowdoin and a member

of its investment committee. She happily reports that her alma mater now has a women's swimming team. -- L.A.