...Investments

The total annualized fund performance for the five-year period ending June 30, 2007 was 10.5% for PSRS and 10.4% for PEERS. The total annualized fund performance for the 10-year period was 8.2% for both PSRS and PEERS. This long-term return exceeded the policy benchmark of 7.8%. The Systems’ basic investment objective is to achieve a total return that exceeds the actuarial assumption of 8.0% over rolling five-year periods. Thus, both PSRS and PEERS have exceeded the 8.0% assumption for both shorter and longer term time horizons. Additionally, PSRS/PEERS’ investment returns were generated while taking less risk than a large majority of other public pension funds in the nation over all time periods. Investment performance throughout this report is calculated using a time-weighted rate of return based on market values.

Changing Asset Allocation

The Board began making significant changes to the historical asset allocation in January 2002 with the decision to allocate 3% of total assets to private equity and 5% to real return assets. Since that time, the Board has followed a long-term strategic plan to further diversify the asset allocation and to systematically reduce the allocation to bonds. As I referenced in the last annual letter, the Board adopted another phase of the long-term plan in October 2006 to increase the target allocation of alternative assets. In April 2007, the Board continued with the strategic changes achieved in the previous fiscal year with the adoption of the Implementation Pool. The funding of this mandate specifically allowed the Systems to reduce the Public Debt exposure to the target of 25%. The Implementation Pool will act as a placeholder for assets that will eventually be invested in the PSRS/PEERS alternative asset classes: Real Estate, Private Equity and the Absolute Return Pool.

The following table indicates the long-term target asset allocation as well as the actual asset allocation at the end of the fiscal year (June 30, 2007) and for the most recent time period (November 30, 2007):

We have included a ‘snapshot’ look at the asset allocation at two recent time periods to indicate the steady progress that is being made toward reaching the long-term asset allocation targets. For example, the allocation to alternative assets (private equity, real estate and absolute return) has increased from 5.8% at the end of the fiscal year to 7.5% at the end of November. The allocation to the Implementation Pool and to Public Equity will decline over time as assets are transitioned into the alternative asset classes. It is anticipated that the Implementation Pool and the over-allocation to Public Equity could be utilized for up to five years because of the long-term investment cycle involved with private assets. We believe that the target asset allocation has laid the foundation for a strong investment program, regardless of market environment, for PSRS/PEERS for many years to come.

From Optimism to Pessimism
Former Secretary of the Treasury, Larry Summers, was quoted as saying “in economics, things happen slower than you expected they would but when they finally do, they happen faster than you imagined they could.” Certainly, the recent transition in the investment markets from ‘optimism’ in early 2007 to ‘pessimism’ at the end of the fiscal year demonstrates this phenomenon.

The subprime issue, which more than a few pundits cautioned about as early as 2006, was relatively ignored until mid-July. At that point, what had been shrugged off as unimportant became everyone’s focus. The subprime problem, most simply, was brought on by the large amount of mortgage credit extended at below market rates, often without proper documentation of collateral. Much of the risk associated with these loans was distributed through the packaging and reselling of mortgage loans. In short, with risk dispersed (through the resale of the mortgage loans) and no one sure who was left holding the bag, everyone became suspect, thereby resulting in a worldwide reduction in risk tolerance. The fundamental, psychological and technical influences devastated the market for subprime investments, but they also had a contagion effect. Investor psychology turned in all markets, even those totally unrelated to subprime loans. Caution replaced optimism. Risk aversion took over from the prior risk seeking mentality.

There is no question that all investors (including PSRS/PEERS) have been negatively impacted to some degree by the overall effect of the subprime event on our economy. However, the Systems had no direct exposure to the problematic investments. Instead, any impact felt by PSRS/PEERS is a function of being a large institutional investor in an economy that has suffered from the negative consequences.

Is the market as good as it was in January 2007 or as bad as it seemed in August 2007? The answer is undoubtedly no. Instead, we have experienced another phase of a long market cycle. In reality, there is strong global economic growth, few current trade wars, relatively low inflation and ample liquidity. We have experienced five years of generally good economic growth, rising equity markets, low interest rates, ample credit, a housing boom and benign inflation. The markets were due for a correction when this past summer’s mortgage-related bad news began to unsettle investors. While unpleasant to go through, we view this movement as a healthy and necessary correction of the overall financial market.

Your Portfolio and Our Focus

We expect further volatility in the financial markets for much of fiscal year 2008. The global unwinding of risk is probably not over nor are the daily reports of new portfolio problems from market participants. As discussed in this letter, the Systems have increased exposure (in a deliberate manner) to alternative investments over the last several years. However, the Systems have not meaningfully increased the total portfolio risk or the exposure to various derivative instruments. Thus far, during the recent credit crisis, the higher risk strategies have suffered more on a relative basis.

The Systems continue to focus on a well diversified and disciplined investment program as the best course of action for the long-term. Ultimately, we believe that the investment environment will offer opportunities for patient, long-term investors such as PSRS and PEERS. As such, the Systems’ investment staff will continue to analyze all investment opportunities within a total portfolio context to allow PSRS/PEERS to maintain a well-diversified and prudent portfolio. Over the long-term, we believe this approach will provide consistent and meaningful investment returns for all members of both PSRS and PEERS.