The PRIT Fund is a pooled investment fund established to invest the assets of the Massachusetts State Teachers’ and Employees’ Retirement Systems, and the assets of county, authority, district, and municipal retirement systems that choose to invest in the Fund. The PRIT Fund was created by the Legislature in December 1983 (Chapter 661 of the Acts 1983) with a mandate to accumulate assets through investment earnings and other revenue sources to reduce the Commonwealth’s significant unfunded pension liability, and to assist local participating retirement systems in meeting their future pension obligations. The PRIT Fund merged with the Massachusetts State Teachers’ and Employees’ Retirement Systems ("MASTERS") Trust on January 1, 1997, in accordance with Chapter 315 of the Acts of 1996. As of June 30, 2001, the assets of the PRIT Fund totaled $29.4 billion. The PRIM Board is charged with the general supervision of the PRIT Fund.

PRIM’s mission is to maximize the return on investment within acceptable levels of risk by broadly diversifying its investment portfolio, capitalizing on economies of scale to achieve cost-effective operations, and providing access to high quality, innovative investment management firms, all under the management of a professional staff and members of the Board.

The PRIT Fund consists of two investment funds: the Capital Fund and the Cash Fund. Cash, deposited and invested on a temporary basis, is transferred monthly from the Cash Fund to the Capital Fund. Once in the Capital Fund, funds are invested and reinvested across all asset classes under PRIM’s long-term investment guidelines and asset allocation plan. The Capital Fund serves as the long-term asset portfolio and consists of ten accounts: General Allocation Account (the investments in which may consist in whole or in part of units of the other accounts), Domestic Equity, Fixed Income, International Equity, Emerging Markets, Core Real Estate, Non-core Real Estate, Alternative Investments, Alternative Investments "Vintage Year" 2000, and Alternative Investments "Vintage Year" 2001.

This year, the PRIM Board revised the "long-term allocation" of the PRIT Fund. Using data from PERAC’s January 1, 2000 Valuation Report of the Commonwealth’s Total Pension Obligation, PRIM’s general fund consultant, Wilshire Associates, prepared an asset-liability analysis addressing the Fund’s long-term return targets, risk and return assumptions for the major asset classes, and various optimal asset allocation plans. At the January 2001 meeting, the PRIM Board approved the following changes in the long-term asset allocation policy:

• reduce the long-term domestic equity allocation from 42% to 38%.
• reduce the emerging markets allocation from 4% to 3%, and increase the international equity allocation from 16% to 17% (this should more accurately reflect the relative market weight of developed and emerging markets).
• maintain the "core" (that is, excluding high-yield bonds) fixed income allocation at 21%, and include within it a dedicated allocation to Treasury Inflation Protected Securities ("TIPS") of up to 5%.
• maintain a dedicated 2% allocation to high-yield bonds, and a dedicated 1% allocation to distressed debt, and combine them into a separate " high-yield debt" asset class (breaking them out of, respectively, fixed income and alternative investments).
• eliminate the 1% dedicated allocation to convertible bonds.
• increase the real estate allocation from 6% to 8%, in order to add a 2% dedicated allocation to Timber, subject to implementation constraints.
• increase the long-term allocation to alternative investments from 8% to 10%.

The "interim allocation" temporarily assigns uninvested alternative investment and real estate allocations to domestic equity and fixed income. Six percent of the Fund (the difference between the long-term alternative investment target of 10% and the interim/current allocation of 6% plus the difference between the long-term real estate investment target of 8% and the interim/current allocation of 6%) is invested in domestic equity and fixed income on a two to one ratio. The current "Interim" and "Long-Term" Allocation Plans, shown on the following page, took effect on July 1, 2001.

After posting six consecutive years of strong double-digit returns, the PRIT Fund experienced the first negative return in its 16-year history for a fiscal year-end. However, the Fund surpassed its interim policy benchmark by a substantial margin, not only validating the benefit of portfolio diversification, but of diversification within asset classes. As a result of this diversification, the Fund "weathered the storm" and withstood a volatile period which could have been far worse had PRIM failed to implement its asset allocation plan as skillfully as it did.

The first half of the fiscal year was wrought with the sting of rising oil prices, the sobering effects of the Internet/technology sector meltdown (both domestically and internationally), a renewed crisis in the Middle East, weak corporate earnings, and the Federal Reserve’s aggressive pursuit of phantom inflation. If all that was not bad enough, the protracted presidential election threatened to plunge the nation into a Constitutional crisis.

For the six-months ended December 31, 2000, the total U.S. stock market, as measured by the Wilshire 5000 index, declined 10%. The developed foreign stock markets, which had produced stellar returns the previous year, fell almost 11% in the first half of the fiscal year according to the MSCI Europe, Australasia, Far East ("EAFE") index. Even more disconcerting was the drastic drop in the emerging markets, an asset class that had produced some of the highest returns among world markets last year. The MSCI Emerging Markets Free ("EMF") Gross Dividends index returned –25.58% for the first six months of fiscal year 2001.

A "safe haven" for investors on the public markets side was bonds, with the exception of the high yield markets. The Lehman Aggregate index rose over seven percent for the six-month period ended December 31, 2000. Publicly traded Real Estate Investment Trusts ("REITs") also performed well, as the NAREIT Equity REIT index recorded a six-month return of 11.64%. Direct investments in real estate properties also yielded positive returns in the first half of fiscal year 2001.

In the second half of the fiscal year, equity markets continued to struggle. The downturn that pulverized the so-called "new economy" stocks (Internet/technology) in the previous two quarters now extended to "old economy" (blue chip) stocks. And, as one company after another released disappointing earnings information, for the first time in a long while, many on Wall Street were using the "R" word to describe where the economy was heading.

Three interest rate cuts by the Federal Reserve (two in April and one in June) did not provide the market stimulus that many had hoped for. The Wilshire 5000 index, a broad market indicator, declined almost six percent for the six months ended June 30, 2001, resulting in a one-year year return of –15.35%. International markets, as measured by the MSCI EAFE index, fell almost 15% in the second half and returned –23.60% for the trailing 12-month period. After staging a comeback in January, the MSCI EMF Gross Dividends index returned –1.64% during the last two quarters of the fiscal year, producing a –25.82% return for the one-year period ended June 30, 2001.

Bonds continued to record positive returns. The Lehman Aggregate index added almost four percent to its previous gains, returning 11.23% for the fiscal year. High yield bonds bounced back and were up over four percent for the second half of the year, but ended basically flat on a trailing one-year basis. The NAREIT Equity index enjoyed another six months of superlative performance, returning 11.44%, which resulted in a 24.42% return for the one-year ended June 30, 2001.

The PRIT Core experienced a –2.56% return in the second half of the fiscal year and achieved a –6.60% for the one-year ended June 30, 2001. Again, PRIM exceeded its interim policy benchmark for the six-month and twelve-month periods by 160 and 244 basis points, respectively. Outperformance was attributable to active management on both the large and small capitalization domestic equity side and certain of the active international equity managers. Also, PRIM’s "core" (investment grade) bond managers outpaced the portfolio benchmark. Unfortunately, PRIT substantially trailed the 8.25% actuarial rate of return assumption mandated in the state’s pension funding schedule for the fiscal year. However, over the long-term, the PRIT Core has achieved an annualized return of 11.91% since inception (January 1, 1985 through June 30, 2001), which is 366 basis points ahead of that benchmark.

Domestic Equity. As of June 30, 2001, PRIM’s Domestic Equity portfolio constituted 42.5% of the Fund’s net asset value. For the fiscal year, the portfolio produced a –10.74% return compared to the Wilshire 5000 index return of –15.35%. Excess return above the benchmark was attributable to active large cap equity manager Legg Mason, and the active small cap managers, specifically AXA Rosenberg, Lazard, and Putnam.

For the one-year ended June 30, 2001, Legg Mason returned a positive 5.66% versus the Standard & Poors 500 index return of –14.82%, a difference of 2048 basis points. Lazard, a small cap value manager, beat its benchmark, the Russell 2500 index, 17.48% versus 2.44%. Small cap value manager Putnam smashed the Russell 2000 index with a return of 38.78% compared to 0.57%. Posting a return of 19.52%, small cap core manager AXA Rosenberg easily outpaced the Russell 2500 index by 1708 basis points.

As a group, PRIM’s large cap managers outperformed the S&P 500 index by 111 basis points for the fiscal year. The large cap component comprised approximately 72% of the total Domestic Equity portfolio at fiscal year-end. For the one-year period ended June 30, 2001, PRIM’s small cap managers substantially outperformed the Wilshire 4500 index (the small cap composite mandate) –2.06% versus –19.41%. The small capitalization component represented approximately 28% of the Domestic Equity portfolio as of June 30, 2001. PRIM’s fundamental strategy for Domestic Equity is to be neutral to the market with respect to capitalization weightings.

Over the longer-term, PRIM’s Domestic Equity portfolio has performed well on both an absolute and relative basis. On a three- five- and ten-year basis through June 30, 2001, the Domestic Equity portfolio returned 5.71%, 14.11%, and 15.17%, respectively, compared to the Wilshire 5000 index, which returned 3.50%, 13.06%, and 14.56%, respectively, for the same periods.

Fixed Income. As of June 30, 2001, 26.0% of the Fund’s net asset value was invested principally in domestic investment grade fixed income securities. On a one-year basis, the Fixed Income composite trailed the Lehman Brothers’ Aggregate Bond index, 10.07% versus 11.23%, resulting from exposure to high yield (below investment grade) bonds. PRIM’s "core" (investment grade) managers actually beat the benchmark by 39 basis points for the fiscal year.

Although the broad high yield market returns were basically flat for the year, one of PRIM’s high yield bond managers, Loomis Sayles, achieved a return of 8.00% for the fiscal year because they hold corporate bonds and U.S. dollar-denominated emerging markets debt.

On a three- five- and ten-year basis, PRIM’s managers returned 6.28%, 8.09%, and 9.16%, respectively, versus 6.26%, 7.48% and 7.87% for the Lehman Aggregate. Effective July, 1, 2001, the Fixed Income portfolio was split into two separate portfolios: Fixed Income "core" (investment grade bonds only, including Treasury Inflation Protected Securities) and High Yield Debt (high yield grade bonds and distressed debt).

International Equity. International Equity comprised 16.5% of the Fund’s net assets on June 30, 2001. This was a particularly challenging fiscal year in the foreign stock markets as the technology-media-telecom ("TMT") sector blew apart and the strong U.S. dollar hampered returns. For the fiscal year, the International Equity portfolio returned –18.74% compared to the MSCI EAFE index return of –23.60%. PRIM’s best performing manager during this period was the London-based, value-oriented Marathon Asset Management. Marathon’s return of –10.05% stood miles above the benchmark, adding 13.55% in excess return.

Over the longer-term, PRIM’s international equity managers continue to add significant value above the benchmark. On a three- five- and ten-year basis, PRIM’s international equity managers handily beat MSCI EAFE, 6.72%, 8.88%, and 9.72%, respectively, versus –1.28%, 2.89%, and 6.38% for the index over the same periods.

Emerging Markets. The Emerging Markets portfolio represented 3.4% of the total Fund’s net assets on June 30, 2001. The emerging markets, which were among the best performing asset classes last year, experienced a reversal in fiscal year 2001. PRIM’s emerging markets managers produced a return of –28.27% for the trailing one-year period versus the MSCI EMF index return of –25.82%. The vast majority of the losses occurred in the first half of the year when the portfolio declined almost 28%. The rebound occurred in the second half of the fiscal year when the portfolio returned –0.94% compared to –1.64% for the benchmark.

Comparisons with the policy benchmark favor PRIM over the long-term. PRIM’s emerging markets managers have returned 3.31% versus the benchmark return of 1.48% on a three-year basis, –0.33% compared to –6.40% for the index on a five-year basis, and 8.29% relative to the benchmark return of 4.83% for the ten-year period ended June 30, 2001.

Real Estate. On June 30, 2001, 5.6% of the Fund’s net assets were invested in Real Estate, which was PRIM’s best performing asset class in fiscal year 2001. For the one-year period, the portfolio returned 11.44%, trailing the NCREIF (one-quarter lag) index return of 11.89%, but well ahead of the long-term expected average return of 8.00% for this asset class. (PRIM’s real estate portfolio typically underperforms NCREIF because the portfolio assumes less risk than the index.)

To support PRIM’s "Segmentation" program, the Real Estate portfolio was bifurcated into "core" and "non-core" portfolios on July 1, 1997. For the one-year ended June 30, 2001, the "core" portfolio (separate account core and value investments in real properties and publicly traded Real Estate Investment Trusts, or REITs) returned 11.44%. The core portfolio represented 98% of the total Real Estate portfolio at fiscal year-end. The REIT market enjoyed a strong fiscal year and PRIM’s two REIT managers (RREEF and John McStay) returned 22.84%, but trailed the NAREIT Equity index by 158 basis points. The core real estate portfolio has returned 9.55% over a three years versus NCREIF at 12.51%, and 11.09% on a five-year basis compared to the NCREIF return of 12.72%. Again, these strong returns have been achieved with less risk than the benchmark. It is also interesting to note that for the fiscal year ended June 30, 2001, PRIM’s core real estate portfolio outperformed the Wilshire 5000 index by 2679 basis points, more testimony to the benefits of diversification.

The total Real Estate portfolio also benefited from the continued divestiture of the "Non-core" assets, which returned 11.52% for the fiscal year. Non-core assets are principally commingled fund investments made in the late 1980’s, of which approximately $33 million remained as of June 30, 2001.

Alternative Investments. As of June 30, 2001, Alternative Investments comprised 5.9% of the PRIT Fund’s net assets. The portfolio consists of special equities (buy-outs, consolidation, expansion capital) and venture capital (young, growing companies). The Internet/technology sector collapse that beset the public markets also took a toll on the private equity markets, specifically on the venture capital side, as some general partners took aggressive writedowns. The heretofore robust Initial Public Offering ("IPO") market also cooled down during the second half of the fiscal year.

For the fiscal year, the Alternative Investments portfolio returned –10.65% (last fiscal year, Alternative Investments was PRIM’s best performing asset class). The special equity and venture capital components returned –6.53% and –20.21%, respectively, for the twelve-months ended June 30, 2001. As there is a one-quarter lag in reporting Alternative Investments portfolio returns, the year-end numbers actually reflect performance for the one-year ended March 31, 2001. It is important to keep current returns in perspective by recalling that last year the venture capital return was in triple-digits. However, even those lofty returns, attributable to early distributions from partnerships focused on the Internet/technology industry, were far from the norm. We may be returning to a more traditional path in the life of a venture capital investment -- what the industry calls "the J curve effect" (low single digit or negative returns in the first three to four years followed by rising returns thereafter).

Over the long-term, however, PRIM’s Alternative Investments returns still compare well to the portfolio objective, which is to generate a return of at least 500 basis points above the S&P 500 index on a time-weighted basis. Through June 30, 2001, on a three-year basis the portfolio returned 13.30% versus the S&P 500 index return of 3.69% (961 basis points), and on a five-year basis, Alternative Investments exceeded the S&P 500 by 650 basis points, 20.94% compared to 14.44%. The portfolio achieved a 10–year average annual return of 18.84%, 376 basis points above the S&P 500. The 10-year performance is below our expectations primarily because PRIM was out of the venture capital market for most of the 1990’s. Notwithstanding that fact, the portfolio still generated a fair premium to the public markets over that period.

In 1995, the PRIM Board began to address this gap in the Alternative Investments program by investing on a more consistent basis. During the last six years, PRIM has committed $3.5 billion to 90 funds managed by 52 general partners, and has worked to establish "key relationships" with general partners in both venture capital and special equity.

Despite PRIM’s participation in the alternative investment asset class since 1986, 81% of PRIM’s commitments were made during the past six and one-half years, and 51% of the commitments were made during the last two and one-half years. While it will take some time before PRIM is able to fully measure its restructured program (investments made since 1995), PRIM believes that a solid foundation is being built for the future and will result in a portfolio that is well diversified by both stage and industry.

Over 95% of PRIM’s total budget was comprised of fees to external investment managers in fiscal 2001. The PRIM Board presents management fees in two ways: 1) including "investment level" or "non-cash management" payments, and 2) excluding such payments. More than one-third of overall fees was attributed to alternative investments and real estate. Most investment management fees for alternative investments are charged by the managing general partners to the investment partnership and not to the limited partner investors (e.g., PRIM) directly. Therefore, these partnerships incur the expense and report income to the limited partners net of those fees. Most investment management fees for real estate investments are charged directly to the property. Most pension funds do not include these non-cash management fees as part of their overall costs. Historically, PRIM has reported all investment management fees, including those charged at the partnership level, as part of the cost of managing the Fund.

The cost for fiscal year 2001 inclusive of all investment management, custodial, consulting, and overhead expenses (the total PRIM budget) was 38 basis points (0.38%) of the average net asset value of the PRIT Fund. This represents an increase over fiscal year 2000 when the expense ratio was 32 basis points. Excluding these "non-cash" management fees (as most public pension funds report), the total cost of managing the Fund was 24.5 basis points, up from 22.6 basis points in fiscal 2000.

Almost all of the increase in PRIM’s budget is due to higher payments to PRIM’s outside investment managers, particularly those managing large cap domestic equities, small cap domestic equities, international equities, alternative investments, and real estate. PRIM’s active public securities managers continue to accrue substantial performance fees by beating their benchmark return targets. In the alternative investment asset class, fees are charged as a percentage of committed, rather than invested capital. Accordingly, PRIM recognizes substantial management fees well before it benefits from actual investment returns. Over time, these fees should be offset many times over by investment returns.

The PRIM Board acts as Trustee for each retirement system that invests in the PRIT Fund and is responsible for the control and management of the Fund. The PRIM Board’s members are: the State Treasurer, ex officio, or her designee, who serves as Chair of the Board; the Governor, ex officio, or her designee; a private citizen experienced in the field of investment or financial management appointed by the State Treasurer; an employee or retiree who is a member of the State Teachers’ Retirement System elected by the members of such system; an employee or retiree who is a member of the State Retirement System elected by the members of such system; the elected member of the State Retirement Board; one of the elected members of the Teachers’ Retirement Board, chosen by the members of the Teachers’ Retirement Board; a person who is not an employee or official of the Commonwealth appointed by the Governor; and a representative of a public safety union appointed by the Governor. The current PRIM Board members are:

The PRIM Board employs a professional staff to manage the day-to-day operations of the Fund and report to the Board. The current staff members are:

The Chair of the PRIM Board has appointed advisory committees to provide a broad range of advice to the Board. These committees include Board members, representatives from participating or purchasing retirement systems, and private citizens from the investment or business community. Currently, there are four working advisory committees: Administration, Audit, Investment, and Real Estate.

Chapter 84 of the Acts of 1996, signed into law on May 15, 1996, explicitly confirms retirement boards’ authority to invest in individual asset classes of the PRIT Fund as an alternative to investing in the General Allocation Account. The program, called "Segmentation", gives local retirement boards the flexibility to select specific asset classes in whatever proportions they believe are best suited to their needs. Because of PRIM’s economies of scale, Segmentation provides an affordable means for retirement boards to make diversified investments in traditional and non-traditional asset classes. Local retirement boards may invest in one or more of the following investment portfolios of the PRIT Fund: Domestic Equity, International Equity (EAFE), Emerging Markets, Fixed Income, Core Real Estate, and Alternative Investments "Vintage Year".

Member State and Municipal Retirement Systems
A public retirement system within the Commonwealth may elect to invest in the PRIT Fund by vote of its board. The board may choose to invest as a Participating System or a Purchasing System. Participating systems invest all their retirement assets in PRIT for a minimum of five years, and qualify for funds appropriated by the Commonwealth to reduce the unfunded pension liability. A Purchasing System may invest in the PRIT "Core" (General Allocation Account) or in one or more of the separate investment accounts of the Core available through "Segmentation".