CITY OF LOS ANGELES DEPARTMENT OF WATER AND POWER

INTRADEPARTMENTAL CORRESPONDENCE

Date: September 5, 2018

To: Retirement Board Members

From: Linda P. Le, Retirement Plan Manager / V' Subject: Board Agenda Item No. 10: Report on Wellington Management, lnc. - On-Site Due

Diligence Visit (September 12, 2018, Regular Retirement Board Meeting)

Recommendation

That the Board of Administration (Retirement Board) of the Water and Power Employees' Retirement Plan (Plan) receive and file this report on the on-site due diligence visit to Wellington Management, Inc. (Wellington).

Summary

Investment Officer Ravi Sharma (staff) met with representatives from Wellington on June 27, 2018, in Boston, Massachusetts, to review and discuss the organization and operational processes relating to the investment portfolios it manages on behalf of the Plan.

The Retirement Board hired Wellington to manage an emerging markets equity mandate for the Retirement Fund (RF) and the Retiree Health Benefits Fund (RHBF) in March 2016. As of July 31, 2018, Wellington managed $333 million and $55.4 million for the RF and the RHBF, respectively.

Staff interviewed personnel directly responsible for managing the Plan's assets. Staff reviewed the capabilities of the management and operational teams and observed the available resources used by the firm to manage the Plan's portfolios. Staff met with the following members of the firm:

• Charles C. Ruch, CFA - Relationship Manager • Sarah B. Lewis, CFA- Consultant Relations Manager • David J. Elliott, CFA, FRM - Co-Director, Quantitative Investments and Director,

Quantitative Portfolio Management • Michael P. McElroy, CFA- Investment Director • Timothy J. Acquaviva - Manager, Securities Valuation • Susan J. Place - Director of Portfolio Accounting • Donna Yang - Client Analyst • Jeffrey Walsh, CBCP- Manager, Client & Enterprise Technology • David A Silva - Compliance Manager • Ryan L. Powers - Manager, Portfolio Guideline Monitoring • Tony da Silva, CPA -Associate Director, Operational Risk Management • Laura H. Lihon, CPA - Manager of Internal Audit • Thomas J. Hanlon - Director, Global Trade Coordination

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Key functional areas discussed were company overview, strategy and trading, portfolio operations, compliance, disaster recovery and business continuity. Wellington is currently not on watch status.

Company Overview

Wellington was established in 1928 as an asset management firm providing both fundamental and quantitative portfolio management. It provides investment management services for both individual and institutional investors in global equity, fixed income, currency, commodity and alternative strategies. Approximately 54 percent of assets under management are in mutual funds or other pooled vehicles. The remainder is in either separate accounts or institutional commingled pools.

Strategy and Process Review - Emerging Markets Equity

Staff met with Portfolio Manager David Elliot and Investment Director Michael McElroy, to review and discuss the emerging markets equity mandate they manage on behalf of the Plan.

The emerging markets systematic equity strategy is designed to be style-neutral, with its risk and return profile derived from stock-specific sources. The portfolio aims to limit structural biases relative to the benchmark and to focus risk taking on themes such as valuation, earnings quality, management behavior, and price momentum. The investment team utilizes proprietary risk models to monitor and control differences from the benchmark in terms of style, industry, sector, beta, country, and market capitalization. The process is intended to minimize unintended and unrewarded exposures relative to the benchmark.

The Emerging Market Systematic Equity approach utilizes quantitative portfolio construction techniques to target alpha generation within a disciplined risk-controlled framework. The primary inputs to the investment process are the quantitative equity model forecasts, a proprietary transaction cost model and a proprietary risk model. The Quantitative Investment Group updates the models over time to adapt to changes in the market by introducing new insights on an ongoing basis.

Wellington's proprietary quantitative equity model uses multiple factors to determine a security's attractiveness. Factors used within the model and their weights are developed according to demonstrated profitability and consistency, incorporating a long look-back period. The model incorporates a factor-weighting framework they call "contextualization" that adjusts the factor weights applied to individual stocks based on their predictive power. The model evolves over time to adapt to changes in the market.

A variety of factors from a proprietary factor library are considered for inclusion in the quantitative equity model. The model components reflect the aim of employing a diverse set of independent sources of alpha in the process. Factors are grouped within the following six investment themes:

• FairValue • Pure Value • Management Behavior • Earnings Quality • Short-Term Momentum • Long-Term Momentum

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Each security in the investment universe receives a composite score based on a weighted set of factors. This score is in the form of a return forecast, which indicates the relative attractiveness of a stock. A portfolio optimization tool combines the inputs from the quantitative equity model, transaction cost model, and risk model to generate suggested trades for the portfolio. The team conducts a fiduciary review of suggested trades before implementation. The portfolio is constructed to maximize the expected outperformance relative to the benchmark within the stipulated risk control parameters.

Portfolio Operations and Trading Review

Staff met with Thomas Hanlon, Director, Global Trade Coordination to review and discuss the firm's trading platform and capabilities.

The initial trading decision for a client account resides within the portfolio manager's discretion. Once the decision is made to buy or sell an instrument for a particular account, the portfolio manager places an order with the Global Trading team for execution. Before the trader works to implement the portfolio manager's objectives in the marketplace, he/she coordinates the general trading strategy with the manager. Traders are organized into fixed income, currency, non-U.S. equity, and U.S. equity desks. They handle the execution of all domestic and international orders for the firm. Wellington has a 24-hour trading operation, which seeks liquidity in the marketplace in order to achieve the best execution at the appropriate commission cost.

The portfolio manager completes a trade authorization and submits it to the trading desk via Portfolio Management Workstation (PMW), an internally developed order entry application. Compliance screening is then performed in Wellington's compliance system, Fidessa Sentinel. After the screening is completed and any violations are resolved, orders are distributed to the trader specializing in the respective sector and region. The trader accepts the orders, which are then entered into an internally developed trading system, Global Trading System (GTS) and if appropriate, the trader combines them with any existing orders for the same security. If the order is entered manually, compliance screening occurs when the order is entered into GTS.

Traders utilize the full range of available resources to evaluate the market and trade execution, including Electronic Communication Networks (ECN's), FIX engines, web-based tools, and third-party market data services. The trader will evaluate the difficulty of the block order (size, liquidity, urgency, price volatility, etc.) and gauge the types of brokerage services necessary to seek best price and execution on the order. Traders are unconstrained when selecting from which approved brol<er/dealers to use in executing specific transactions. The trader then places the order verbally or electronically, via an ECN. Once the order is executed, the trader records the details of the trade into a notebook and inputs the details into GTS. GTS automatically allocates the order on a pro rata basis. The process then moves to Trade Coordination for confirmation and trades are confirmed verbally or electronically, via a Virtual Matching Utility. Each evening the portfolio accounting system is updated with order executions. The trade operations team handles client and custodian trade notification. Most trades are communicated electronically to a client's custodian bank via SWIFT.

In order to minimize transaction costs on equity trades, all orders in a single security on substantially similar terms are typically aggregated across accounts and worked as a single transaction in the marketplace. They control the trade order using price limits and parcel trades into the marketplace rather than delegating full responsibility to outside brokers. If a stock's price is volatile and is moving away, the trader may choose to aggressively push the order in the marketplace in order to take maximum advantage of all available liquidity. The general trading

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strategy is coordinated with the portfolio manager as the trader works to implement the manager's objectives in the marketplace.

Compliance

Staff met with David A. Silva, Compliance Manager, and Ryan Powers, Manager of Portfolio Guideline Monitoring, to review and discuss the compliance capabilities utilized by Wellington.

Primary responsibility for compliance with each client's investment objectives and constraints resides with the portfolio management teams. The main system used for compliance monitoring is Fidessa Sentinel. This system contains the rules applied to each account that are tested by the compliance screening processes. Sentinel compliance screening can be performed on a pre-trade basis, in an overnight post-trade process, or both. The proprietary investment and trading systems are linked to compliance screens, which enable most investment restrictions to be tested at the time an order is entered. Pre-trade overrides are reviewed throughout the day by the guideline monitoring team. Compliance tests are also applied to account holdings overnight, with results reviewed the next morning. The end users throughout the firm have read­only access to the rules managed and maintained by the guideline monitoring team.

The firm also maintains compliance with the U.S. Securities and Exchange Commission's (SEC) regulations. The Legal and Compliance Group is responsible for ensuring that the firm has policies, procedures, and controls to ensure compliance with specific regulatory requirements. It is also responsible for establishing, maintaining, and implementing the firm's compliance monitoring program. The Legal and Compliance Group identifies regulatory compliance· issues for the entire firm.

Risk Management

Staff met with Tony da Silva, Associate Director, Operational Risk Management, and Laura Lihon, Manager of Internal Audit to discuss and review the firm's risk management capabilities.

Principal risk factors at the portfolio level are portfolio beta deviations from the benchmark, along with region, sector, and country exposures having significant deviations from the benchmark weights. These risks are controlled as part of the portfolio construction and _management process. A key objective of Wellington's emerging markets strategy is to minimize unintended and unrewarded exposures relative to the benchmark. The investment team

·monitors the balance between stock-specific and factor risk, with the expectation being that approximately 70 to 75 percent of the risk should come from stock-specific sources, and the remainder from style, country, sector, and industry tilts relative to benchmark. In order to achieve this objective, the investment team employs constraints around portfolio weights in order to minimize differences from the benchmark.

Another risk the team attempts to mitigate is the performance of the alpha model as market environments or risk regimes change. The Quantitative Investment Group has researched and built a contextual alpha model that calculates a measure of "information uncertainty" for individual stocks on a daily basis. This measure incorporates risk information, sentiment information, and trading information to rank stocks on a "difficult-to-value" (DTV) spectrum. Stocks which are most DTV are those with high risk and uncertain sentiment as indicated by a wide dispersion of estimates and heightened recent trading activity relative to longer-term averages. Stocks that are easy to value are those with more stability. Incorporation of this contextual alpha model has helped a bias that many systematic models can have, and helps the model better navigate changing market environments.

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Disaster Recovery and Business Continuity

Staff met with Jeffrey Walsh, Manager, Client & Enterprise Technology to review and discuss Wellington's disaster recovery and business continuity program.

Wellington's business continuity program consists of various elements that represent the processes for planning for and responding to significant business disruptions. The program is designed to enable Wellington to meet its obligations to provide investment management services to its clients in the event of a significant business disruption.

The Business Continuity Planning (BCP) Group is responsible for the ongoing management of the business continuity program, including coordinating tests of business continuity plans, assessing the effectiveness of the program, providing training, and supporting the incident management process.

The Disaster Recovery Group within Information Technology is responsible for maintaining, testing; and executing Wellington's system resiliency plan. The process involves continual monitoring of the internally managed data centers and remote cloud computing environments, identification and prioritization of critical systems, and the development and testing of critical systems' resiliency strategies. A group called the Operational Resilience Committee, comprising cross-functional senior professionals, oversees the BCP and the Business Continuity Policy and Procedures.

For systems recovery, Wellington employs a primary/secondary data center strategy for trading and investing applications and systems. The primary data center operation is in Windsor, Connecticut, 90 miles southwest of Boston, in a building in which they are the sole tenant. Trading and investing applications and databases are all available within the primary data center and the system is recoverable locally without having to move to the secondary data center.

The secondary data center is in Marlborough, Massachusetts, 35 miles west of Boston. All systems in this secondary disaster recovery site are configured with like hardware capacity production in order to provide the same functionality and performance levels if a disaster recovery solution is invoked. All applications, systems, and databases hosted in the primary data center are available at this site, and replication from the primary site to the secondary site occurs on a near real time basis for all critical databases and applications.

The firm provides remote access to all employees and consultants through a model that requires a two factor user authentication to access. Remote access appliances are located in both US-based data centers and in the London, Hong Kong, Tokyo, Singapore, and Sydney offices. While remotely connected, employees and consultants may securely remotely connect to their desktops or use key applications and services directly. The remote access environment has supported approximately 2,400 users simultaneously and has the capacity to accommodate 3,200 concurrent users.

Wellington is in the process of transitioning applications, infrastructure, and services from its own data centers to Amazon Web Services (AWS) data centers. The process started with applications and services that did not directly affect trading and investing applications, allowing Wellington to confirm the AWS data centers functioned with the appropriate level of reliability, stability, and security as the internal data centers. Over 75 percent of Wellington's applications have migrated to AWS. By the end of 2019 all investment and trading applications will be

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migrated to AWS, with the goal to retire Wellington's internally managed data centers at that time.

Summary and Findings

Staff covered a comprehensive agenda with various representatives from Wellington, and discussed and observed various areas and functions of the firm. From staff's perspective, Wellington demonstrated a strong culture of compliance, corporate processes and controls, and adequately addressed management and operational topics of discussion relating to the Plan's portfolios. Staff did not observe any areas of concern during this visit.

~ Jer' y "Qjf$Oi1

-LPL/JW/CM/RS: mea

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