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Appendix A PROPOSED EMPLOYEES RETIREMENT SYSTEM OF TEXAS HEDGE FUND (ABSOLUTE RETURN STRATEGIES) FISCAL YEAR 2012 ANNUAL

TACTICAL PLAN

I.

EXECUTIVE SUMMARY ERS investments in hedge funds are designed to create a portfolio of alternative investments which will enhance long-term investment performance, diversify the asset base and reduce the volatility of returns for the entire ERS investment portfolio. The ultimate objectives are to preserve capital, provide competitive returns, reduce portfolio volatility and act as a diversifier to the total ERS portfolio. This Hedge Fund Portfolio Fiscal Year 2012 Tactical Plan (Annual Tactical Plan) has been prepared by Staff and the Consultant. It is intended to be a planning document which outlines the steps to be taken over the next twelve (12) months to further hedge fund portfolio objectives and to address considerations germane to the administration and success of the hedge fund program. This Annual Tactical Plan is a guiding reference only, and it is not intended to overrule prudent hedge fund investment decision-making. While this Annual Tactical Plan is considered prudent and effective for the implementation of the hedge fund program it may require amending based upon the opportunities available in the market. Importantly, while this Annual Tactical Plan highlights significant capital commitments during the 2012, 2013, and 2014 fiscal years, not all of the capital committed may be invested by ERS due to factors beyond ERS control. The ranges given provide flexibility to the targeted commitment amount to provide for varying market opportunities as well as availability of ERS resources. Moreover, Staff and the Consultant may request a change of pace of investment in subsequent Annual Tactical Plans in order to better take advantage of market opportunities.

II. GENERAL ALLOCATION COMMENTS Although academic literature would suggest that 15 hedge funds in the portfolio would provide near optimal portfolio diversification, allocating to additional funds does further reduce manager specific idiosyncratic risk. Furthermore, additional funds may also be added as a result of qualitative and quantitative factors involved in manager sizing decisions. These factors include, but are not limited to: fund and/or strategy capacity, conviction, alignment of interests, risk management, and transparency. It is anticipated that the portfolio will be comprised of 15 to 25 funds by the end of 2014. Fund redemptions, once the portfolio becomes more fully invested, are also possible due to strategy reallocations and changes in manager conviction. In general, some level of manager turnover is expected on an annual basis. Individual funds will typically receive initial allocations between USD $50 million and USD $100 million. More established funds in the portfolio may have larger allocations due to growth through positive returns. Regional target allocations by geographic region are not specified because allocations are strategy driven. Core investments are expected to represent between one-third and one-half of all investments, with allocations generally between USD $75 million and USD $100 million (approximately 6.5% to 8.5% of the hedge fund portfolio). Satellite investments are expected to represent between one-

half and two-thirds of all investments, with allocations generally between USD $40 million and USD $60 million (approximately 3.5% to 5% of the hedge fund portfolio).

III. FUNDING LEVELS FOR FISCAL YEARS 2012 - 2014 As of June 30, 2011, the hedge fund portfolio stands at $0, thereby necessitating significant capital commitments during the 2012 to 2014 fiscal years in order to achieve the full hedge fund portfolio allocation by the end of fiscal year 2014 (5.0% of the Trust for the hedge fund portfolio). While this Annual Tactical Plan is considered prudent and effective for the implementation of the hedge fund program, it may require amending based upon opportunities available in the market. The ERS hedge fund portfolio projects the following capital commitment requirements over the next three fiscal years:

Fiscal Year 2012 2013 2014 Total

Commitment (+/- 100m) $358,000,000 $500,000,000 $300,000,000 $1,158,000,000

It is anticipated that allocations in the first year will be biased towards core investments, whereas allocations in subsequent years are expected to be progressively biased towards satellite investments. As a result of this progression from core to satellite investments, the fiscal year commitments are expected to decline in year three. The following table illustrates how investments in the next three fiscal years will be divided between core and satellite positions:

Category Core Satellite Total

New Investments per Fiscal Year Cumulative Portfolio Investments 2012 2013 2014 2012 2013 2014 46 26 02 N/A 6 10 6 10 02 48 6 10 N/A 6 10 10 16 48 8 12 6 12 48 12 18 16 24

IV. PROPOSED FUNDING BY STRATEGY FOR FISCAL YEARS 2012 - 2014

Category Relative Value Event Driven Long/Short Equity Tactical/Directional Opportunistic Total

New Investments per Fiscal Year 2012 2013 2014 $107,000,000 $150,000,000 $90,000,000 $107,000,000 $150,000,000 $90,000,000 $72,000,000 $100,000,000 $60,000,000 $72,000,000 $100,000,000 $60,000,000 $0 $0 $0 $358,000,000 $500,000,000 $300,000,000

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Category Relative Value Event Driven Long/Short Equity Tactical/Directional Opportunistic Total

Cumulative Portfolio Investments 2012 2013 2014 $107,000,000 $257,000,000 $347,000,000 $107,000,000 $257,000,000 $347,000,000 $72,000,000 $172,000,000 $232,000,000 $72,000,000 $172,000,000 $232,000,000 $0 $0 $0 $358,000,000 $858,000,000 $1,158,000,000

Commentary These proposed strategy class allocations represent the mid-points of the policy target ranges. The proposed funding to Relative Value and Event Driven strategy classes each equate to 30% of the hedge fund portfolio assets. The proposed funding to Long/Short Equity and Tactical/Directional strategy classes each equate to 20% of the hedge fund portfolio assets. Funding Tables Current Funding Position Total ERS of Texas Portfolio Size as of June 30, 2011 Total Hedge Fund Allocation at 5.0% Current Hedge Fund Portfolio Value

$23,158,625,353 $1,158,000,000 $0

Fiscal Year 2012 2013 2014 Total Yearly Average

Commitment (+/- $100m) $358,000,000 $500,000,000 $300,000,000 $1,158,000,000 $386,000,000

Ranges $250,000,000 $450,000,000 $400,000,000 $600,000,000 $200,000,000 $400,000,000

Proposed Funding for Fiscal Year 2012 Category Relative Value Event Driven Long/Short Equity Tactical/Directional Multi-Strategy* Opportunistic Total Number of Investments 12 12 12 12 12 0 -3 48 Commitment $107,000,000 $107,000,000 $72,000,000 $72,000,000 N/A $0 $358,000,000 Ranges $50,000,000 - $150,000,000 $50,000,000 - $150,000,000 $50,000,00 - $100,000,000 $50,000,000 $100,000,000 N/A $0 - $53,700,000 $250,000,000 $450,000,000

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Proposed Funding for Fiscal Year 2013 Category Relative Value Event Driven Long/Short Equity Tactical/Directional Multi-Strategy* Opportunistic Total Number of Investments 13 13 13 13 02 0- 3 8 12 Commitment $150,000,000 $150,000,000 $100,000,000 $100,000,000 N/A $0 $500,000,000 Ranges $100,000,000 $200,000,000 $100,000,000 $200,000,000 $50,000,000 $150,000,000 $50,000,000 $150,000,000 N/A $0 - $75,000,000 $400,000,000 $600,000,000

Proposed Funding for Fiscal Year 2014 Category Relative Value Event Driven Long/Short Equity Tactical/Directional Multi-Strategy* Opportunistic Total Number of Investments 03 03 02 02 02 0-3 6 12 Commitment $90,000,000 $90,000,000 $60,000,000 $60,000,000 N/A $0 $300,000,000 Ranges $0 - $150,000,000 $0- $1050,000,000 $0 - $100,000,000 $0 - $100,000,000 N/A $0 - $45,000,000 $200,000,000 $400,000,000

* Multi-Strategy hedge funds which allocate less than three-quarters of their assets to a single strategy class. In the funding tables above, proposed Multi-Strategy allocations are distributed between the four main hedge fund strategy classes.

V. STRATEGY ALLOCATION COMMENTS As noted in Section III, the proposed strategy class allocations correspond to the mid-point of the strategy class policy target ranges established in the hedge fund portfolio Policies and Procedures. Market events over the past three to five years have presented a variety of tactical hedge fund strategy class opportunities which would have called for tactical over- and under- weights. For example, during 2008, Tactical/Directional strategies were particularly attractive and in 2009 Event Driven and Relative Value strategies were attractive and Tactical/Directional strategies were unattractive. In contrast, current market conditions are believed to present hedge fund strategy opportunities which are broadly in line with long term expectations. Relative Value Relative Value sub-strategies demonstrate the most significant dispersion in return expectations. This dispersion is most notable in a very weak environment for risky assets, which is because A-4

Relative Value fixed income strategies (G7 and Mortgage) are expected to significantly underperform, whereas equity market neutral strategies are expected to deliver positive performance. ERS expects Relative Value investments to preserve capital in such an environment. In light of these considerations, it is anticipated that non-equity relative value strategies will only be accessed via multi-strategy managers rather than specialists during the 2012 fiscal year. Event Driven Return expectations for Event Driven strategies are marginally above long-term expectations. These expectations are inflated by a favorable outlook for Event Driven equity strategies, although such strategies often demonstrate moderate to high beta to equities. Excluding higher beta Event Driven strategies, expectations are in line with long-term expectations. It is anticipated that the portfolio will initially comprise a combination of diversified multi-strategy managers, which allocate to both Event Driven arbitrage and value strategies, as well as more opportunistic Event Driven managers, which are both capital structure agnostic and demonstrate consistent hedging discipline. Long/Short Equity We note that overall Long/Short Equity expectations are below those for the long-term due to a reduced short-term outlook for European, Asian and Emerging Market specialists. In contrast, expectations for U.S. focused managers are in line with long-term expectations. ERS anticipates allocating to Global Long/Short Equity managers with meaningful U.S. exposure, which can allocate opportunistically between regions and sectors. As a result, for the 2012 fiscal year, the tactical allocation to Long/Short Equity is neutral. Tactical/Directional The outlook for the Tactical/Directional strategies is broadly in line with long-term expectations. However, it is worth noting that Macro-Systematic-CTA and Macro- Discretionary strategies are expected to provide the most significant outperformance in an environment where risky assets significantly underperform (i.e., these strategies will be most diversifying relative to the Trust). In contrast, Global Asset Allocation (GAA) managers are expected to be positively correlated with the Trust. As a result of this dispersion within the Tactical/Directional strategy class, it is anticipated that MacroSystematic-CTA and Macro-Discretionary strategies will receive a higher allocation than GAA. Furthermore, any managers funded in the 2012 fiscal year are anticipated to be diversified by asset class and region. Due to low correlations between Tactical/Directional managers and their relatively high return volatility, Tactical/Directional managers will typically receive satellite allocations. Summary Outlook for hedge funds overall is currently neutral with limited dispersion in the tactical outlook for the hedge fund strategy classes. Neutral expectations lead to proposed strategy class allocations in line with the mid-point of the policy target ranges. It is anticipated that in the 2012 fiscal year, the portfolio will largely comprise core multistrategy and global managers. ERS does not anticipate allocating to regional specialists until year two or three.

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