The $140 billion Teacher Retirement System of Texas is working successfully with its hedge fund managers on a new compensation structure that promises to “radically realign” the fees the fund pays. Speaking at his last TRS board meeting, departing chief investment officer Britt Harris explained that TRS hedge fund managers are taking up the so-called 1-or-30 model.
Under the model, TRS pays hedge fund performance fees only after managers meet an agreed upon hurdle rate. Managers can earn whichever is greater – either a 1 per cent management fee or a 30 per cent cut of the alpha or performance after benchmark.
“We get at least 70 per cent of the alpha, gross, after a hurdle rate; we’ve approached 22 managers and 17 or 18 are on board,” said Harris, who is leaving to become CIO of the $40 billion University of Texas Investment Management Company, UTIMCO, also based in Austin, Texas.
Under the model, in years when the fund underperforms, the management fee gets paid back to investors from the following year’s performance fees.
It’s a switch from the industry practice of charging investors 2 per cent of assets and 20 per cent of profits. Given TRS’s respected status among peers, it could set a precedent. Indeed, the fund has pledged to “lead the industry in improving terms for better alignment in a low-return environment”.
Hedge funds will have a place
Investors withdrew $106 billion from the $3 trillion hedge fund industry last year, in the largest annual outflows since 2009, data provider eVestment states. Yet Harris, who briefly served as chief executive at hedge fund giant Bridgewater Associates – of which TRS bought a minority stake in 2012 – believes hedge funds still make up an important part of the TRS portfolio when markets get more challenging.
“We haven’t needed hedge funds,” he said. “The market has gone pretty much straight up for eight years and, in general, hedge funds haven’t performed that well. There will come a time when we will need hedge funds, when markets go in the other direction. But right now, hedge funds are losing assets and are open to better compensation structures. We are collaborating with them to make sure that happens.”
The HFRI Fund of Funds Composite Index returned 3.2 per cent over the last five years, trailing the 7 per cent to 8 per cent return most US pension funds target. However, Harris does note that some strategies have performed well in the tougher climate, like event-driven and restructuring funds, both of which have “shot forward”.
TRS has been investing in hedge funds since 2001, deploying capital to AQR Capital Management, Fir Tree, GoldenTree Asset Management, MKP Capital Management and PDT Partners, among others. The fund has $10.6 billion in hedge fund investments, accounting for 8.3 per cent of its total assets, and paid $203.5 million in management and performance fees to them, directly or indirectly, in the fiscal year to August 2016.
Focus on fees across the fund
At the trustee meeting, Harris and his team touched on ways to improve the monitoring of fees, relative to alpha generation, across the fund. The fund has previously pledged to customise all its investment strategies where appropriate, to better reflect TRS’s needs than off-the-shelf products could. Harris also noted in his presentation the success of co-investment and principle investing at driving down fees.
“We have $11 billion in principle investments in private equity and real estate,” he said. “Both those portfolios have performed at or above the peer benchmark. On the private-equity side, there are essentially no fees, and on the real-estate side it is a significantly reduced fee.”
Harris leaves the fund in robust financial health after 11 years as chief investment officer.
TRS told its trustees of strong first-quarter results, with investment earnings at “a pretty remarkable” $6 billion for the first three months of 2017, equating to a 5 per cent return for the fund. Performance has been driven particularly by the emerging market equity allocation, where MSCI benchmark returns have come in at 11.4 per cent for the first quarter of 2017. TRS has $14 billion of exposure to emerging markets, or 10 per cent of fund assets.
TRS’s investment team also attributed the strong results so far to “asset allocation positioning”. Namely, being underweight US Treasuries in the stable value portfolio and, therefore, avoiding their relatively poor performance. Strong returns in the high-end core real-estate portfolio also pushed the result northwards, although Harris’s investment team now expects that asset class to slacken off.
“The expected return for real estate has gone from high towards low,” said Harris, who joined TRS when the pension fund was valued at $100 billion. Shortly after his arrival, that value dropped to $67 billion, due to being ravaged by the 2007-08 financial crisis. Today, he leaves with assets under management doubled from that time.
Harris also attributes the strong returns to historically low volatility.
“Market conditions, the volatility of individual asset classes and the correlation between asset classes has allowed us, and other people, to generate these returns at half the risk over this period of time. This will not last.”
TRS’s fund is divided between a global equity portfolio that accounts for 58.7 per cent of assets and a stable value portfolio accounting for 16.5 per cent of assets, half of which is an allocation to US Treasuries. Real return accounts for 19.8 per cent of assets, comprising real estate and other inflation-hedging holdings; while risk parity accounts for 5 per cent of assets under management.