Texas ERS reallocates to managers to help navigate concentrated equity market

The Employees Retirement System of Texas is re-allocating around a quarter of its public equity portfolio to external managers, away from the internal team, a move at odds with the internalisation trend among asset owners.

The 80-person in-house staff will now run around 50 per cent of the public equity allocation – equivalent to $8-9 billion – along with $4 billion in public credit, a $4.8 billion rates/treasury book and a $1.3 billion cash portfolio.

ERS plans to upsize with existing fundamental mandates but also allocate to new incremental relationships with diversifying strategies, says chief investment officer David Veal in an interview with Top1000funds.com in the fund’s Austin office.

The objective is to create a more diversified set of uncorrelated alpha streams and provide consistent returns in today’s highly concentrated market.

Navigating market concentration and maintaining diversification is one of the biggest challengers for the$46 billion fund. For example, ERS has deliberately kept its allocation to small caps and emerging markets which has caused the portfolio to lag the benchmark on a one-year basis. But it is an ongoing struggle as AI becomes an ever larger portion of the capital markets.

“Our public equity is up 26 per cent, which sounds awesome until you hear the benchmark is up 28 per cent. Our portfolio does best when diversification works,” says Veal.

Take Nvidia, he continues, ERS’ largest single stock exposure valued at over $700 million and accounting for nearly 2 per cent of the total portfolio: equivalent to an asset class in its own right. And that doesn’t include additional exposure to AI and chips from allocations in private equity and private credit, and infrastructure, via data center exposure.

Capacity constraints with preferred managers; the shift to RfQ’s

ERS allocates to around 12 public equity managers already. But Veal says up-sizing with some of these existing relationships has run into manager capacity constraints.

“Our top two managers that together manage around $2 billion between them have only $50 million of extra capacity.”

To try and help the search, ERS has just completed a US small cap Request for Qualifications (RFQ) in a deliberate shift from the extensive back and forth that can take 12-18 months under a Request for Proposal, (RFP). The small cap RFQ process has produced two good managers in a successful test test run for a process that he says he will now extend to global strategies.

An RFQ gives the fund more control. IN the process ERS produces its own standard agreement, and requests that only managers that can meet their stated terms apply.

“It allows us to negotiate terms while we have most negotiating leverage instead of at the back end, when we have less. We get better cooperation in the RFQ process,” he enthuses.

He is looking for managers with moderate risk levels. Mandating to heavily concentrated managers can put up a “spicy” 1200 basis points of tracking error, but he believes 400-600 basis points (of tracking error) equates to good value for the fees ERS will pay in US small cap (around 40-50 basis points).

“You can get an 8 to 10 multiplier on the fees you pay so that’s a good return on investment, and worth doing,” he says.

Strategies for when alpha gets harder

Veal says finding alpha is increasingly hard. Strategies that worked well yesterday are more challenging today and managers must constantly optimise and refine their models to stay ahead of the competition given the proliferation of talent, and the fact many original strategies now face headwinds.

It is leading the team to explore new approaches and portable alpha, a departure from traditional long only, is on the radar.

“It is a question of trying to get comfortable with a sustainable source of alpha that is worth the fees we are paying, and also exploring how correlated it would be with the rest of the portfolio.”

He says portable alpha is also more complicated to get through ERS’ governance as it crosses over asset classes. But trustees are ploughing new ground, and keen to put the right structures in place.

He doesn’t believe a move to TPA would particularly help alpha or diversification. In terms of agility, he says ERS has a 5 per cent plus or minus band around its strategic allocations, and already has ample discretion to enact strategic tilts.

“I’m interested in TPA, but I don’t yet see it as worth us making a leap as we already have many of its benefits,” he says.

Structurally, security selection is also pushed down to the individual asset class teams, although he observes that he still personally receives hundreds of emails a day introducing him to a new fund or strategy.

“Managers looking for allocations often seek an audience with the CIO. But unless I think it’s a particularly compelling idea, I am content to be more like a traffic cop and just make sure people are talking to the right people. I will then come in at the end of process rather than at the beginning,” he reflects.

Venture capital and innovation

Accessing the best opportunities also depends on exposure to innovation. It’s one of the reasons why he’d love to see more companies go public earlier, allowing public market investors to tap into the type of value creation only on offer to private shareholders.

Tantalizingly, Austin is also home to companies at the forefront of innovation in areas like small modular reactor development and defence tech. The naval drones built by Austin-based Saronic Technologies helped rescue the crew of the downed Apache helicopter in Iran.

“There is a ton of innovation going on behind the scenes, and this where the conversation gets really interesting,” Veal says.

ERS doesn’t have a significant venture capital allocation because it lacks the relationships and in-house expertise to invest in primary VC funds. Instead exposure comes via secondaries and buying existing stakes in mature funds and is one of the reason why ERS only had a small early stage allocation to SpaceX.

“It wasn’t as big as we would have liked,” he says.

Meanwhile other forms for innovation remain too risky for the public pension fund.

ERS doesn’t have any allocation to crypto. The fund’s governing statutes say investments must have an intrinsic value, yet bitcoin doesn’t pay a dividend or interest rate; is hard to value and has a speculative quality.

“It’s hard to get comfortable as an asset class, and we haven’t gotten there on our analysis quite yet.”

But he concludes that the team is having good conversations with hedge funds in this space and he has set up a digital assets working group, led by ERS’ head of hedge funds.

“The logical entry point for us into crypto would probably not be the coins themselves. It would probably be through a hedge fund that has expertise in this space and has a go-anywhere strategy where their goal is to deliver absolute returns.”