Texas Teachers revamps AA, adds leverage

The board of the $154 billion Teacher Retirement System of Texas has approved changes to its strategic asset allocation as a result of its latest five-year study, increasing its allocation to private markets, risk parity and introducing leverage.

In addition to allocation changes, which focused on the illiquidity premia, the strategic asset allocation recommendations also focused on efficiency and more diversity across assets.

Allocation changes include a 1 per cent increase to each of the private market portfolios: private equity (now 14 per cent), real estate (15 per cent) and energy, natural resources and infrastructure (6 per cent).

In a bid to diversify away from equity risk, the new asset allocation increases US Treasuries by 5 per cent, increasing stable value hedge funds (up by 1 per cent to 5 per cent of total trust), and increasing risk parity, which has been part of the allocation since 2014, by 3 per cent to 8 per cent of the total trust.

The hedge fund allocations were re-jigged so the increase in the stable value hedge fund allocation was countered by a decrease in the directional hedge fund allocation to now 3 per cent of assets, down by 1 per cent. This sits in global equities and will have its benchmark changed to a global equity benchmark.

The fund also introduced leverage for the first time, with a -4 per cent target, which will primarily be used to acquire the US Treasuries exposure increase.

Talking about the leverage exposure, Matt Talbert, senior investment manager at TRS said the best assets to lever will vary over time. The performance of leverage will be benchmarked against a three-month LIBOR rate, as recommended by the fund’s consultant, Aon.

Talbert said other important considerations in terms of implementing leverage include internal infrastructure. The TRS investment management department has a 10-year track record in implementing derivatives and has a dedicated operating team. It currently has $30 billion in derivatives usage, and the leverage adds another $9 billion to that.

The fund also increased the allocation to cash by 1 per cent to reflect the need for extra cash arising from operational and liquidity needs, given the introduction of leverage and increase allocation to illiquid assets.

In addressing the investment management committee, Mohan Balachandran, senior managing director of asset allocation at TRS said global equities remained the highest allocation at the fund and was still the key driver of trust returns in the long run, but the asset allocation changes looked to add diversification.

Balachandran said the net results of the changes are that the expected return will increase by 25 per basis points from 6.97 to 7.23 per cent; expected volatility also rises slightly from 11.3 to 11.6 per cent; and the expected Sharpe Ratio increases, as risk-taking becomes more efficient, from 0.4 to 0.41.

“We are becoming a little bit more efficient in risk-taking, and even though we are adding in leverage, the actual risk of the trust comes down,” he said.

In the strategic asset allocation study, James Nield, chief risk officer at the fund said more than 50 risk metrics were examined, but there were five key risk metrics used to evaluate any changes in strategic asset allocation. The potential changes indicate overall improvement in these, he said:

·       The historical probability of three-year returns earning 7.25 per cent improved with these changes, increasing from 49 to 54 per cent probability

·       Volatility stayed the same at 7.7 per cent

·       Percentage of time that rolling three-year returns are negative improved from 16 to 13 per cent

·       The maximum drawdown stayed constant at 26 per cent

·       And the liquidity ratio declines from 1.9 to 1.8 but stays above the 1.5 threshold.

Nield also said while the fund reduced its allocation to global equities by 3 per cent in dollar terms, the actual risk contribution from global equity declined by 10 per cent, from 82 to 72 per cent VaR.

The changes also mean the percentage of the trust in active strategies declines by 2 per cent, although active still dominates at 86 per cent of the fund. The internal management increases primarily due to treasuries, by 1 per cent to 35 per cent of the total.

The fund will transition three of the larger changes over a six-month period, with US Treasuries, global inflation linked bonds, risk parity all transitioning slowly.

The pace of the transition will not be set in advance, rather the benchmark weight will be set to the actual allocation at the end of each month, allowing an early end of the transition if investments can be added to it faster than the six-month period.

Texas Teachers has returned 10.8 per cent for the past 10 years, against a benchmark of 10.3 per cent.