Saturday, July 10, 2010
By Kate Alexander
AUSTIN AMERICAN-STATESMAN
Teachers' pension fund faces judgment on its strategy
Britt Harris said he and his merry band of "capitalistic Robin Hoods" set out to beat Wall Street at its own game for the benefit of Texas' teachers.
In 2007, as the new chief investment officer of the Teacher Retirement System of Texas, Harris made big promises that he could earn the fund an extra $1 billion or more a year if the board approved a bolder — some might say riskier — investment approach.
To make it happen, Harris would also need a few new arrows for his quiver.
He started a potentially lucrative bonus program to lure some top-flight financial minds to work for the retirement system and set them up in a Congress Avenue office with a state-of-the-art trading floor and a stunning Capitol view.
Then, with help from the Legislature, Harris armed them with some Wall Street-caliber investment tools to make money for the state's 1.3 million active and retired teachers, school janitors, college professors and principals. The $97 billion fund is fed by member contributions and tax dollars as well as investment returns.
It is probably too early to judge whether Harris and his crew have produced as promised, given the market volatility of the past two years and the fund's long-term outlook. In the past year, the fund had its best returns ever, but they were lower than major market indexes such as the S&P 500.
But making that judgment is exactly what legislators will do next year when they must decide whether to renew the retirement system's authority to use the investment tools that Harris says are essential to managing a huge fund and reducing market risk.
It might not be an easy sell.
New tools
A lot has changed since 2007, when the Legislature gave the retirement system new authority to invest in complicated financial instruments known as derivatives and to tap a network of outside investment managers to get into different areas of the markets.
Over the past two years, once-arcane financial terms such as derivatives have become part of the common parlance because the investments were central to high-profile market failures.
And hedge funds, which were capped at 5 percent of the fund under the 2007 legislation, have been tainted by their role in the financial crisis, not to mention Bernie Madoff and his Ponzi scheme.
"The jury is still out if these are politically acceptable investments for public funds," said Sen. Robert Duncan , R-Lubbock, the State Affairs Committee chairman and sponsor of the legislation.
When used responsibly, the tools approved in 2007 are crucial for such a large pension fund, investment experts say.
Hedge funds, for example, can produce good returns when stocks are in the tank, so they can cushion the blow of a volatile market. Hedge funds can actually reduce the financial risk of the overall fund.
But they are opaque and complicated investments that should not be used lightly or without thorough investigation, said Stephen Brown, a professor of finance at the New York University Stern School of Business.
"It's appropriate that they are (investing in hedge funds) if they are willing and able to do the operational due diligence," Brown said.
Most public investors, he said, tend to chase investments with past high returns, without regard for other risks, such as fraud.
Harris insists that the Teacher Retirement System is discriminating in its hedge fund investments. And its use of derivatives, which are contracts based on stocks, bonds or commodities, is pretty "plain vanilla," and allows the retirement system to balance its portfolio cheaply and efficiently, Harris said.
The retirement fund has not been mucking around with the "exotic" derivatives that helped sink the financial markets in 2008, he added.
The final piece of authority that is up for review allowed the retirement system to hire for the first time outside investment managers to invest the fund's dollars. Under that authority, the system struck "strategic partnerships" with four top investment firms, including J.P. Morgan and BlackRock, and gave them $1 billion each to invest.
The fund benefits from the returns generated by those partnerships as well as access to the firms' expertise and pays them based on their performance, Harris said.
A state auditor's report is due in December to provide independent assurance that all the tools are being used in accordance with the law.
Jim Hille , the head of the Texas Christian University endowment and Harris' immediate predecessor, said it would be a major setback for the fund if the Legislature were to take away that authority.
Duncan said he expects the evidence to show the investment tools helped the retirement system lose less during the market tumult.
"We're no worse off for doing it," he said. "The question is, are we better off?"
Senate Finance Committee Chairman Steve Ogden , R-Bryan, is not convinced that the teachers are better off. He added the 2012 expiration date for the investment authority to the bill because, he said, "I couldn't kill it."
He is still concerned that the state's pension funds are taking too much risk. "This idea that if you're just smart enough and just clever enough you can beat the market is a false promise," Ogden said.
New blood
Long considered a sleepy Southern giant, the Texas teachers' fund had lumbered through the investment world during most of its 73-year history.
When Harris signed on, the fund had a pretty conventional balance of stocks and bonds while also dabbling in some alternative investments.
That approach, while perceived as safe, would actually be quite risky in the case of a stock market meltdown, Harris argued.
A heavier commitment to alternatives — including real estate, private equity and hedge funds — would gird against stock market losses and produce gains down the road that are necessary to meet the fund's long-term investment goal of earning 8 percent per year.
It was a strategy similar to what university endowments and a few other large public pension funds had long been using with good success.
It was not a new concept for the board, either, Hille said. He had encouraged the board to diversify its investment approach to no avail before leaving in 2006 for Texas Christian.
But a different cast of characters was taking center stage when the job of chief investment officer came open.
The conservative bankers appointed to the retirement system board by Gov. George W. Bush had given way to a more adventurous group of investors and other financial professionals named by Gov. Rick Perry. The new guard welcomed Harris' argument that the fund could earn more if it fully embraced alternatives.
Time will tell.
A month into the multiyear transition, a crushing bear market sank its teeth into the U.S. economy. The fund lost more than 40 percent of its value, dropping from its peak of $118 billion in the fall of 2007 to $67 billion in March 2009 .
"We can only control what we are able to get out of the turnip," Harris said. "We can't control the turnip."
Never were benefits for retirees in question, since the fund had enough, even at its lowest value, to provide 30 years of pension payments.
Such severe losses, however, will push back the day that retirees get a permanent boost to their monthly checks, last done in 2001 .
Much of the value lost during those dark days has since been recovered, and the fund just recorded its best year ever, as of the end of March. Harris said his team's management yielded almost $2 billion in added value to the fund beyond what the market produced.
With a 35 percent return over the past year, the retirement system beat out the handful of other huge public pension funds across the U.S., such as those serving California teachers and public employees.
That annual return was about the same as the more conventional $21 billion Employees Retirement System of Texas, which registered a 34.9 percent return over the one-year period. Harris, however, disputes that the two funds are comparable because the teachers' fund is about five times the size of the employees' fund.
Going forward, the Teacher Retirement System is well-positioned to take advantage of the markets because it has money to invest while other investors were left weakened over the past two years, Harris said.
"This is actually the classic definition of strong hands," Harris said. "The money gets into strong hands when you have a calamity."
Power shift
The calamity created more than investment opportunities for the fund. It gave it the chance to assert itself as a player in the industry.
Private equity investments, such as venture capital and company buyouts, had been a top-performing asset class over the past decade, peaking in 2006 with a 31 percent annual return.
For a number of years, there was so much capital flowing into private equity that the deal-making firms had essentially unilateral say on the terms of deals made with investors, said Bruce Zimmerman , head of the University of Texas Investment Management Co.
While private equity was doing well, there was little reason to question the fees and other terms of the private equity deals, said Klaas Baks , executive director of the Emory University Center for Alternative Investments. The management fees alone could generate millions for a private equity firm, even without regard to a deal's performance.
But in 2008 , the returns on private equity plummeted 25 percent as credit and new capital froze. Investors started to question why they were paying so much to tie up their money in potentially risky deals.
With so little credit out there, the balance of power had shifted to the investors that had available capital, including pension funds, endowments and sovereign wealth funds.
Zimmerman helped initiate the idea of teaming up with other major institutional investors to establish guidelines that might put the private equity firms and their investors on more even footing.
Steve LeBlanc , senior managing director for private markets at the Texas teachers' fund, ran with it and worked with about a dozen of the largest funds around the world to draw up the first draft of the principles.
"We were the kindling to get the fire going," LeBlanc said, but the result was a collaborative effort.
More than 100 institutional investors representing more than $1 trillion in private equity capital have signed on to the principles, which touch on fees and transparency.
The principles aren't binding, but they are providing a framework for negotiating future contracts, LeBlanc said .
Some of the firms have claimed the effort smacks of collusion that could violate antitrust laws, a contention that the organizers dispute.
The teacher fund has kept quiet about its role till now, but Harris said taking the initiative was part of its obligation.
"We're exercising our industry leadership in an area that is important to our fund," he said. "When you're a fund of our size ... you're expected to lead."