Texas Employees moves to revamp fixed-income portfolio

The Employees Retirement System of Texas, Austin, is radically revamping its $7 billion fixed-income portfolio, bifurcating strategies into different portfolios with different return expectations.

The reconstruction creates a global credit portfolio, eliminates a large core bond allocation, and will require the hire of credit investment specialists who initially will oversee a portfolio of externally managed assets.

As the ERS staff gains experience and expertise, management of the global credit portfolio will be brought in-house, said Charles Thomas “Tom” Tull, chief investment officer. Between 70% and 75% of the $24.7 billion fund is managed internally now.

The system's board approved a new asset allocation at the end of February which increased the broad bucket of return-seeking assets to 79% of assets from 61% and decreased the allocation to risk reduction/liquidity assets to 21% from 39%.

Mr. Tull said the biggest part of the targeted asset allocation change is the restructuring of fixed-income investments that will increase commitments to a variety of higher risk-higher return global credit strategies and decrease the size of the “safe” liquidity portfolio. The transition plans were presented to the ERS board of trustees on May 21.

The reason for the shift is pretty simple, Mr. Tull said: “We need to get more return from our dollars invested.” The system's actuarial assumed rate of return is 8%, a formidable bogey given predictions for dismal returns from traditional fixed-income strategies, Mr. Tull added.

Fixed income is slotted into each of the wider categories with a reduced overall allocation of 25%, down from 33%, Mr. Tull confirmed. The new global credit portfolio will hold 10% of plan assets, and the rates/liquid portfolio, 15% allocation.

The global credit portfolio will invest 3% of plan assets in high-yield securities, 5% in bank loans and 2% in emerging market debt. The system had already invested $246 million or about 1% of the fixed-income portfolio in a high-yield strategy managed by Fountain Capital Management LLC that has been moved into the global credit bucket.

The rates/liquid portfolio is the legacy of the retirement system's previous fixed-income portfolio, which was entirely invested in traditional core strategies that were internally managed.

The core fixed-income allocation has been eliminated in the fund's new model. All 15% of the new rates allocation will be internally managed in Treasury securities.

Texas ERS' investment team has started to move assets into the new fixed-income structure. As of March 31, the rates portfolio totaled $4.1 billion; the credit portfolio was $550 million; and $2.8 billion was in a transition portfolio.

The rates portfolio will be comparatively simple to set up, but the global credit portfolio could take two to three years to become fully functional, Mr. Tull said.

The system's internal infrastructure, including new information technology support, data sources and risk management systems need to be procured and installed.

Simultaneously, Mr. Tull is scouting global credit portfolio managers, veterans “with battle scars from surviving through previous credit crunches. We aren't looking for college recruits or interns for these jobs. On-the-job experience is necessary,” he said. That long market experience will be crucial as ERS begins to manage the credit portfolio internally.

In the meantime, as per ERS' usual practice, the internal credit investment team will select external high-yield, bank loan and emerging market debt money management firms to join a select pool of firms that can be tapped quickly to take advantage of fleeting market opportunities, Mr. Tull said.

There won't be a rush to get all of the $2.5 billion earmarked for the global credit portfolio invested, Mr. Tull stressed, noting “the investment opportunities will depend on various market conditions.”

The investment staff of the Texas fund has an advantage in its “very responsive and informed” board of trustees and investment committee that have granted the staff investment discretion that lets them move assets swiftly in response to market conditions, said Mr. Tull.

Other adjustments to the ERS asset allocation designed to enhance an active tactical investment approach are:

  • the total allocation to global equity rose to 55% from 53%, within which public equity remained at 45% and private equity rose two percentage points to 10%;
  • the real asset allocation rose to 14% of plan assets from 8%, within which real estate increased to 10% from 8%, and a 4% allocation to infrastructure was added; and
  • within the new 10% real estate allocation, 7% is earmarked for private real estate investment, up from 5%, while public real estate investment trusts were maintained at 3%.

The system's new asset allocation is part of the investment team's plan to do “everything we can to be as tactical as possible in constantly changing market,” Mr. Tull said.