SPRINGFIELD, Ill. -- Trustees of the Teachers' Retirement System of the State of Illinois are radically restructuring $18 billion of the $22 billion fund.
The board is indexing a significant portion of equity assets and seeking to add alpha and risk control through a combination of specialty managers. Key moves will:
* Reduce the total number of managers to 30 from 54;
* Initiate searches for nine managers;
* Save at least $16 million in managers' fees;
* Realign the passive and enhanced portions of U.S. equity;
* Put 10% of U.S. fixed income into passive strategies, for the first time;
* Significantly increase the dollar mandates for some existing managers; and
* Create a structure emphasizing managers that consistently add value to the portfolio over their relative benchmarks.
The changes implement the asset allocation model the board adopted in July: 30% U.S. equities; 20% international equities; 27% U.S. fixed income; 8% real estate; 7% international fixed income; 7% private equity; and 1% short-term investments.
Next year, the board will review the fund's real estate and private equity investments. Staff is interviewing finalists in a search for a real estate consultant and expects to make a recommendation to the board next month, said Mark Caplinger, chief investment officer.
Illinois Teachers' investment consultant, Michael Beasley, of Strategic Investment Solutions Inc., San Francisco -- who conducted the manager review -- told trustees his objective was to minimize style bias relative to the benchmark for each major asset class and to minimize risk taken to hit optimal portfolio performance. The allocation among managers in an asset class resembles the general style orientation of its benchmark.
The board also had charged him with lowering fees and making an unbiased review of existing managers.
U.S. equity underperforms
The U.S. equity area is the "place where the bulk of underperformance is coming from. The absolute number of managers masked what was going on. . . . there are holes to be filled," Mr. Beasley told the board. The fund's total target allocation to U.S. equities is $6.6 billion.
Adding another enhanced value manager, slightly increasing SSgA's S&P 500 index strategy and doubling PIMCO's mandate to stocks plus, an enhanced value strategy, bring the passive and enhanced weighting to 48.5% of U.S. equity assets.
Twelve of the fund's 18 U.S. equity managers were terminated: Ark Asset Management Co., which managed a total of $1.022 billion in three styles for the fund; Chicago Equity Partners, $583 million; Edgar Lomax Co., $31 million; Fiduciary Management Associates, $34 million; Hotchkis and Wiley, $14 million; Insight Capital Research & Management Inc., $39 million; Institutional Capital Corp., $302 million; Lazard Freres, $90 million; Mentor Investment Group LLC, $30 million; Paradigm Asset Management, $368 million; Valenzuela Capital Partners Inc., $110 million; and Wayne Hummer Management Co., $8 million.
The fund retained the following U.S. equity managers, with some changes in the size of mandates:
* State Street Global Advisors for S&P 500 index management, up to $1.9 billion from $1.7 billion;
* Lincoln Capital Management Co., large-cap growth, to $1.9 billion from $792 million;
* Sanford C. Bernstein Inc., large-cap value, down to $315 million from $660 million;
* Lazard Asset Management, small-cap value, up to $287 million from $198 million;
* UBS Brinson Inc., small-cap value, to $271 million from $198 million; and
* Pacific Investment Management Co., enhanced indexing, to $1.3 billion from $660 million.
SIS will conduct searches for a small-cap to midcap growth manager to run $198 million; a small-cap growth manager to run $100 million; two all-cap growth managers to run $396 million and $198 million each; one large-cap value manager to run $660 million; and an enhanced large-cap value manager to run $660 million.
New benchmark
Illinois Teachers will use seven managers for its $4.4 billion weighting in international equities. Each of the seven will run $629 million.
Five existing international equity managers will be kept on the roster but will move to a new benchmark, the Morgan Stanley Capital International All-Country World Free index, from the MSCI Europe Australasia Far East index. SSgA now manages $585 million in an EAFE index strategy; Brandes Investment Partners LP, $129 million; Capital Guardian Trust Co., $247 million; Delaware International Advisers Ltd., $365 million; and Dresdner RCM Global Investors, $280 million.
The fund will conduct searches for two non-U.S., all-country managers.
Terminated international equity managers are: Clay Finlay Inc. for three strategies totaling $401 million; Hotchkis and Wiley International, $110 million; Scudder Kemper Investments, $335 million; and Pyrford International PLC, $87 million. The fund also is dropping a $192 million active international balanced portfolio run by Pyrford, and a $1.3 billion global tactical asset allocation portfolio run by UBS Brinson.
In all, the fund will drop to seven international equity managers from 11.
Seven bond managers
Seven managers -- six of which now manage bonds for the system -- will handle the $6 billion U.S. fixed-income portfolio, down from 14.
The two core bond managers, each of which will run $1.5 billion, are BlackRock Inc., which now manages $505 million, and PIMCO, now with $2.2 billion.
The four other existing managers now will manage $600 million each. They are Chicago Trust Co., now running $144 million; Miller, Anderson & Sherrerd LLP, $290 million; Payden & Rygel, $469 million; and Weiss, Peck & Greer LLC, $133 million. SSgA will add a $600 million indexed bond strategy to the other strategies it already manages for the fund.
Each active bond manager will be permitted to invest up to 3% in high-yield bonds.
Terminated bond managers are: Conseco Capital Management, $290 million; Forstmann-Leff International Inc., $106 million; Hughes Capital Management, $53 million; Taplin, Canida & Habacht, $80 million; PIMCO for high-yield bonds, $142; Strong Capital Management, $210 million; and W.R. Huff Asset Management, $148 million.
The number of international bond managers will drop to three from four, with two incumbents retained to manage the $1.5 billion asset class weighting. UBS Brinson, now managing $343 million, and Julius Baer Investment Management Inc., now managing $178 million, each will manage $500 million. SIS will conduct a search for a third foreign bond manager.
Terminated international bond managers are Delaware International, $144 million, and PIMCO, $138 million.
Illinois Teachers will use one short-term manager -- Northern Trust Co. -- to manage the $220 million allocation. Northern Trust now manages $310 million in short-term assets. Terminated as short-term managers are Hotchkis and Wiley and Atlantic Asset Management Partners LLC, which run $156 million each.
Significant savings
Staff have renegotiated the investment contracts of all existing managers, exacting significant cost savings, said Keith Bozarth, executive director. Fees overall for public market investments in the plan will drop an estimated $16 million, to $37 million from $53 million per year. The actual cost might be even lower, depending on negotiations to hire nine new managers, Mr. Bozarth indicated.
Under the new system, the estimated basis-point fee for U.S. equity in aggregate will be 19.96 basis points, down from 29.01 basis points under the old system. International equity fees will drop to about 34.10 basis points from 42.41. U.S. bond fees will go down to 11.84 basis points from 18.94; international bonds will drop to 16 basis points from 22.29; and short-term fees will move to 8 basis points from 10.88.
Ark's fees
Only one existing manager that staff wanted to use in the new format -- Ark -- refused to renegotiate fees to what the system considered an acceptable level.
Staff told trustees that despite on-going negotiations with Ark, the company would not reduce fees for its specialty growth product.
Glenn McGee, board president, argued unsuccessfully that Ark should be retained because its performance is good and requested that staff write a letter to Ark executives encouraging them to rebid for the business.
Officials from Ark did not comment by press time.
Mr. McGee also expressed regret that the fund's emerging managers program did not survive the restructuring. Six emerging managers managed about $1.1 billion under the old program, but only one survived the cut. Payden & Rygel, a woman-owned firm, was given a larger bond management assignment.
The other managers -- Paradigm, Wayne Hummer, Edgar Lomax, Hughes Capital and Taplin, Canida & Habacht -- were cut. Trustees asked for a report on emerging manager programs for their December meeting.
The board also approved SSgA as the interim manager and steward for assets that come from terminated managers.
The assets will be invested temporarily in SSgA index funds or in stewardship accounts while assets are liquidated, with the exception of international fixed income, which will go to existing managers until the new manager is hired.
