Texas Teachers brings more global equity in-house to seize alpha

The $142 billion Teacher Retirement System of the State of Texas is the latest big institution to increase internal management of global equities and embrace risk premium-based investing.

After an 18-month best-practices review, the investment staff of the Austin-based pension fund completed a major overhaul in September of the retirement system's $54.3 billion global public markets equity portfolio with the goal of increasing its alpha production.

Among the biggest changes to management of the global equity portfolio is an 8-percentage-point increase in internally managed assets, said Jase Auby, Texas Teachers' deputy chief investment officer.

Another critical element to improving TRS' alpha production is the incorporation of alternative risk-premium investment across the entire pension fund. Mr. Auby said the goal is for risk-premium investment strategies to contribute half of the 100-basis-point excess-return target for the whole portfolio.

Alpha production by the global public markets equity portfolio has ​ been good, producing a total of 29 basis points over the five years ended June 30 with the greatest outperformance over the period — 384 basis points — coming from an internally managed, quantitative low-volatility fund.

"We had positive alpha but would have preferred to have had more. We wanted to see what we could do to increase alpha from the global equity portfolio," Mr. Auby said.

By way of setting the stage, TRS' actual overall asset allocation as of June 30 was 59.9% global equity, 19.6% real return, 15.5% stable value and 5% risk parity.

The public markets portion of the global equity portfolio totaled 43.4%, with a breakdown of 17.6% U.S. equities, 15.9% non-U.S. equities and 9.9% emerging markets equity, according to a quarterly investment review prepared by Aon Hewitt Investment Consulting.

The $5.8 billion directional hedge fund and $12.5 billion private equity portfolios housed within TRS' overall global equity allocation were not part of the restructuring.

About 52% of the existing global public markets equity portfolio was managed by external managers as of June 30; close to 40% was internally managed in a fundamental strategy; and the balance was managed internally in quantitative, passive and experimental strategies.

Annualized returns of the global equity portfolio for periods ended June 30 were one quarter, 4.3% (benchmark, 4.3%); one year, 18.6% (18.1%); three years, 5.5% (5.3%); and five years, 10.5% (9.8%).

About 40% of the entire TRS portfolio is managed internally across asset classes.

Texas Teachers staff conducted an intensive evaluation of the global public markets equity portfolio, part of the pension fund's routine asset class reviews.

The staff also investigated the global equity investment practices of peer funds in the U.S., Canada and Europe and tapped the expertise of external money managers who run multistrategy equity portfolios.

Mr. Auby said the internal/external research process led the staff to focus on four key considerations: internal vs. external management; increase in internally managed quantitative strategies; the challenging environment for alpha production in U.S. portfolios; and management of risk premiums in the overall portfolio.

Resulting changes to the global equity public markets portfolio and its management included:

• a 5% to 15% increase each for internally managed passive and quantitatively managed strategies;


• commensurate reductions in externally managed assets and internally managed fundamental equities;


• the addition of a $300 million internally managed risk premium-based equity portfolio; and


• the merger of TRS' external and internal global public equity investment teams.

The TRS investment management team evaluated each of the equity portfolio's 50 internally and externally managed "alpha streams" — defined by Mr. Auby as single, transparent investment approaches — to find redundancies.

Eight equity portfolios were eliminated, four of which were externally managed, bringing the number of outside money managers to 30. The percentage of assets managed externally dropped to 44% of the global public markets equity portfolio from 52%.

"Our clear preference is for internal management for obvious reasons of cost, control and transparency," Mr. Auby said, stressing that internal management "will be a primary issue for us over the next few years. We need to make sure we are staffed and resourced to handle more internal management."

In addition to moving more public markets equity investment in house, TRS also intends to build up its capability for direct investment, including co-investments, in private markets.

A lot is riding on the success of the pension fund's shift to a more expansive, portfolio-wide focus on alternative risk-premium investment strategies.

Texas Teachers is no stranger to risk premiums; the investment staff has employed some form of factor-based investing since the early 2000s, Mr. Auby said.

The staff has experience with risk-premium investing through internal management of an alternative risk-premium overlay portfolio for the total pension fund. The multifactor/multiasset portfolio relies on value, momentum, carry and quality factors, and invests in equities, equity indexes, bonds, currencies and commodities.

Some of the pension fund's external managers, including AQR Capital Management LLC and Dimensional Fund Advisors LP also employ a multifactor approach in their individual strategies.

"We previously managed our portfolios by only addressing these exposures in a risk context. We didn't want the portfolio to exceed certain tolerances," Mr. Auby said, noting "however, we are now more open to actively seeking, to purposely tilting, the portfolio towards premia that we believe are compensated."

"We believe that managing compensated and uncompensated exposures at the total portfolio level and choosing 'good' alpha streams will combine to a good result," he added.

Texas Teachers is not alone among pension funds incorporating risk premium-based investment processes into their portfolio.

TRS' research of peer pension fund practices found:

• ATP, Hilleroed, Denmark, for example, has put 15% of its risk budget in alternative risk premiums from the 745.8 billion Danish kroner ($118.3 billion) fund;


• Sweden's 336.3 billion Swedish kroner ($41.2 billion) AP2, Gothenburg, has about 50% of its equity portfolio managed in smart-beta approaches; and


• PGGM, which manages the €185 billion ($218.5 billion) Pensioenfonds Zorg en Welzijn has allocated 40% of the equity portfolio of the pension fund to three risk factors — value, low-volatility and quality.

Risk-premium managers report continued interest and full pipelines from asset owners worldwide.

"We continue to see strong interest on the part of … TRS and other sophisticated investors in incorporating factor insights," said Andrew Ang, managing director and head of factor-based investing at BlackRock Inc., New York, in an email.

"Investors have clearly moved past the tire-kicking phase and into a period of practical application of these insights for diversification and return enhancement," he added.

BlackRock is one of TRS' strategic partners, managing $1.9 billion in global public markets as well as providing customized research, market intelligence and development of new investment strategies for the pension fund.