Summary of Report 03-019

February 2003

Report Number 03-019

This report is a comparison of the State of Texas's five largest long-term investment funds (Texas funds). Its objective is to help decision makers obtain a high-level understanding of the similarities and differences in how each fund chose to invest its assets and the performance results of those investment choices. It does not attempt to explain why each fund's governing board chose a particular asset allocation, assess whether each board adopted an optimal allocation, or define and identify the "best performing" fund. For some time periods, the report includes asset allocation and/or performance information for several peer groups (composed of non-state funds that were reasonably similar in size and/or fund type). The Texas funds' information in the report was provided by the funds and was not audited by the State Auditor's Office (SAO).

Variations in the Texas funds' asset allocation strategies likely contributed to differences in the funds' rates of return during time periods ending June 30, 2001, and June 30, 2002. For the five-year period ending June 30, 2001, the latest period for which the SAO collected risk-related data, the Texas funds that took more investment risk earned higher returns. This outcome is consistent with the principle that investors expect to earn higher returns in exchange for accepting more risk. (When speaking of investments, "risk" measures the degree to which returns vary over time. See glossary.)

• Significant Differences Existed Between the Texas Funds' Asset Allocations

  The Texas funds' asset allocations-how they divided their total fund assets among categories of investments such as stocks and bonds-generally differed from one another and from the peer groups' allocations. Asset allocation decisions contribute significantly to a fund's total investment return, the variability of a fund's returns over time (a measure of investment risk), and the variation in investment returns across funds. These asset allocation differences arise from a combination of characteristics unique to each fund and the way a fund's governing board addresses those characteristics. Given the same set of fund characteristics, the asset allocation choices might vary from board to board because of differences in each board's collective level of investment expertise and risk tolerance.
  
  A fund's unique characteristics include the fund's purpose, beneficiaries, and any statutory restrictions. For example, the Teacher Retirement System (TRS) and the Employees Retirement System (ERS) cannot directly invest in real estate and generally cannot delegate decision making to outside money managers. The Permanent School Fund (PSF) must annually distribute all interest and dividend income but cannot distribute capital gains from market value increases, while the Permanent University Fund (PUF) and The University of Texas System Long Term Fund (LTF) have fewer legal restrictions on determining the dollar amounts of their annual distributions.
  
  Figure 1 compares TRS's and ERS's June 30, 2001, asset allocations with averages for two public pension fund peer groups, and it compares PSF's, PUF's, and LTF's allocations with averages for two endowment fund peer groups.
  
  This comparison and data for other periods show the following:

  • PUF and LTF invested a larger percentage in "nontraditional" assets (alternative assets, real estate, and other inflation hedging assets) than PSF and the endowment peer groups in this comparison. However, other studies show that PUF's and LTF's allocations to such nontraditional assets were in line with the allocations of higher education endowment funds larger than $1 billion. TRS's allocation to alternative assets is in line with the pension peer groups', but its strategy of eliminating its real estate investments differentiated it from the average public pension fund. Unlike their respective peer groups, ERS and PSF avoid alternative assets and real estate.
  • ERS and PSF invested a significantly higher percentage of assets in bonds (fixed income) than their respective peer groups.
    
  
  As of June 30, 2002, the Texas funds' allocations were largely unchanged except that:
  
  
  • PSF's bond allocation increased from 39 percent to about 47 percent, while its stock allocation declined.
  • PUF and LTF approximately doubled their inflation hedging assets to about 9 percent.
    
  
  
  
• Significant Differences Existed Between the Texas Funds' Rates of Return

  At highly summarized levels, differences existed in the funds' investment returns and in how closely those returns matched the funds' policy index returns. (A fund's unique policy index is calculated with the assumptions that the fund consistently adhered to its asset allocation policy target and that each type of investment in the target portfolio earned a return equal to its benchmark return.) Because of the factors that affect the funds' asset allocations, comparing a fund's return to its policy index return may be more meaningful than comparing the returns of different funds.
  
  Table 2 compares each fund's five- and ten-year returns against its policy index returns; it also presents the median return for the NEPC peer groups and returns for a hypothetical diversified pension fund (CII index). Although the report presents returns for one-, three-, five-, and ten-year periods, assessing performance for pension and endowment funds might be more meaningful over the longer periods because of these funds' long-term time horizons. Table 2 and data for other measurement periods show that:

  • TRS's and ERS's returns were typically close to the returns of their policy indexes. (Over the ten-year time periods, TRS slightly exceeded and ERS slightly lagged their policy indexes.)
  • PSF's returns were not generally as close to its policy index returns as TRS's and ERS's were to theirs. (PSF did not have an asset allocation policy prior to 1995, so a ten-year policy index return does not exist. Over the five-year time periods, PSF outperformed its policy index.)
  • PUF and LTF usually underperformed when compared with the returns of their policy index. The performance shortfall may have been due, at least in part, to factors discussed in the text accompanying Slides 4.15. and 5.4. in the report's Detailed Results section. PUF's and LTF's policy index returns significantly exceeded the other funds' policy index returns. Their higher policy index returns suggest that PUF and LTF may have adopted a more aggressive investment strategy than the other three Texas funds, in which PUF and LTF anticipated higher returns in exchange for a higher level of expected risk. The risk/return relationship for each of the funds is summarized in the next section. (The University of Texas Investment Management Company [UTIMCO] manages PUF and LTF and uses the same asset allocation policy for both funds.)

Differences between a fund's actual and policy index returns would be the result of asset allocations departing from policy targets and/or actual returns for individual investment types differing from the returns of each type's assigned benchmark.

• The Texas Funds' Rates of Return Generally Corresponded to Their Levels of Risk

  For the five-year period ending June 30, 2001, the Texas funds tended to earn rates of return that generally corresponded to the levels of risk they took. The relative risk/return relationships were consistent with the principle that investors expect to earn higher levels of return in exchange for accepting higher levels of risk.
  
  Figure 2 plots the return earned versus the risk taken for each Texas fund, the median for each NEPC peer group (pension and endowment funds), the CII Index, and selected stock (S&P 500) and bond (Lehman Brothers Aggregate) indexes. It also lists the Sharpe Ratio calculation for each, which is a measurement of risk-adjusted return. Figure 2 facilitates an assessment of how efficient each fund was in generating additional return by assuming more risk.

  Figure 2 shows the following:

  • As represented by NEPC's peer group medians, endowment funds invested less conservatively than public pension funds.
  • ERS's lower level of return and risk relative to TRS or to the median results for NEPC's public pension peer group suggests that ERS has adopted a comparatively conservative investment strategy. This conclusion is consistent with ERS's relatively higher allocation to bonds over time. TRS took slightly less risk and earned a slightly higher return than the median NEPC pension fund.
  • PSF's levels of return and risk matched the NEPC median for endowment funds. PUF took less risk and earned slightly less return than the median NEPC endowment. LTF took the same level of risk and earned a slightly higher return than the median NEPC endowment fund.
  • Based on their calculated Sharpe Ratios, all five Texas funds were somewhat more efficient in generating excess return per unit of risk taken than were the median funds in their respective NEPC peer groups. A higher Sharpe Ratio represents greater efficiency. Differences in the funds' Sharpe Ratios are small; if the Sharpe Ratios were calculated differently (for example, if monthly, rather than quarterly, returns had been used to measure risk), then the funds' comparative rankings could change.
    

Contact the SAO about this report.

Download the PDF version of this report. (.pdf)

HTML Equivalent (utilizing Adobe's PDF Conversion by Simple Form).