Outsourcing lifts management costs of UT endowment

Higher performance justifies higher fees, UTIMCO says.

Courtesy: http://www.statesman.com/

When the University of Texas Investment Management Co. was created in 1996, the idea was to hire private-sector money managers to generate private-sector-size returns with the university's money.

While the investment results have been mixed, one effect of this arrangement is clear: It has cost more to manage UT's endowment than the state's other major public funds.

Operating out of plush offices on two floors of the downtown Frost Bank Tower, UTIMCO relies heavily on outsourcing, hiring "external managers" who are experts in complex investments to handle the university's trust funds. The largest of these is the Permanent University Fund, which generates investment income that supports schools in the UT and Texas A&M systems.

Today, about 86 percent of that fund's assets are handled by external managers. By comparison, the Employees Retirement System of Texas outsources 25 percent of its investments; at the Teacher Retirement System of Texas, the figure is less than 10 percent.

Texas' major trust funds have different goals, so their investment strategies vary. Pension funds are legally obligated to pay eligible members fixed retirement benefits, so they tend to favor more conservative investment strategies; a university endowment's goal is to maximize returns to supplement annual school budgets and can be more aggressive.

The result: While the Permanent University Fund is the state's fourth-largest trust fund in terms of assets, it has been the most expensive to manage, according to the Legislative Budget Board's latest study comparing public investment funds.

In 2007, for example, UTIMCO paid a little over $28 million in fees to manage the then-$11.7 billion university fund — more than $20 million of that to external advisers. By comparison, managing the Teacher Retirement System Pension Trust Fund, whose investments that year were handled almost entirely by state employees, cost only $21 million — even though the teachers' fund is nearly 10 times the size of the Permanent University Fund.

Pay for performance?

UTIMCO executives say their performance justifies the higher cost of private advisers. And when compared side by side with other state funds, the Permanent University Fund has often outperformed them.

But compared with the past 10 years of returns earned by its national peers — universities with endowments of at least $1 billion — UT's performance is only average, ranking 38th out of 77 institutions, according to statistics compiled by the National Association of College and Business Officers.

And when subjected to "risk-adjusted return" calculations — a tool used to compare the performance of funds with different types of assets — the fund's returns between 2003 and 2007 lagged behind all but two of the state's nine investment funds, according to a Legislative Budget Board analysis.

Asked for comment on that assessment, UTIMCO spokeswoman Christy Wallace said the budget board had used "an inaccurate methodology. As a result, those numbers are not meaningful."

As the nation's economy has stalled, all of the state's investment funds have reported dramatic drops in value. The Permanent University Fund is now worth $8.8 billion, down nearly 25 percent from 2007; the teacher retirement fund has fallen 27 percent, from $111 billion to $81 billion. Experts say those declines could steepen soon as private investments are revalued to reflect the soured economy.

The losses formed the backdrop last week when the chairman of the UTIMCO board, Robert Rowling, resigned in a dust-up over $3 million in bonuses — paid out of the agency's management fees — for executives such as CEO Bruce Zimmerman, who earned just over $1.5 million in salary and bonuses last year. UTIMCO officials defended the payments as reasonable and required under contracts negotiated before the economy collapsed.

In house vs. outsource

Over the years, many large endowment funds eager to grow have increased their reliance on specialized private advisers. "Most public funds don't have that kind of expertise in-house," said Craig Hester, a trustee of the Employees Retirement System Pension Trust Fund.

So-called alternative investments often require managers to take a more active role in handling them, such as in real estate, said Ehud Ronn, a finance professor at UT's McCombs School of Business. More hands-on management means higher fees — sometimes much higher.

Managers of hedge funds — smaller private funds that use riskier trading strategies and are less regulated than stocks — typically have been paid generous commissions keyed to what's known as the "2 and 20" rule: 2 percent of the value of the assets being managed, plus 20 percent of net profits above a predetermined benchmark. At the end of 2008, about a third of the Permanent University Fund portfolio was invested in hedge funds, some of whose managers earned the traditional 2/20 compensation.

Gary Hill, UTIMCO's director of financial reporting, acknowledged that using external investment advisers is more expensive than relying on in-house employees. By government standards, state-salaried investment advisers are well-paid: five of the Teacher Retirement System's investment advisers and managers, for example, earned more than $200,000 in 2007, according to a database of state salaries compiled by Texas Watchdog, a nonprofit Web site. Teacher Retirement System chief investment officer Britt Harris earns just under $500,000 annually.

Still, those paychecks pale in comparison with the compensation of private investment advisers, whose annual salaries and bonuses can easily run into the millions of dollars.

All of Texas' funds have used some external investment managers to varying degrees. The exception had been the Teacher Retirement System, which until recently was managed almost exclusively by state employees.

In 2007, however, the Legislature granted the Teacher Retirement System permission to use outside advisers to invest up to 30 percent of the pension fund. Noting that most large pension systems outsource more than 70 percent of their assets to private managers, Harris said he is proceeding cautiously. In 2008, he said, only about 7.8 percent of teacher retirement fund assets was invested by outside consultants, at a cost of $1.6 million in management fees.

The $18 billion Employees Retirement System Pension Trust Fund, which pays pensions to retired state workers, has moved in the opposite direction. That's because in recent years its in-house investors have performed better than their outsourced counterparts in some instances.

According to the Legislative Budget Board's 2007 comparison of domestic stock investments, Employees Retirement System staff investors generated 15.6 percent returns in 2007. Its outside advisers, by comparison, had a 13.5 percent rate of return over the same period — lower, even, than the S&P 500's returns, a common performance benchmark.

As a result, the Employees Retirement System has reduced its reliance on outside consultants. In 2007, about a third of its portfolio was invested by external managers. Today, a quarter of the fund is outsourced for investment advice, a spokeswoman said.