2005 Permanent Health Fund
Totaling $925.9 million, the Permanent Health Fund (PHF) is an internal UT System mutual fund for the pooled investment of state endowment funds for health-related institutions of higher education. The UT Board of Regents established the PHF in August 1999 with proceeds from state tobacco litigation.
In order to take advantage of lower unit costs, attractive investment opportunities, and broader diversification benefits available from a larger investment fund, the funds in the PHF are invested in The University of Texas System General Endowment Fund (GEF), a broadly diversified mutual fund created by the UT Board of Regents in March, 2001, which is managed by The University of Texas Investment Management Company (UTIMCO). The PHF currently owns 18.8% of the GEF's $4.9 billion net asset value. The other GEF unit holder is The University of Texas System Long Term Fund (LTF.)
The primary investment objective is to preserve the purchasing power of PHF assets by earning an average annual real return of 5.1% over rolling ten year periods or longer, which permits the PHF to accomplish two goals:
- Provide for current beneficiaries by increasing the annual distribution at a rate at least equal to the current rate of inflation so that real purchasing power is maintained, and
- Provide for future beneficiaries by increasing the market value of endowment funds after the annual distribution at a rate at least equal to the rate of inflation so that future distributions maintain purchasing power as well.
Since the PHF's investment return is dependent on the GEF return, the operation and results of the GEF must be examined to determine the results of the PHF's activities for the year. The design of the GEF's portfolio is based on a combination of quantitative analysis and market judgment employed by UTIMCO's Board of Directors and investment staff. Sophisticated statistical techniques are combined with judgment to test many asset allocation alternatives, including the sensitivity of potential future results to changes in assumptions, in order to make portfolio construction decisions. Investment management involves as much art as science and qualitative considerations often play an extremely important role in successful portfolio management decisions. Art and science were used to develop the target and current GEF portfolios as shown below.
Investment Return and Market Commentary
The PHF posted a net investment return of 18.7% for the year ended August 31, 2005. The PHF derives it return mainly from the shares it owns in the GEF. The PHF's return is slightly less than the GEF's return due to additional expenses incurred by the PHF.
The GEF posted a net investment return of 18.8%. All asset categories of the GEF posted positive returns for the year, with the commodity (+32.2%), private capital (+28.3%), and international equity (+26.8%) asset categories leading the strong relative and absolute returns across the overall portfolio.
The table below reports the GEF's investment results by asset class compared to each individual benchmark for the year ended August 31, 2005
Shakespeare might best describe Fiscal 2005 as "Much ado about Nothing". Yes, there were
- Nine Federal Reserve interest rate increases totaling 225 bps (2.25%),
- and oil prices did rise from $42/barrel to an all-time high of $69/barrel,
- and housing prices in some areas were appreciating dramatically to record levels,
- and New Orleans was almost obliterated…..but,
seemingly nothing could impede the continuing progress of the latest global bull market run.
In fact, looking at the results of the year, it is easy to tick off good result after good result with nary a trace of concern. The S&P 500, up 12.6%, well above the 10.4% long run average, and Russell Mid and Small Cap indices up over 27.5% and 23.1%, are key examples of what the U.S. equity markets accomplished in 2005. Overseas, international equity markets kept up their part of the bargain, as developed international markets and emerging markets equities pulled off respective returns of 23.6% and 42.0% over the same period. In fact, the emerging markets completed a remarkable run, an annualized rate of 30.0% over the prior three year period. Even REITs, which had put on an impressive multi-year showing before 2005, returned in excess of 25% in 2005, propelling the three year asset class return average to 25.0% annualized.
In general, this was a year in which the more 'risk' an investor elected to take, the greater the reward. Witness fixed income, where the standard Lehman Aggregate benchmark index was up a respectable 4.15% in a year peppered with Federal Reserve interest rate hikes. However, High Yield and Emerging Market debt securities, which typically weaken as monetary conditions tighten, turned in results of 9.35% and 13.98%, respectively. In sum, all appeared to go as even the most optimistic of bull market devotees could have hoped.
However, when taking a look at the timeline of the market's advance for the year, three distinct performance periods emerged.
The first is the period from September 1 through October 22, 2004 during which oil prices rose from $44 to $55/barrel-reaching a then all-time high, stoking renewed concerns about inflation-or even potential stagflation (inflation coupled with little economic growth). Combined with the uncertainty over rising interest rates and the pending U.S. presidential election, a near term bout of market indecision ensued, resulting in low returns across most markets.
The second period covered October 23 through December 31, 2004. During this period, oil retreated from its highs back down to near fiscal year starting levels of $44/barrel. In addition, investors were relieved to find a clear cut winner of the U.S. presidential election, and took the opportunity to express their continued domestic and global economic confidence by pushing most equities markets higher.
The third period covered January 1, 2005, through August 31, 2005, and was a decidedly bipolar environment. On the negative side, concerns over an economic soft patch, the continuing rise in interest rates, and the specter of a housing bubble in the U.S., were counterpoints to the positive real news of continued economic strength, interest rates remaining at relatively low levels, and building continuing to thrive.
All the while, however, the price of energy retained its upward momentum, ending the fiscal year at an all-time high of $69/barrel with some assistance from another highly active Atlantic hurricane season. Again, even within this tug-of-war period, investors found plenty of opportunity in the higher risk areas of small cap U.S. stocks, REITs, Emerging Markets equities, and especially energy-related securities.
In sum, most investors probably found fiscal 2005 quite satisfying. It might not have been "Much ado about Nothing", but, as in recent years, the big winners were "real" assets such as REITs, Commodities and Emerging Markets. And, as in the past two years, double digit returns were a likely result. For the GEF, we found the environment quite challenging, but also very rewarding, as the funds were able to generate double digit results for the third consecutive fiscal year.
The marketable endowment assets enjoyed a return of 17.8% - strongly ahead of the benchmark result of 14.5% - resulting in a net value-added to the GEF of more than $116.0 million. Non-marketable assets also posted a double digit return of 28.3% during the year, which greatly exceeded the benchmark of 17.7%, resulting in a net value added to the GEF of $43.2. For the year, total value added to the GEF was $159.2 million.
Distribution (or Spending) Policy
The distributions of the PHF are based on a distribution policy which balances the needs and interests of current beneficiaries with those of the future. The PHF utilizes what is often called a "constant growth" spending policy in determining annual distributions. Under a constant growth spending policy, distributions in any year are equal to the distributions in the prior year plus an increase to offset actual inflation in the particular year. Thus, distributions grow at a steady rate equal to the rate of inflation, providing a stable stream of "real" resources to the beneficiaries of the PHF.
The PHF's distribution policy defines the compromise between the conflicting goals of providing substantial, sustainable support for current operations and preserving purchasing power of the endowment assets. The PHF's distribution policy objectives are an integral element in the success of the PHF preserving its purchasing power. The PHF distribution policy was designed to meet the following objectives:
- Provide a predictable, stable stream of distributions over time.
- Ensure that the inflation adjusted value of distributions is maintained.
- Ensure that the inflation adjusted value of PHF assets after distributions is maintained over the long-term.
The PHF distribution policy states that distributions are increased annually at the average rate of inflation (twelve quarter average) provided that the distribution rate remains within a range of 3.5% to 5.5% of the PHF net asset value. In 2000, the PHF's first full year of existence, the distribution rate was $.045 per unit, or 4.5% of the initial market value. For the years ended August 31, 2001 and 2002, the distribution rate was increased each year by 2.2%, approximately the average rate of inflation. The rate for fiscal year 2005 was $.047 per unit, the same as in fiscal year 2002. During this time period the average distribution rate has not exceeded the upper range of 5.5%, but the rate has not been increased by the UT Board because significant negative returns in the global equity markets during 2001 and 2002 resulted in the PHF's net asset value being less than the original PHF contributions of $820.0 million. As a result of the strong positive results of the past three years the PHF's net asset value has increased above the original contribution amount, and the UT Board approved an increase in the distribution rate for fiscal year 2006 to $.0482 per unit.
The large asset base under UTIMCO's management allows for economies of scale in management of the endowment funds. The GEF was created as the investment vehicle in which the PHF and LTF could get cost effective exposure to a well diversified investment portfolio. The GEF incurs expenses for external management fees, custody and safekeeping fees, and other fees related to its operations. Both the PHF and LTF pay the same fee for every unit of GEF owned by these funds. However, there are additional expenses which differ for the PHF and LTF. Therefore, the total fee paid by each unit of the PHF includes PHF expenses plus a portion of the GEF expenses. The UTIMCO fee for 2005 fiscal year was .06% of PHF average net assets; fees and expenses paid to external managers and other service providers totaled .32% of PHF average net assets.
Management and Oversight
Since the PHF's inception, UTIMCO has been responsible for the investment management of the PHF. UTIMCO's sole purpose is the management of investment assets under the fiduciary care of the UT Board of Regents. UTIMCO is governed by a nine-member Board of Directors appointed by the UT Board of Regents. The UTIMCO Board of Directors includes three members of the UT Board of Regents, the Chancellor of The University of Texas System, and five independent investment professionals. Annual and quarterly information, including the audited financial statements of the PHF, is available to the public via UTIMCO's website at www.utimco.org