Letter from the Executive Management
Fiscal Year 2010 Returns
The Permanent University Fund (the “PUF”) and the General Endowment Fund (the “GEF”) – together the “Endowments” – had investment gains of 13.04% and 13.02%, respectively, for the fiscal year ending August 31, 2010. PUF assets totaled $10.7 billion and GEF assets totaled $6.0 billion at fiscal year-end.
Coincidentally, these gains almost mirror the losses experienced in fiscal year 2009, resulting in the Endowments being at approximately ninety-eight cents on the dollar for the two year period after adjusting for contributions in and distributions out. This compares to the S&P 500 being at eighty-two cents on the dollar over the same period. The actual peak for Endowment assets occurred in October 2007 - coinciding with the peak in the public equity markets. Since then, the Endowments’ assets are at eighty-nine cents on the dollar, as compared to public equity markets which are at sixty-eight cents on the dollar.
The Endowments’ actual returns were 4.26%, or 426 basis points, in excess of the Policy Portfolio Benchmark, thus producing $640 million of assets for the UT and A&M Systems. As a reminder, the Policy Portfolio Benchmark represents the returns that would result without UTIMCO staff, namely the returns from investing at each asset class’ target weight and receiving the market average returns for each asset class. The outperformance in 2010 is due both to tactical asset allocation – overweighting and underweighting asset classes around targets but within approved ranges – as well as active management on the part of external investment managers.
For the year ending June 30, 2010, as measured against the twenty largest university endowments, UTIMCO ranked third, helping to secure a three-year ranking of sixth out of twenty.
The Intermediate Term Fund (the “ITF”) returned 11.04% for the fiscal year. Actual performance was 4.99% better than the Policy Portfolio Benchmark, producing $186 million of additional assets for the fifteen institutions comprising the UT System.
UTIMCO’s investment strategy remains both constant and flexible, which we believe is appropriate for our long-term mandate.
We believe that when it comes to investing, skill matters. Therefore, we continue to rely on ‘best in class’ external investment managers. This is evident across all investment styles: long only, hedge funds and private equity.
We believe that a diversified portfolio produces the best risk-adjusted returns so we invest across asset classes, investment styles, geographies and other metrics of differentiation.
We believe that, over the long term, equities will outperform fixed income, so we retain an ‘equity bent’; however, we also recognize that during certain periods of time fixed income can provide extremely attractive risk-reward opportunities so we are not rigid in the implementation of the investment strategy.
For example, leading up to and during the Fall 2008 capital markets shocks, we developed a view that opportunities will exist for some time in the prudent accumulation of debt securities and over-levered assets from stressed sellers, including corporate, residential and commercial real estate, consumer and even sovereign debt. We began accumulating these debt positions in late 2007 and remain attractively exposed to these assets.
We have a bias towards value and we welcome a margin of safety in our investments. We also believe in the growth prospects of many emerging markets but are mindful of valuations. Said another way, as long as we invest at the right price we are always happy to benefit from the positive effects of growth.
We believe that as an in-perpetuity investor our long-term horizon allows us to assume prudent levels of illiquidity as long as we are appropriately compensated. That said, we are always vigilant to maintain safe levels of liquidity from which to meet our obligations.
We also believe that our portfolio will benefit from adding exposure to real assets – natural resources and real estate – both from the attractive risk-reward opportunities of the individual investments as well as from their portfolio diversifying and hedging of potential inflation characteristics. We continue to phase implementation of these strategies.
This year, as we do every year, we engaged in a thorough review of our Investment Policies with the UTIMCO Board of Directors and The Board of Regents of The University of Texas System, both which helped shape and ultimately affirmed the funds’ investment strategies.
Tactical Allocation and Portfolio Positioning
Over the course of the fiscal year, tactical asset allocation produced approximately 0.55%, or 55 basis points, of ‘value add’ which resulted in $100 million of additional assets for the Endowments and ITF.
Under-weights to Developed Country Equity and over-weights to Credit Related Fixed Income and Private Investments (which was also highly concentrated in credit related opportunities) were the major positive contributors to this outperformance. Slight under-weights to Emerging Market Equity and Real Estate, and over-weights to Investment Grade Fixed Income and Natural Resources, offset some of the tactical asset allocation gross gains, as we maintained a defensive position throughout the year.
As shown in Figure B, the long-only (“More Correlated and Constrained” or “MCC”) Investment Grade Fixed Income allocation of 13.1% of total assets at fiscal year-end is slightly higher than last year’s 12.2%, consistent with our strategy of maintaining a defensive position and keeping ‘powder dry’. While this may cost some in the short term, we believe maintaining the flexibility to take advantage of opportunities as they arise and maintaining ample liquidity will benefit the Endowments in the long term.
MCC Credit Related Fixed Income declined from 2.3% of total assets at fiscal year-end 2009 to 1.3% at fiscal year-end 2010. With the rally in these markets during the past twelve months, we harvested gains exceeding 44%.
MCC Real Estate assets also declined from 4.5% of total assets at fiscal year-end 2009 to 3.0% at fiscal year-end 2010. Again, the rally in these markets, coupled with our concern about the underlying fundamentals in the real estate markets, led us to monetize some of our gains.
MCC Natural Resources assets increased from 4.6% of total assets at fiscal year-end 2009 to 8.1% at fiscal year-end 2010. A substantial portion of this increase is attributable to a position in gold futures we laddered into during the year. As a hedge for our overall portfolio against weakening financial assets, particularly the US dollar, Euro and Yen, we allocated assets to gold. To date, this tactical position has produced strong returns. The majority of our MCC Natural Resources portfolio remains allocated to active, long-only natural resources-related public equities as well as a diversified portfolio of actively managed commodity futures.
MCC Developed Country Public Equity assets were reduced from 14.7% of total assets to 12.4% of assets during the fiscal year. We remain under-weight in public equities as a result of our shift to credit-related assets. The Developed Country Public Equity exposure we do have is concentrated in high-quality, global companies together with mandates for active managers typically investing in midcap companies.
MCC Emerging Market Public Equity assets remained fairly constant, ending fiscal year 2010 at 9.4%. Our portfolio consists of a diversified set of managers, with some investing globally across all emerging markets, some investing across regional emerging markets such as in Asia or the Middle East and Africa, and other investing in specific countries such as Brazil, China and Russia.
Hedge Funds (“Less Correlated and Constrained” or “LCC” managers) remain the single largest allocation, although they were slightly increased from 29.2% at the end of fiscal year 2009 to 30.3% at the end of fiscal year 2010. UTIMCO has a diversified portfolio of approximately thirty LCC managers employing a wide variety of investment strategies including long/short equities, distressed securities, global macro, relative value and other approaches. Our largest ten managers represent approximately 60% of our LCC portfolio. Three of these managers have been in our portfolio for over ten years and five have been in the portfolio for over five years. The two newer additions to the top ten are two very highly regarded investment managers whose principals we have known for a long time, with particular expertise in credit-related strategies. Our LCC managers utilize low levels of leverage, provide substantial transparency, practice strong risk management and generally approach investing with a value bias based on superior fundamental research.
Lastly, UTIMCO’s private investments have remained relatively stable representing 22.4% of total assets. The composition of this portfolio is important, given that approximately one-third of the total private investments are in credit-related strategies that have shorter lives and much more downside protection than traditional buy-out oriented private equity. Another fifteen percent of the private portfolio is comprised of venture capital investments. The remaining half of our private portfolio is distributed across natural resources, real estate, small and mid-cap buyout and growth capital including emerging markets growth.
During the fiscal year, UTIMCO received $1,017 million in distributions from the private investment portfolio and made $816 million in 14 new commitments in private investments.
The efforts of our external investment managers in buying and selling securities to produce investment returns that exceed their markets’ averages is referred to as ‘active management’. These efforts generated approximately 3.70% or 370 basis points of ‘value add’ or over $700 million of additional assets for the Endowments and ITF.
Our long-only, or MCC, Investment Grade Fixed Income managers bested their market averages, or benchmarks, by approximately 0.45% or 45 basis points, which is strong performance in this more efficient area of the capital markets. As noted above, our long-only credit-related fixed income managers generated a 44% return versus a market average 21% return for the year.
UTIMCO’s MCC Real Estate managers generated a 16.7% return versus their market average of 15.1% and the Natural Resources managers delivered 12.8% returns, significantly outpacing their market average of 2.8% by over 1,000 basis points or 10%.
Over the past few years, in previous annual letters, we have noted our dissatisfaction with our public equity managers and a significant devotion of effort to redeem from underperforming managers and place capital with managers in whom we have higher conviction in their ability to deliver better than market-average results. We are pleased to report that these efforts appear to be beginning to pay off.
During fiscal year 2010, our Developed Country Public Equity managers delivered 7.08% returns, significantly exceeding their market average or benchmark returns of 1.54%. And our Emerging Market Public Equity managers produced returns of 19.11%, besting their benchmark returns of 18.02%.
The only area where our managers’ returns appeared to lag their benchmark was in Private Investments. We say ‘appeared’ because one-year numbers can be misleading when evaluating a long-lived investment like private equity. In fact, our portfolio’s returns were primarily the result of credit-related investments we made in 2007 and 2008, while the market average returns were primarily the result of an uptick in the valuation of leveraged buyout investments made in the 2004-2007 time period. We remain concerned about equity investments of these vintages given the high degree of leverage underpinning the equity, and believe some of these one-year unrealized gains may, in fact, never become realized gains.
FY 2010 Market Overview and FY 2011 Market Outlook
Most capital markets were fairly choppy during fiscal year 2010. In most investment areas – natural resources and Japan being the exceptions – a strong fiscal year first quarter represented the final throes of the strong “bounce back” from the declines experienced during the Fall 2008. This was followed by a mixed second fiscal quarter, with Europe and investment grade fixed income particularly weak due to concerns about sovereign debt. The third fiscal quarter was weak across the board again, especially in Europe and natural resources. The fourth fiscal quarter showed strong gains in fixed income, real estate, natural resources and emerging market public equities, although developed country public equities were off.
Last year we wrote:
“Our base case for most developed countries is a slow, subpar economic recovery as global assets are rebalanced. At the same time, many developing countries around the world have good prospects for growth and development.
Global excess capacity retards inflation and, together with limited credit supply or demand, deflation concerns are understandable. The vast amounts of monetary stimulus governments have injected, however, cause concerns about inflation and currency devaluation over the longer term.”
This continues to capture our outlook with the exception that credit supply has not been limited over the past year – for better or for worse, as the case may prove to be.
The reality is that no one knows what the next fiscal year will bring in the capital markets. And while the future can never be known with certainty, the future looks particularly uncertain to us at this time.
The developed world labors under historically high debt levels, a need to bring consumption back in line with production and excess capacity. Emerging countries will need to rely more on domestic consumption than exports to the developed world to power continued growth.
Unprecedented levels of government monetary and fiscal stimulus will have implications that cannot yet be certain and the role of governments in the economy continues to evolve differentially – and often in unexpected ways – across the globe.
In this context, capital markets – always volatile – are likely to be even more so, particularly over shorter time periods as emotional euphoria and despair rear their ever present heads.
Our mantra is to remain long-term investors: focused on value, cognizant of manic market swings and patiently investing in opportunities that will protect our capital and produce attractive returns over the longer term. We continue to view capital markets as global and we continue to consider the full spectrum of asset classes, investment vehicles and approaches. We remain committed to partnering with best-in-class investment managers and to having a diversified portfolio.
Given the uncertainty and headwinds, we do remain defensive, liquid and flexible. We do believe that the stresses and changes will present attractive opportunities to those that are patient, flexible and ready to move quickly when the situations arise.
Board and Staff
The UTIMCO staff and Board are the keys to investment success. Along with the Board of Regents, and the UT System and its fifteen institutions’ staffs, it is the team of people that produce the returns that provide additional resources for the state’s educational and health well being.
We are especially grateful for Erle Nye’s splendid leadership as Board Chairman during fiscal year 2010, and we are delighted that Paul Foster has agreed to be the organization’s new Board Chairman. We are extremely grateful for Colleen McHugh’s and Clint Carlson’s years of service on the UTIMCO Board and we warmly welcome Printice Gary and Kyle Bass to the Board.
We are grateful for the open communications we have with our colleagues at the UT and A&M Systems and their respective institutions. In addition, we appreciate the oversight, direction and support we receive from the Regents.
Lastly, we cannot express enough our appreciation to all of our colleagues at UTIMCO. We have a great group of people who tirelessly apply their extraordinary skills to enhance the resources available to the public institutions that we serve.
We are pleased to have had a very good year of investment returns. We are prepared for whatever the markets offer and we are committed to doing our best, each and every day. As always, we welcome your inquiries and input.
Chief Executive Officer and
Chief Investment Officer
President and Deputy
Chief Investment Officer