Letter from the Executive Management
Fiscal Year 2011 Returns
The Permanent University Fund (the “PUF”) and the General Endowment Fund (the “GEF”) – together the “Endowments” – had investment gains of 14.62% and 14.74%, respectively, for the fiscal year ending August 31, 2011. PUF assets totaled $12.7 billion and GEF assets totaled $7.1 billion at fiscal year-end. This represents all-time peaks for the Endowments.
As noted in last year’s Annual Report, the previous peak for Endowment assets occurred in October 2007 - coinciding with the peak in the public equity markets. Since then, adjusting for contributions and distributions in order to reflect only investment returns, the Endowments’ assets are at 101 cents on the dollar, as compared to public equity markets which are at 85 cents on the dollar.
The Endowments’ actual returns were 2.63%, or 263 basis points, in excess of the Policy Portfolio Benchmark, thus producing $461 million of additional 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 2011 is due almost exclusively to the active management on the part of external investment managers, as tactical allocations – which reduced the risk of the overall portfolio – had very little effect (positive 6 basis points) on investment returns.
For the twelve months ending June 30, 2011, the twenty largest university endowments had returns ranging from 11.7 % to 24.5%. The best returning five endowments produced 23.0%-24.5%, the bottom five endowments produced 11.7%-18.9%, and the middle ten, which include UTIMCO, produced 20.0%-22.4% returns. Importantly, for the three year period ending June 30, 2011, UTIMCO ranked 6th among the twenty largest endowments.
The Intermediate Term Fund (the “ITF”) returned 11.39% for the fiscal year. Actual performance was 2.33% better than the Policy Portfolio Benchmark, producing $99 million of additional assets for the fifteen institutions comprising the UT System. Thus, in total UTIMCO staff added $560 million of additional assets to the Funds it manages.
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 equities will outperform fixed income over the long-term, particularly in areas with solid economic growth, so we retain an “equity orientation”. 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 our implementation of an “equity oriented” investment strategy. In fact, as of August 31, 2011, 24.9% of the Endowments’ assets were invested in fixed income securities and 19.5% were invested in real assets (albeit, often in the form of equity).
We have a bias towards value and welcome a margin of safety in our investments. We also believe in the growth prospects of many emerging markets, but are mindful of valuations and the political and economic risks in these areas. 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 ever mindful of maintaining safe levels of liquidity from which to meet our obligations.
We believe that our portfolio will benefit from continuing to add 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 in the portfolio.
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 of which helped shape and ultimately affirmed the Funds’ investment strategies. This year’s process included a strategy offsite meeting which proved very informative and beneficial.
Tactical Allocation and Portfolio Positioning
Over the course of the fiscal year, tactical asset allocation added six basis points of return, but more importantly it served to reduce the portfolio’s risk as the Endowments’ averaged 91% of the risk of the Policy Portfolio.
Under-weights to Emerging Markets Equity and over-weights to Natural Resources and Private Investments (which were highly concentrated in credit related opportunities) positively contributed to the tactical investment outperformance. An under-weight to Developed Country Equity, and an over-weight to Investment Grade Fixed Income, however offset some of the tactical asset allocation gross gains, as we maintained a defensive position throughout the year.
The long-only (“More Correlated and Constrained” or “MCC”) Investment Grade Fixed Income allocation of 10.9% of total assets at fiscal year-end is slightly lower than last year’s 13.1%, although we maintain a defensive positioning and continue to have ‘dry powder’. While this may cost some in the short term, we believe that maintaining the flexibility to take advantage of opportunities as they arise and ample liquidity from which to meet our obligations will benefit the Endowments in the long term.
MCC Credit Related Fixed Income declined from 1.3% of total assets at fiscal year-end 2010 to 0.1% at fiscal year-end 2011. During the continued rally in these markets during the past twelve months, we harvested 20% gains.
MCC Real Estate assets also declined from 3.0% of total assets at fiscal year-end 2010 to 2.3% at fiscal year-end 2011. Again, the continuing 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 8.1% of total assets at fiscal year-end 2010 to 12.6% at fiscal year-end 2011. A substantial portion of this increase is attributable to a position in gold we laddered into during fiscal years 2010 and 2011. We allocated assets to gold as a hedge for our overall portfolio against weakening currencies, particularly the U.S. dollar, Euro and Yen. 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 12.4% of total assets to 8.7% of assets during the fiscal year. We remain underweight in public equities as a result of our shift to credit-related assets and our gold position. The Developed Country Public Equity exposure we do have is generally comprised of managers who invest in high-quality, global companies as well as managers who typically invest in midcap companies that have a unique, defensible niche.
MCC Emerging Market Public Equity assets remained constant, ending fiscal year 2011 at 9.4%. Our portfolio consists of a diversified set of managers, with some investing globally across all emerging markets, some investing across emerging regions such as in Asia or the Middle East and Africa, and others 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 this slightly decreased from 30.3% at the end of fiscal year 2010 to 29.6% at the end of fiscal year 2011. UTIMCO has a diversified portfolio of approximately forty 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. All but two of these managers have been in our portfolio for over five years. One of the other two is a manager that is headed by individuals that departed from organizations with which we have had a long term relationship. The final manager is one we have known for over a decade and which had been closed to new investments until three and a half years ago. Our LCC managers utilize modest 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 increased from 22.4% of total assets at fiscal year-end 2010 to 24.9% at fiscal year-end 2011. The composition of this portfolio is important. Approximately one-quarter of the total Private Investments are in credit-related strategies that have shorter lives, employ less leverage, and much have more downside protection than traditional buyout-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 – primarily in emerging markets which is where the majority of global GDP growth came from over the past year. Growth in this half of the portfolio was the primary source of growth in the overall Private Investment portfolio.
During the fiscal year, UTIMCO received $820 million in distributions from the Private Investment portfolio, sent $1,075 million of capital to our general partners and made 28 new commitments totaling $1,413 million in Private Investments.
One tactical activity that bears particular mention is staff’s efforts to protect the Endowments from severe drawdown should dramatic scenarios unfold. For example, in the event of a sovereign default, high U.S. inflation, or the severe slowing of emerging market growth – to name a few such dramatic events – staff forecasts that the Endowments’ returns would be insufficient given the investment objectives.
To protect against such scenarios, “insurance”, in the form of financial options have been purchased. The maximum loss of such activities is known: it is the cost of the option. This cost would be realized should these scenarios not unfold, however, if the scenarios do not come about the Endowments’ returns should remain sufficient to meet the investment objectives. Should one or more of these dramatic scenarios unfold, the ‘insurance’ would help offset the losses likely to be incurred in the overall portfolio.
While there is no “free lunch” the current cost of such “insurance” has been determined to be acceptable given the severe undesirable consequences of not having the “insurance” in place. This activity has been fully vetted with the UTIMCO Board and the UT System Board of Regents, and is carefully monitored and reported in detail.
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 2.68% or 268 basis points of “value-add” or approximately $550 million of additional assets for the Endowments and ITF during the fiscal year.
Our active long-only, or MCC, Investment Grade Fixed Income managers underperformed their market averages, or benchmarks, by 0.08% or 8 basis points. Our long-only Credit Related Fixed Income managers generated investment returns of 20.2% vs. the market average of 9.2%.
MCC Real Estate managers generated an 8.7% return versus their market average of 15.5% and the Natural Resources managers delivered 35.5% returns, significantly outpacing their market average of 25.1%.
During fiscal year 2011, our MCC Developed Country Public Equity managers delivered 15.5% returns, exceeding their market average or benchmark returns of 14.5%. And our MCC Emerging Market Public Equity managers produced returns of 9.3%, besting their benchmark returns of 9.1%.
LCC managers continue to outperform the market average, posting returns of 7.5% versus the average hedge fund of fund return of 3.0%.
Private Investment managers produced a 23.3% return, versus a market average 20.0% return. Of particular note, over five years ago the Private Investment staff determined that UTIMCO’s venture capital portfolio was not world class. The staff undertook an effort to identify the best area for venture capital investment at that time and concluded that social media would provide attractive returns. Staff then identified the best firms in this area to partner with – no small feat given that neither the area nor the firms were yet proven. The fruits of these efforts began to be realized this year as gains in this part of the portfolio alone exceeded $280 million.
FY 2011 Market Overview and FY 2012 Market Outlook
Public equity markets and natural resources were exceptionally strong in the first half of the fiscal year, posting gains of 25%-30%, depending on the market. These markets stalled, however, in the spring and then fell 10%-20%, over the summer.
Fixed Income markets, conversely, were fairly soft in the first half of the year but rallied strongly in the second half of the year.
For the full fiscal year, fixed income markets rose 9%, natural resources rallied 25%, developed country public equities returned 14.5% and emerging market public equities rose 9.1%. Thus the Endowments’ returns approximated developed country public equity returns, although the Endowments exhibit substantially lower volatility due to their diversification and defensive positioning.
Two years ago and again 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.”
Continuing with last year’s musings:
“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 this team of people that produce the returns that provide additional resources for the state’s educational and health well being.
We are grateful for Erle Nye’s many years on the UTIMCO Board, which concluded this past year, as well as for Janiece Longoria’s service which also ended this year. We welcome Steve Hicks and Jim Wilson to our 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 appreciation for 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 believe 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