This article first appeared in the Modern Investor magazine.
'Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.’
This quote comes from Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds. The book analyses why we are drawn to delusion and folly: fortune-telling; witch-hunting; and all kinds of market crashes, such as the Mississippi bubble, the South Sea bubble and the Dutch ‘Tulipomania’.
Despite being first published in 1841, Mackay’s work remains strikingly relevant, especially in today’s volatile market environment.
This is one reason why it’s an all-time favourite of Tom Tull, CIO of the $25 billion (€22 billion) Employees Retirement System of Texas (ERS), which looks after the pension benefits of state employees of Texas.
‘The more market cycles you go through, the more you know about how your gut will react to different environments, and you learn how you can respond accordingly so you don’t get wrapped up in this kind of crowd psychology,’ Tull tells Modern Investor.
Tull, who joined ERS as a strategic research director in 2009 and went on to become CIO in 2012, has been in the investment business for decades. But there is another reason he comes across as a workaholic. Asked about the hobbies that help him take his mind off investing, Tull says: ‘I do all the usual stuff, such as reading and exercising, but investments is really my true love.’
A former member of the US Army, where he served in the Vietnam War as a platoon sergeant, Tull is unfazed by negotiating fund fees. One of ERS’s papers notes that in 2015 pension fund staff ‘aggressively negotiated private equity, hedge fund and private real estate fees’, resulting in realised and future savings of about $63 million (€56 million). Notably, the pension scheme managed to reduce significantly the fees paid to hedge funds, which account for around 5% of the portfolio.
‘The usual fees in hedge funds are “two and 20”: 2% management fee, 20% carry. But I can’t think of the last two and 20 we did. We tend to be nearer to 1.1-1.5% in management fees, depending on the asset class. We not only negotiate the management fee but also the carry. For example, in hedge funds we reduce the carry further by negotiating a hurdle rate.’
Tull adds that in the negotiation process, the scheme definitely benefits from its large size.
What also helps is that ERS views its relationship with funds as long-term partnerships, so a fund that makes it into the portfolio is likely to be there for some time.
Tull tends to look for mid-sized hedge funds because they are more flexible than large ones. ‘We are constantly looking for opportunities in real estate and other areas where we can add a hedge fund as a return seeker. But we’re finding much better value in stepping down to the mid-sized asset gatherers, where people are more willing to negotiate.’
In the risk-reducing part of its portfolio, ERS uses hedge funds to reduce volatility and add diversification. ‘We don’t look at hedge funds as an asset class, but as a business model. Because of that, we use them in the absolute return area tactically; for example we use a 150/50 strategy in our equity area to complement returns in our equity portfolio.’
Tull emphasises that the scheme doesn’t use funds of funds because they charge too much. Boasting a four-strong hedge fund team, ERS is able to put together its own funds of funds without all the extra fees.
ERS's overall asset allocation
Bringing it all back home
Being able to create its own funds of funds is just one example of what ERS’s in-house crew is capable of. The team, which has been expanding over the past four years, has grown to 73 people and counting. ‘We’ve just recently added a number of people in the public equity area. We are now looking for somebody in infrastructure, and are trying to add more people in credit.’
Tull is no stranger to the recent trend of pension fund insourcing – making use of a fund’s in-house capabilities to reduce fees paid to external managers.
‘I think you are going to see more public funds moving management in-house. Even sovereign wealth funds are moving money in-house. We are fortunate because our board made the decision about insourcing a number of years ago.
‘Now, I can have money managed internally rather than externally, where we were paying three or four times higher management fees.’
ERS manages approximately 60% of its assets internally, including equities, fixed income and public real estate.
Attracting talent is one of the difficulties of bringing more asset management in-house. ‘You have to be willing to pay salaries and have a good working environment. Although we can’t afford to pay what the private sector pays, we can offer a professional environment with opportunity for growth.’
Despite having most of its assets managed in-house, Tull says leaving some of the assets with third-party external managers has been profitable for the scheme. ‘There are certain styles and flavours that we do pick up with external asset managers.’
For example, they use the services of Lazard Asset Management as they believe they are very good at fundamental, bottom-up stock selection. BlackRock, meanwhile, has a focused, best-ideas approach with an emphasis on risk management, according to Tull’s team.
Other public equity managers ERS uses include Barrow Hanley, Fisher Investments Institutional Group and Franklin Templeton. In addition to equities, all alternative investments are managed externally, including private real estate and infrastructure.
ERS's allocation to emerging markets
ERS established a dedicated emerging managers programme a few years ago, which aims to find and invest in asset management companies that have less than $2 billion under management (to learn more about emerging managers, turn to page 22).
The trend of hiring smaller managers was picked up in the US several years ago, Tull says.
‘We are seeing more and more public funds increasing allocations to them, including foundations and corporations.
‘They are moving from broad mandates to more specialised mandates. And, most importantly, we are seeing the US government beginning to utilise emerging managers more. For example, the Pension Benefit Guaranty Corporation is getting more actively involved in that space.’
Many emerging managers outperform their larger peers because they look at things differently, Tull says. ‘Lots of them are thought leaders; they have market niches that they get more actively involved in.
‘Our objective is to find a smaller managers who can really benefit the trust by enhancing our risk-adjusted return. But there are other factors which are unique to them, and we’ve found that they tend to provide above-average risk-adjusted returns at reasonable costs.’
At the moment, of the $9.7 billion (€8.6 billion) that is externally managed on behalf of ERS, approximately $1.1 billion (€1 billion), or 11%, has been invested with or committed to emerging managers.
Most of the allocation to emerging managers is in hedge funds (43%) and private equity funds (21%). Among the firms the pension scheme has invested in are hedge fund Stone Lion Capital Partners, private equity company GCM Grosvenor and private real estate firm Oak Street Real Estate Capital.
However, regardless of a fund’s size, solid due-diligence is a must. And even though investment with emerging managers is now common in the US, that doesn’t mean Tull will sign on the line without fully understanding the rationale.
‘You always need to concentrate on the true virtues of the investment that you are making. Ask yourself some basic questions: what is the return, what is the risk? If everybody is investing in one particular idea, that is usually a cause for a pause.’