Texas Turnaround

Britt Harris brings alternative investments to the Teacher Retirement System.


Britt Harris went home in 2006 to revive the giant Teacher Retirement System of Texas. After two decades back East, where he’d run Verizon Communications’ pension fund and served as CEO of quantitative investment manager Bridgewater Associates, the Bryan, Texas, native took one look at the more than $100 billion TRS portfolio and saw a dangerously narrow, all-too-basic mix of stocks and bonds that urgently needed a shaking up. Harris had a personal interest at stake: His 73-year-old mother, Allana, a retired fifth-grade science teacher, receives a $1,200 check from TRS each month at her home in Mesquite, Texas.

When he interviewed for the job of chief investment officer, Harris was blunt: He told the board of trustees, which oversees the system and hires its CIO and executive director, that he would take the position only if he could make widespread changes. “It wasn’t an ultimatum, but I wanted to tell them ahead of time that ‘if you hire me, this is what I’ll want to do,’” says Harris. “My approach has never been incrementalist.”

Harris’s recipe was simple and sweeping — diversify out of plain-vanilla stocks and bonds into a wide range of alternative investments, from hedge funds to real estate to commodities, and hire outside portfolio managers. Run in-house in Austin, the stock and bond investments generated indexlike returns at low cost for domestic securities, but left TRS at a disadvantage when it came to trading emerging-markets and other alternative instruments.

Revamping a portfolio now worth just under $81 billion and covering 1.2 million active and retired members can’t be done overnight, and today Harris has completed only part of his radical overhaul. From the start he’s had to contend with hothouse local politics, from a meddlesome governor to a legislature wary of potential conflicts of interest or of surrendering too much control. In 2007, the legislature trimmed Harris’s target allocation for hedge funds from 10 percent to 5 percent while authorizing TRS to hire outside managers to run 30 percent of its publicly managed stocks and bonds. (Harris preferred no constraints.)

Still, Harris has been remarkably effective. He has mostly achieved his new allocation goals, placing nearly 58.5 percent of assets in global equities; 22.8 percent in stable value assets, such as long Treasuries and intermediate-maturity government credits, hedge funds and high-yield bonds; and 18.7 percent in real-return assets, including Treasury inflation-protected securities, commodities and real estate.

In so doing, he has made a keen impression on his peers. “The transformation of Texas TRS has been significant in paving the way for far greater diversification than what has been typical of pension plans and institutional investors more broadly,” notes Russell Read, who stepped down as CIO of the California Public Employees’ Retirement System in June to pursue environmental investing as co-founder of C Change Investments.

Along the way Harris has become one of the most powerful U.S. public pension plan CIOs. In 2007 he convinced the board of trustees to raise compensation for the fund’s investment professionals — including himself — just a year after they had last done so. In June the board gave Harris an additional 17 percent raise, and set his pay cap, including performance-based bonus, at $1.08 million. That’s more than three times what his predecessor earned and the highest compensation of any public pension fund manager in the U.S. His independence is equally Texas-size: Trustees have given his staff authority to make private equity investments of up to $1 billion without board approval. Previously, the board had to approve every private investment.

“He came in as the agent of change we had been looking for,” says Dory Wiley, chairman of the trustees’ alternative investments committee and president of Samco Capital Markets, a Dallas-based broker-dealer that serves community banks. “He’s been a bit of a bull in a china shop, but it’s probably the only way to have gotten it done, and he’s done a great job.”

Now, though, the global market upheaval is casting shadows over Harris’s plans. Pension funds throughout the country have been hit hard — mighty CalPERS warned in late October that if it sustains losses of 20 percent or more in the fiscal year ending next June 30, it will need to raise contributions from its public-agency employers. (As of October 28, it was down 29 percent from its year-earlier peak.) Alternatives have been hammered: Commodities are in free fall, real estate values are sinking, and private equity and hedge funds have been whipsawed by the ongoing liquidity crisis.

The Teacher Retirement System of Texas Pension Trust Fund has suffered too. As of August 31, 2008,

TRS had a ratio of assets to liabilities of 90.5 percent. That’s better than the aggregate funding ratio of 86 percent among 125 major plans tracked by the National Association of State Retirement Administrators. But TRS’s $11.5 billion shortfall was, in absolute terms, among the nation’s biggest. And the system’s actuary warns that the shortfall and funding gaps are likely to worsen in the coming year as deferred investment losses are recognized.

Harris contends the moves he has made helped soften the blow; left unchanged, the fund’s legacy portfolio would have lost an additional $400 million during the nine months ended September 30. To be sure, with asset values deteriorating, the final verdict on his strategies is not yet in, a point he readily concedes. “One year does not a long-term track record make,” says Harris. “But the performance is coming in as expected.”

Political storms are also causing a disturbance. A minority on the board of trustees, along with some elected officials and local investors, fret that TRS, the biggest single pool of assets in Texas, is falling increasingly under the sway of Governor Rick Perry, who appoints all nine trustees — three directly and six from lists of nominees from different constituencies, such as active public school and university employees and retirees. The chairman since February, a nominee of the State Board of Education, is James Lee, a Perry contributor who made a fortune as founder of broker-dealer Momentum Securities during the 1990s day-trading boom and was national finance chairman for former New York mayor Rudolph Giuliani’s campaign for the Republican presidential nomination. Perry, a fiscally and socially conservative Republican, became governor in December 2000 after his predecessor, George W. Bush, won the presidency.

“Jim Lee is the driving force behind everything right now,” says Mark Henry, a trustee and superintendent of a school district near Dallas. “I feel like there’s a group of decision makers and I don’t know who those people are, but it’s not the whole board.”

There has been a lot of jockeying going on inside the fund. In September the trustees in a 5-4 vote appointed Brian Guthrie, a budgetary aide to Perry, to a long-vacant position as deputy director. TRS chief operating officer Pattie Featherston, who had been with the fund 11 years and had applied for the deputy director job, stepped aside the following month into an advisory role.

Then there’s the matter of the board’s fiduciary counsel. In July the board voted not to renew the contract, which expired at the end of August, of Ian Lanoff of the Groom Law Group in Washington, D.C., who has a sterling reputation for being vigilant about conflicts of interest. In his place as fiduciary counsel it chose Roel Campos, a former member of the Securities and Exchange Commission who heads the Washington office of San Francisco–based Cooley Godward Kronish. Then in November, under pressure from Texas Attorney General Greg Abbott and State Senator Robert Duncan, both Republicans, Campos, a Democrat and adviser to President-elect Barack Obama, withdrew himself from consideration. The board subsequently voted to select the law firm of Morgan, Lewis & Bockius instead, only to terminate that contract on December 17, because Morgan Lewis had recently repped another TRS client in a TRS investment transaction, a violation of state contracting guidelines.

“The pieces of the puzzle don’t all fit together,” says State Senator Duncan, who, as chairman of the State Affairs Committee, convened hearings in August into the switch in fiduciary counsels. “It’s easy to overreact, but I’d rather be proactive.” He notes that TRS’s expanded authority comes up for review in 2011.

Duncan and other officials worry that, even as falling markets threaten TRS’s funding status, the board may be swayed to make politically driven investments. Perry, who plans to run for reelection in 2010, has a history of proposing pet projects to large state funds. In 2003 he urged TRS to consider a plan put forward by UBS vice chairman and former U.S. senator Phil Gramm, a Perry supporter, to buy life insurance on retired educators that would funnel death benefits to the pension fund. In 2006 a Perry aide proposed that TRS invest as much as $600 million in start-up companies funded by the state-run Texas Emerging Technology Fund. Neither proposal was put to a board vote. Now the Texas Department of Transportation is urging TRS to consider investing in private toll roads in Texas, among other infrastructure projects, in a program supported by Perry and other Republican leaders.

Critics also fear that the growing reliance on external managers could lead to pay-to-play abuses, in which money managers make campaign contributions in exchange for mandates. As Henry puts it, “We were led to believe there might be less disclosure — that board members would not have to disclose when they had visited with vendors or sat in on meetings where investments are decided.” Campos tells Institutional Investor that he wanted to bring in experts to develop “best practice” policies and says any suggestion he would facilitate anyone’s political agenda is an insult to his reputation and absurd, given that he has never met Perry and had been a champion of investor rights while serving on the SEC.

State legislators recognized a decade ago that the pension fund was overexposed to domestic stocks, but tensions with TRS hampered diversification efforts. Although the legislature in 1999 authorized putting up to 4 percent of assets into private equity and hedge funds, it kept the fund on a tight leash.

In the early 1990s executives at TRS annoyed legislators when they crossed into politics, working with unions lobbying lawmakers to boost benefits. Lawmakers were stunned by a 1993 report by then–attorney general Dan Morales that found “pervasive conflicts of interest” in TRS’s real estate operations — including instances in which consultants paid for TRS staff junkets to Las Vegas and overseas — that might have contributed to nearly $500 million in losses in the 1980s. The report detailed lavish spending by TRS, including $18.7 million to build a new headquarters in Austin with a fortresslike façade and a soaring marble-lined lobby and $1 million more for furniture, artwork, a weight room, a greenhouse and other items.

TRS, which was mostly passively managed and in stocks and bonds, performed well in the late-1990s boom: Assets climbed from $62.2 billion in August 1997 to $90.0 billion in 2000. What’s more, the in-house approach meant the cost of running the portfolio was minimal — only about 2 basis points annually, says executive director Ronnie Jung, Harris’s boss.

TRS made its first foray into alternatives, with legislative approval, in 2000 but moved slowly because it lacked the necessary manpower and systems. Then the tech bubble burst, and assets plunged. In 2005, Governor Perry replaced TRS board chairman Terence Ellis, a retired managing partner from Nicholas-Applegate Capital Management in Houston, with Jarvis Hollingsworth, an attorney in the Houston office of Bracewell & Patterson, now Bracewell & Giuliani. (Perry, like Lee, supported Giuliani in this year’s GOP primaries.) In March 2006 the CIO position opened up when James Hille left to run the endowment at Texas Christian University, his alma mater.

Enter Harris.

Every day when I come to work, I’ve got 1.2 million people to think about,” Harris says. “It’s very clear to me what they do and how important they are, because all I have to do is think about my mother.” Harris, 50, who keeps a well-thumbed Bible in his office, speaks with an evangelical zeal inherited from his father. From age three to eight, Harris lived in Ankara, Turkey, where his father was a Mobil Oil Corp. executive. The family relocated to the U.S. in 1966, settling in Connecticut. A year later, at 33, his father was diagnosed with spinal cancer and underwent an enormous change. “He felt he’d had a dramatic calling to the ministry,” says Harris. The family moved to Fort Worth, where the elder Harris became a Baptist preacher.

“I went from living in something that was close to a mansion to a home that was essentially a shotgun tract house, and my dad went from being a senior vice president of Mobil Oil to selling insurance door to door, with my brother and me tagging along, to try to make ends meet,” Harris recalls. “I remember that as a very pleasant time.”

Harris earned a degree in finance from Texas A&M University in 1980 and took a job as an analyst with the pension fund of Texas Utilities Corp., now TXU Corp. In 1988 — the year his father died at age 53 — Harris moved to Connecticut. He spent three years helping to run the U.S. arm of the pension plan at ABB, the Swedish-Swiss power and engineering conglomerate, then became a portfolio manager at the then–$10 billion pension fund of GTE Corp., which merged with Bell Atlantic Corp. in 2000 to form Verizon. In 1995, Harris and his boss, GTE Investment Management Corp. president John Carroll, began to establish long-term strategic partnerships with fund managers. The idea was to give them broad discretion, instead of narrowly defined mandates, and to align incentives with performance fees. The clutch of managers — Goldman Sachs Asset Management, J.P. Morgan Investment Management, Morgan Stanley Investment Management and Grantham, Mayo, Van Otterloo & Co. — provided diversification and market insight. The strategic partner concept has been emulated by many public pension funds, including public retirement systems in Arizona and South Carolina, and by the Pension Benefit Guarantee Corp.

Harris says that when he left in 2005, the portfolio had $50 billion in defined benefit assets and had been a consistent top-quartile performer. A Verizon spokesman says the four original asset management firms are among six current strategic partners. But the program today “is different in approach, design and relationships, and you wouldn’t recognize it,” the spokesman says, declining to elaborate.

Harris left Verizon to become CEO of Bridgewater Associates, an alternatives powerhouse that now has some $80 billion in assets under management. Harris is a friend of co-CIOs Robert Prince and Ray Dalio, who founded the Westport, Connecticut, firm. But he stayed just five months. The job entailed a lot of client schmoozing, which, Harris explains, made it a poor fit.

Back home in Texas, Harris says he concluded that the TRS leadership “had not thought deeply enough about the way they’re diversified.” Harris designed a portfolio that would provide diversification across all market and macroeconomic conditions, in part through alternatives. But the wary legislature didn’t give him carte blanche.

“Politicians are always worried about public perception,” says Dan Gattis, a Republican state representative.“What are we really opening up our tax dollars to be invested in?”

Before Harris arrived the fund had allocated 52 percent to domestic equity and 15 percent to international stocks; fixed income comprised 27 percent and alternative assets 4 percent, with cash making up the rest. “Our main allocation is still in this long-term equity-oriented world,” says Harris, “but we’re better diversified for periods when the equity world is not in favor, like recently.” He adds that his new strategy is designed to deliver higher returns with lower volatility: a projected 8.72 percent annually, 99 basis points better than the previous allocation.

Following the approach he used at Verizon, Harris brought prospective strategic partners — four of the biggest names in finance — to Austin in April. In a wood-paneled room at Fleming’s Prime Steakhouse & Wine Bar downtown, Perry, Harris and Hollingsworth, who left the board in February, joined several other trustees to dine with CEOs John Mack of Morgan Stanley, Richard Fuld of Lehman Brothers and Lawrence Fink of BlackRock as well as Jes Staley, head of JPMorgan Asset Management. Soon after that night, each firm got $1 billion to manage in a strategy that essentially clones Texas’s portfolio. “This is called Texas hospitality,” says Harris about the dinner. “Also, from a practical point of view, it was a way to make sure that we didn’t have anybody miss the board meeting at 8:00 the next morning.”

Base management fees are closely aligned with performance — from as little as 20 basis points to as much as 85 basis points. Harris also sees the firms as an information resource for his 95-person Austin staff, which will continue to manage 70 percent of publicly traded assets. In addition to tracking where the Wall Street firms over- or underweight different asset classes, they will be able to call money managers and ask questions. Harris expects TRS to gain access to analytic and trading software and proprietary deals — such as its $250 million investment in June in a BlackRock fund that acquired $15 billion of distressed debt from UBS in May.

“Most of the financial community is set up for the equivalent of a one-night stand,” Harris observes. “They will do a transaction with you and move on. Nothing can accumulate. But we’ll be working on several joint research projects and get to know each other really well.”

It’s not clear, though, how far these synergies will develop.

(The bankruptcy of Lehman Brothers has forced TRS to reassess that relationship. Investment managers led by CEO George Walker [see related story, page 89] will acquire Lehman’s asset management business, which was not part of the bankruptcy proceedings. TRS says it is committed to its strategic relationship with the new entity, called Neuberger Investment Management.)

Harris insists that $1 billion “is a significant account for each of the four.” Nonetheless, he proposed giving the managers more capital, only to be rebuffed by his board. In April, the trustees balked when Harris made an offhand suggestion that individual external managers be allowed to invest as much as 5 percent of TRS’s assets. That could have given the strategic partners as much as $5 billion each to manage. “That caught me by surprise,” says TRS trustee Henry. “My feeling is, ‘You’ve got a billion, now prove what you can do.” Henry had another problem: He says he was miffed that he was not made aware of the steak house dinner until the day after it occurred, shortly after he had voted to allocate the initial $1 billion mandates.

All told, Harris has placed about half of the maximum 30 percent of fund assets with external managers. The four strategic partners were chosen through a rigorous nine-month process, and their selections were ratified by the board. TRS has been doing due diligence on dozens of additional managers and expects the level of assets managed outside to reach 20 percent by next summer.

Harris, who says he tries to stay above the political fray, retains strong support from the board and from politicians. Despite investment losses, there’s widespread acknowledgement, even among dissident board members and legislators such as Duncan, that his new strategy has saved TRS hundreds of millions of dollars.

TRS is trying to manage political risks. Under a new incentive compensation scheme, Harris and other staffers won’t get bonuses for having outperformed their benchmarks this year; payments will be deferred for a year because the fund lost money. In September, Harris held an unprecedented conference call with TRS members to assuage concerns related to the demise of Lehman and other Wall Street events. TRS and Harris went on the road in October and November to deliver “report cards” on their new strategy to the state’s teachers and the public at large.

“People are watching very closely,” says Harris. “We’re going to get out and tell our story.”