In late 2006, Thomas (Britt) Harris found a comfortable new perch from which to weigh in on the world economy. After extricating himself from a brief dip in the shark-infested hedge fund waters of Southern Connecticut, Harris, known to all as Britt, took over as chief investment officer of the $117 billion Teacher Retirement System of Texas in Austin. Although he now invests on behalf of 1.3 million teachers, among them his own mother, the CIO is perhaps best known in the pension world as a pioneer in forming strategic partnerships with asset managers who took on large, broad mandates to oversee diversified portfolios while at the pension fund of GTE Corp. (now Verizon Communications) in the mid-1990s. Today, as head of the fifth-largest U.S. public pension system, Harris commands a rapt audience wherever he goes.
Harris, 55, took the CIO job with promises to shake up the portfolio. He brought strategic partnerships to Texas, instating a program that gives managers like KKR & Co. and Apollo Global Asset Management wide scope and several billion dollars each to invest as they choose. He has also built up a one-third allocation to alternative investments that includes a full 20 percent in private equity and real assets such as energy. Investors should have learned that traditional diversification does not work and never has, says Harris. Being diversified on average should not be the goal being diversified at the right time should be.
In February 2012 the Texas Teacher's fund bought a $250 million private equity stake in Bridgewater Associates, the Westport, Connecticutbased alternative asset manager with $150 billion under management (including $84 billion in hedge funds) where Harris spent five months in 2006 as CEO. That role, which was heavily marketing-focused, turned out to be antithetical to the deeply religious Harriss need for meaning and spiritual fulfillment in his daily work, resulting in his swift departure.
After taking six months off to regroup following the Bridgewater exit, Harris, a pastors son, returned to his home state for the more congenial atmosphere of Bible studies and teaching at his alma mater, Texas A&M University. After graduating in 1980 Harris worked in asset management in Texas before moving east to work as Chief Investment Officer and President of Verizon Investment Management Corporation in Stamford, Connecticut.
In mid-May, Harris flew into New York City to receive Institutional Investors Large Pension Fund Manager of the Year award, taking time to talk with Senior Writer Frances Denmark for a wide-ranging conversation on the future of the Texas Teacher's fund, risk management, the global economy and the start of the American Empire.
Will the Texas Teacher's pension fund be able to sustain pension payouts in the long run?
The most relevant thing for us is long term. Our time horizon is 24 years, and we have a lot of advantages over most investors. We are not only truly long-term investors, but we are very large, very liquid and not highly levered. We are also better diversified then the vast majority of investors around the world. This makes us the proverbial strong hands in the marketplace, which generally means that we, and others like us, have a better chance of performing well than most others.
Will you have to take on greater risk to meet your future payout goals?
That depends on two things: Are you talking about risk from an academic sense or a long-term investors perspective? In an academic sense, traditional investors will have to hold more equity than debt than they have had to over the past 30 years. That wont decrease the short-term volatility of stocks or change the expected correlations versus other asset classes. So in the academic and short-term sense the answer is yes. However, while more equity probably means more short-term volatility for most investors and more potential danger from systemic risk, long-term investors will also consider a number of factors. Unlevered debt is virtually useless now as a long-term wealth accumulator and cannot now play a meaningful role for most traditional long-term investors. We are now in a world where you want to be a borrower not a lender.
The probability that equity will outperform bonds over the next ten to 20 years is probably unusually high, assuming that systemic risk is contained. Short-term dislocations are actually helpful to well-diversified and well-capitalized long-term investors.
Often risk is the highest when people think that it is the lowest, and then the lowest when they feel like it is the highest. We should be the type of investor who suffers less than most from that upside-down thinking, and we should be the investors who actually profit from it.
How have your views on risk management changed in the past decade?
First, what most people call risk management is really risk monitoring and that probably has not changed much. However, for those who do practice risk management, there have been some important changes. Surely no one relies on VaR [the value-at-risk measurement tool] to anywhere near the extent they did previously. We have found that VaR massively understates risk when it is high and massively overstates risk when risk is low.
We have done several things to try to improve our risk management functions going forward. We now have an extensive system for monitoring both bubbles and antibubbles. We have developed what we refer to as economic maps for most of the worlds key regions designed to inform us more precisely about whether we are in a global equity environment, disinflation or reflationary regime. We have focused less on small risk factors and more on what we refer to as bullet to the brain risks, meaning risk factors that you cannot survive. Those include excessive leverage, excessive concentration and inadequate liquidity.
Where are you finding the best opportunities for growth?
We are living in the early years of the American Empire that began with the fall of the Berlin Wall. That means we are only about 25 years into the new empire. Every historical empire has lasted for centuries, not decades. We have the soundest economy, the most innovation, the best rule of law, a relatively deep spiritual core, a competitive banking system and the largest and best military force in the history of mankind which we use to reduce the probability of large-scale global conflict and increase international trade. So opportunities in the U.S. should continue.
Outside the U.S. it varies a lot. Europe looks to be the odd man out on a long-term basis. Their demographic situation is terrible, as they are likely to see their population decline by over 100 million people over the next few decades. They really have no political system to speak of. In many countries government spending is half of total GDP. In addition, their banking system is still a mess; and Europe has to figure out how to get its productivity massively higher, or it cannot remain as relevant over the next few decades as it has been in the past.
What about emerging countries like China, Brazil and India?
Emerging countries are at an inflection point. While they are likely to continue to grow at a more rapid rate then developed countries the spread in growth is likely to decline. After ten years of massive growth, most of these countries are reaching natural thresholds for continued improvement. What they have achieved in the past has been impressive and important. For instance, millions of people have been raised above the poverty line, and if the world were divided into just two countries, a developed county and an emerging country, the relative GDP of the two would be similar, but there would be massive disparities in people (80 percent would be in the developing country) and wealth (80 percent would be in the developed county).
Still, many of them are likely to stall going forward, as what is required to go through these economic gates changes as a country reaches various thresholds. The BRICs and commodity exporters may have some trouble, while countries in the emerging world may continue to advance. The wild cards are Africa and Japan. If they could get themselves into a secular positive position that would be helpful.
You have been a big hedge fund investor. Where are they headed next?
There are way too many of them and there will be fewer in the future. If you believe that hedge funds are higher alpha engines, which I dont, then you still have to confront the fact that alpha is zero sum and the pie doesnt get larger just because more people come into the field. Hedge funds have a different return stream and are probably best used as a substitute for bonds.
What about hedge fund fees?
Because the return stream is engineered, it is harder to produce and therefore takes more effort, which might be worth a higher fee in some cases. Most people pay a higher fee for two reasons: because that is the way it has always been and because people will overpay for downside protection if they are led to believe that that will make money too and that they are a part of some special group. Thus far, the vast percentage of the money has gone to the top-100 funds and those 100, while some have struggled, seem to have outperformed the median of the smaller funds, which obviously have both a wider range of returns and a higher death rate.
Is a 5 percent real (after inflation) return a realistic goal for public pensions?
The answer depends on several factors: how things are priced right now and what your time frame is. In the very short term, say, one to three years, anything is possible. If you assume that bonds earn 3 percent, then stocks would have to earn 8.5 percent in order for the total portfolio to come in at 7 percent. About 2.5 percent of that is backed in from dividends, so nominal capital appreciation would need to average 6 percent. When you look at the history of rolling 10-year returns, and then start five years ago, and look at the results in 55 previous periods when the first five years were about what we have just had, you discover that the next two years [historically] have actually averaged 12.2 percent, twice what we need to get to a 5 percent real over that time.
So to say that we wont reach 5 percent real may still be correct, but if we say that we are betting against a lot of history that would say otherwise.
What about the longer-term outlook?
Over the intermediate term, it is probably less likely. Thats because in that time period the odds that we will have at least a 30 to 35 percent pullback in the stock market are high. We just completed the recovery from the financial crisis that took 16 quarters four times longer than the historical average yet, here we are in the stock markets expansion phase and things are starting to boom as the bubble begins to subside. All the normal signs are there you see the IPO [initial public offerings] market heating up, M&A [merger and acquisition] activity starting to accelerate, individual investors jumping on the train and margin debt rising. Mr. Market may be a manic-depressive, but he is also patient. He always waits to move until he has just about all of us on the train. What this means in simple terms is that we are closer to the end of this business and market cycle then we are to the beginning.
Nobody who has studied how the markets work should say that they would be surprised to see a normal bear market begin within the next 12 to 36 months. That timing would be fairly normal and it would undermine our efforts to achieve 5 percent real.