After demanding new hedge fund fee structure, CIO moves from public pension to endowment

CIO: What are the nuances between a public pension plan and an endowment, and how might this affect your approach in managing risk and investing?

Harris: The similarity between the two is that they both have the advantage of serving what most people would consider a “higher purpose.”

The differences are that in a public pension system, you are managing against a very specific liability, and the “accounting” process is very different (e.g., you can be under/over funded) and the taxpayer is an important consideration. In an endowment, the funding source is completely different, and although endowment returns are a part of the university’s budget, there is not legal, long-term obligation. Nor are taxpayers on the hook to the same extent for any shortfall. Most endowments are beholden primarily to alumni support, although we have the unique situation in Texas where we are the owners of significant tangible assets, outside of the endowment. As a result, the payout ratio for many endowments is much lower than what can often be the case in a public fund. As a result, endowments can take more illiquidity risk generally, but have tried to offset that downside potential with higher allocations to hedge funds and much more elaborate implementation approaches. In the end, public funds are better protected in disinflationary scenarios, while endowments are more hedge against reflation, generally speaking.

CIO: At UTIMCO, do you plan to change how you perceive each asset class?

Harris: No. The markets don’t know, or care, whether you are an endowment or a public fund.

CIO: Your 1 or 30 fee-reduced model for hedge funds sent ripples across the industry. What is your advice to those at smaller funds who may not have as much leverage?

Harris: Compensation arrangements should be aligned and sustainable. In addition, when gross returns are low, a larger percentage should go to the teachers, professors, and key research center and medical centers than to the managers. Under the Texas Model, the clients should always receive at least 70% of the gross alpha unless the net return to the client is unusually high (e.g., 15%+). This is fair, just, and ultimately produces a sustainable system. Clients pay less when the returns are lower. This is simply common sense. The old model comes out of a different era when hedge funds were primarily used by wealthy individuals interested in preserving their wealth and feeling “special.” It was also a time with massively lower competition. Today, hedge funds are generally a small part of a much larger institutional structure. The typical hedge fund since the [global financial crisis] has produced a net return to their clients of under 5%, often even lower. The time to make the change is now. Although the philosophy was engineered in the public fund space (specifically TRS), it has already been endorsed by Albourne, the world’s largest hedge fund consultant, and by BlackRock, the world’s largest asset manager.

CIO: Are there other asset class fees that need to be looked at more closely?

Harris: Private equity is unlikely to deliver the risk premium that it has in the past, as multiples are high and dry power is massive, although we are later in the economic cycle. [See how Britt has been acting on this.]

CIO: Having been at Bridgewater, you were one of the first to partner with asset managers. What should CIOs and managers keep in mind?

Harris: Partnership is about creating long-term sustainable advantages for both parties. This means a long-term commitment to a common framework, culture, and throughout both organizations, starting at the top. It also means accepting the fact that getting the top-performing product in every area is a “fool’s errand” and that it is better to pursue high-quality products and services across the board, in a way that is customized to your particular needs, where compensation is aligned and where commitment to continual improvement is absolute.
—Reported by Christine Giordano