The University of Texas System Permanent Health Fund
Totaling $814.4 million, the Permanent Health Fund (PHF) is an internal UT System mutual fund for the pooled investment of state endowment funds for health-related institutions of higher education. The UT Board of Regents established the PHF in August 1999 with proceeds from state tobacco litigation.
In order to take advantage of lower unit costs, attractive investment opportunities, and broader diversification benefits available from a larger investment fund, the funds in the PHF are invested in The University of Texas System General Endowment Fund (GEF), a broadly diversified mutual fund created by the UT Board of Regents in March, 2001, which is managed by The University of Texas Investment Management Company (UTIMCO). The PHF currently owns 19.4% of the GEF's $4.2 billion net asset value. The other GEF unit holder is The University of Texas System Long Term Fund (LTF.)
The primary investment objective is to preserve the purchasing power of PHF assets by earning an average annual real return of 5.1% over rolling ten year periods or longer. Earning an average annual real return of 5.1% permits the PHF to reach two goals:
- Provide for current beneficiaries by increasing the annual distribution at a rate at least equal to the current rate of inflation so that real purchasing power is maintained, and
- Provide for future beneficiaries by increasing the market value of endowment funds after the annual distribution at a rate at least equal to the rate of inflation so that future distributions maintain purchasing power as well.
Since the PHF's investment return is dependent on the GEF return, the operation and results of the GEF must be examined to determine the results of the PHF's activities for the year. The design of the GEF's portfolio is based on a combination of quantitative analysis and market judgment employed by UTIMCO's Board of Directors and investment staff. Sophisticated statistical techniques are combined with judgment to test many asset allocation alternatives, including the sensitivity of potential future results to changes in assumptions, in order to make portfolio construction decisions. Investment management involves as much art as science and qualitative considerations often play an extremely important role in successful portfolio management decisions. Art and science were used to develop the target and current GEF portfolios.
Investment Return and Market Commentary
The PHF posted an investment return of 14.6% for the year ended August 31, 2004. The PHF derives its return mainly from the shares it owns in the GEF. The PHF's return is slightly less than the GEF's return due to additional expenses incurred by the PHF. The GEF posted a net investment return of 14.8%. All asset categories of the GEF posted positive returns for the year, with commodity (+24.4%), absolute return (+13.0%), and U.S. (+13.3%) and global (+19.6%) equity asset categories leading the strong relative and absolute performance across the portfolio.
Fiscal year 2004 could well be titled "Great Expectations." As September 2003 began, the world was still honeymooning over the economic relief provided by a liberated Iraq, an accommodating world banking system, and an only mildly challenging hurdle of earnings expectations based on depressed prior year results. Whether at home or abroad, such macroeconomic expectations proved uplifting to stocks of all kinds for the first half of the year with domestic and international stock indices rising impressively. April 2004, however, heralded a new environment, as strong U.S. payroll gains triggered concerns that the Federal Reserve would soon reverse their policy accommodation of low 1.0% interest rates. This caused a dramatic upward move in U.S. interest rate expectations and rates. These events caused several beneficiaries of the prior year "easy money" policy - namely emerging markets, small cap global equities and REITs (Real Estate Investment Trusts) - to suffer considerable near term performance setbacks. Additionally, the surge of "hot" or short term money from speculative institutional and retail investors exacerbated this poor performance as those investors exited these assets "en masse" in April and May. During this period, the Russell 2000 equity index, the Morgan Stanley REIT index, and the MSCI Emerging Markets equity index all fell significantly.
In sum, the "great expectations" that began the year, closed on a less sanguine note, with concerns about the state of worldwide growth, rising inflation, interest rates, sky rocketing oil prices, and the uncertainty of the upcoming U.S. presidential election. While the S&P 500, Russell 2000, Developed International and Emerging Markets equity indices all closed with double digit gains, they were all off of their highs for the year and momentum remained to the downside as the year drew to a close.
Just as in fiscal year 2003, the disparate investment environments proved challenging from an investment management perspective. However, by maintaining a diversified asset exposure - including a meaningful allocation to REITs, commodity futures and hedge funds - along with strategic and timely rebalancing out of winning asset classes during the year, the GEF was able to effectively capitalize on the investment landscape of the fiscal year period.
For the year, UTIMCO's marketable endowment assets enjoyed a return of 15.1% - strongly ahead of the benchmark result of 12.4% - resulting in a net value-added to the GEF of more than $80.1 million. Non-marketable assets also posted a double-digit return of 12.1% during the year, but trailed their benchmark of 17.6%.
Distribution (or Spending) Policy
The distributions of the PHF are based on a distribution policy which balances the needs and interests of current beneficiaries with those of the future. The PHF utilizes what is often called a "constant growth" spending policy in determining annual distributions. Under a constant growth spending policy, distributions in any year are equal to the distributions in the prior year plus an increase to offset actual inflation in the particular year. Thus, distributions grow at a steady rate equal to the rate of inflation, providing a stable stream of "real" resources to the beneficiaries of the PHF.
The PHF's distribution policy defines the compromise between the conflicting goals of providing substantial, sustainable support for current operations and preserving purchasing power of the endowment assets. The PHF's distribution policy objectives are an integral element in the success of the PHF preserving its purchasing power. The PHF distribution policy was designed to meet the following objectives:
- Provide a predictable, stable stream of distributions over time.
- Ensure that the inflation adjusted value of distributions is maintained.
- Ensure that the inflation adjusted value of PHF assets after distributions is maintained over the long-term.
The PHF distribution policy states that distributions are increased annually at the average rate of inflation (twelve quarter average) provided that the distribution rate remains within a range of 3.5% to 5.5% of the PHF net asset value. In 2000, the PHF's first full year of existence, the distribution rate was $.045 per unit, or 4.5% of the initial market value. For the years ended August 31, 2001 and 2002, the distribution rate was increased each year by 2.2%, approximately the average rate of inflation. The rate is currently at $.047 per unit and has remained at that rate since fiscal year 2002 and will remain at $.047 for fiscal year 2005. Although the average distribution rate has not exceeded the upper range of 5.5%, the rate has not been increased by the UT Board because significant negative returns in the global equity markets during 2001 and 2002 have resulted in the PHF's net asset value of $814.4 being less than the original PHF contributions of $820.0 million. The PHF's short time of existence, only five years, coupled with two years of negative performance, has not allowed for the PHF to build and preserve purchasing power.
The large asset base under UTIMCO's management allows for economies of scale in management of the endowment funds. The GEF was created as the investment vehicle in which the PHF and LTF could get cost effective exposure to a well diversified investment portfolio. The GEF incurs expenses for external management fees, custody and safekeeping fees, and other fees related to its operations. Both the PHF and LTF pay the same fee for every unit of GEF owned by these funds. However, there are additional expenses which differ for the PHF and LTF. Therefore, the total fee paid by each unit of the PHF includes PHF expenses plus a portion of the GEF expenses. The UTIMCO fee for 2004 fiscal year was .08% of PHF average net assets; fees and expenses paid to external managers and other service providers totaled .23% of PHF average net assets.
Management and Oversight
Since the PHF's inception, UTIMCO has been responsible for the investment management of the PHF. UTIMCO's sole purpose is the management of investment assets under the fiduciary care of the UT Board of Regents. UTIMCO is governed by a nine-member Board of Directors appointed by the UT Board of Regents. The UTIMCO Board of Directors includes three members of the UT Board of Regents, the Chancellor of The University of Texas System, and five independent investment professionals. Annual and quarterly information, including the audited financial statements of the PHF, is available to the public via UTIMCO's website at www.utimco.org