TEACHER RETIREMENT SYSTEM OF TEXAS COMPREHENSIVE ANNUAL FINANCIAL REPORT <strong>2011</strong> This page is intentionally left blank. 82 INVESTMENT SECTION
TEACHER RETIREMENT SYSTEM OF TEXAS COMPREHENSIVE ANNUAL FINANCIAL REPORT <strong>2011</strong> Investment Overview PORTFOLIO STRUCTURE In 2008, <strong>TRS</strong> began a transition to a more diversified investment strategy. That transition is now complete. The investment strategy focuses on three possible economic scenarios. Scenario One is characterized by favorable Gross Domestic Product (GDP) growth and an average Consumer Price Index (CPI) which, since 1948, has been the prevailing economic condition 66% of the time. Scenario Two is one of low GDP growth and high CPI, which has occurred 21% of the time. Finally, Scenario Three is characterized by stagnant GDP and low CPI, which has occurred 13% of the time. <strong>TRS</strong> is positioned to take advantage of any of these various market scenarios by allocating 60% to global equity markets, which perform well under Scenario One, 20% to real return, which should perform well in Scenario Two, and 20% to a stable value portfolio, which should perform well and minimize downside risk in Scenario Three. INVESTMENT PORTFOLIO PERFORMANCE <strong>TRS</strong> had a return of 15.5% for the year ending August 31, <strong>2011</strong>, which exceeded the fund’s benchmark by 1%. This return ranked in the second quartile of public pension funds for the year. The total investment value of the trust as of August 31 was $107.1 billion. <strong>Annual</strong> rates of return for the three-, five- and 10-year periods ending August 31, <strong>2011</strong> were 3.6%, 4.0% and 5.8% respectively. Additional performance information is included on the Total Time-Weighted Returns and Asset Allocation Charts on the following pages. The Total Time-Weighted Returns shown are for the 12-month period ended June 30, <strong>2011</strong>, and include comparisons with established benchmarks for the same time period. Investment performance is calculated using a time-weighted rate of return. Returns are calculated by State Street Bank and Trust Company, the fund’s custodian bank, independently and using industry best practices. STRATEGIC INITIATIVES In July <strong>2011</strong>, the Investment Management Division (IMD) celebrated the third anniversary of its Strategic Partnership Network (SPN). Four managers, JP Morgan, Neuberger Berman, Morgan Stanley, and BlackRock, were funded $1 billion each to invest globally across the same public asset classes as the trust. The IMD gains valuable insight from the positioning of each Strategic Partner and incorporates that information into our own Tactical Asset Allocation models. In addition, each year the SPN collaborates to produce eight research projects used to benefit the trust, with a special focus on asset allocation. In July <strong>2011</strong>, a fifth partner, Barclays Capital, was added to the SPN with an allocation of $500 million. As of August 31, <strong>2011</strong>, the total SPN is valued at $5 billion. For the three-year period as of August 31, the SPN returned 5.3% annually, which added 1.83% over its three-year benchmark. For the one-year period, the SPN returned 14.89% to the trust, adding 0.8% over its benchmark. The Investment Management Division has a dedicated risk management function. Risk Management performs an independent risk certification for every new manager commitment and monitors the performance of each manager and portfolio monthly with a risk alarm review. During the last 12 months, the Risk Management team launched an improved suite of tools and reports, which monitor the risk levels of the trust and its portfolios. One of the tools developed is a bubble monitor, which scans the global markets for significant overvaluations in an asset class. The indications from this monitor provide an independent alert on asset classes where something abnormal is occurring. The IMD investigates each signal and may decide to lower our exposure to that asset class, either through entering into protective derivatives or an outright sale. On October 1, 2009, the IMD launched an internal gold fund to provide protection in times of uncertainty. Uncertainty has continued in the last 12 months due to continued concerns about Europe and potential currency devaluation in the US. For the one-year ended August 31, <strong>2011</strong>, the gold fund produced a return of 41.94%. In <strong>2011</strong>, the Private Markets Group continued to build <strong>TRS</strong>’ first Principal Investments Program. Since the beginning of the program in 2009, the trust has committed $2.7 billion in nine private equity principal investments and nine real asset principal investments. While this program is still growing, we believe the combination of lower fees and increased transparency into the decision-making of our private partners will be accretive to the trust. In September, the board reviewed and adjusted the investment policy to help achieve the trust’s targeted 8% long-term return. The primary adjustments starting October 1, <strong>2011</strong> are to incorporate the increased allocation to hedge funds approved by the Texas Legislature and to increase the amount allocated to private equity. These changes result in a 2% increase to Global Equity from current 60% policy benchmark to a 62% allocation and corresponding decrease in Stable Value from a current 20% policy benchmark to a 18% allocation. This adjustment will provide greater flexibility for the IMD to respond to changes in market conditions. Looking forward, our investment outlook has not changed in the past 12 months. Due to the very low interest rates today and the European sovereign debt concerns, our expectations are for muted returns over the next few years. Prepared by: Investment staff of the system INVESTMENT SECTION 83
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