Texas pension concern sees inflation as a threat.

The Teachers Retirement System of Texas (TRST) rebalanced portfolio–designed to perform well in an inflationary environment—saw crimped returns in the 3^rd quarter, although less so then most of its public-pension peers thanks to its diversification into alternative investments.

“The typical pension fund in this country is significantly under-diversified against rising, unexpected inflation. They’re only got a 10% hedge in that area,” said Britt Harris, the TRST’s chief investment officer in a December 12 presentation to the pension fund’s board. “You can understand why. We haven’t had high inflation in 30 years.”

Harris’ group, however, sees inflation as a future threat. Consequently, it had backed off the pension fund’s 15% benchmark allocation to fixed-income treasuries, which are hurt by inflation, and was holding closer to 11% going in the third quarter, when treasuries rallied a record 25%. The rally was unexpected, given U.S. treasuries had recently been downgraded and the state of the economy.

“If all you knew was that our economy was growing [at a rate of less than 2.5%], you would not believe treasury [bond yields] went from 340 basis points to 190 basis points” during the third quarter, Harris said.

Nevertheless, the rally ended up costing the $101 billion-asset fund about 105 basis points in return for the quarter, according to Harris, although the fund remains well positioned to ride future inflation.

In addition, the loss could have been worse, had TRST not rebalanced the fund more than three years ago to lessen its allocation to equities and include a variety of alternative investments. Although the fund underperformed the benchmark, its performance in the third quarter was still in the upper 27% of public pension funds managing over $1 billion in assets.

Harris said the fund’s allocation to stable-value investments—bonds—was less than most other pension funds, but it’s longer-maturity, higher quality treasury-bond holdings performed much better than the short-term treasuries held by most pension funds.

In addition, Texas Teachers’ rebalancing had shifted $35 billion out of the public equity markets and into not only treasuries but also hedge funds, which posted a negative return in the third quarter but less so than public equities. The rebalancing, which TRST pursued incrementally and completed last summer, also included allocations to private equity, real assets and treasury inflation-protected securities, all of which posted positive returns in the third quarter.