STUMP » Articles » Public Pensions Watch: Alternative Asset Classes, pt 4 of many, San Diego » 5 September 2014, 01:19

After New Jersey and South Carolina, it’s San Diego’s turn at the plate.

Let’s start with some questions

It is not surprising then that the reaction to news accounts about what sounds like a material use of leverage by the San Diego County Employees Retirement Association (“SDCERA”) is drawing criticism. In “San Diego Pension Dials Up the Risk to Combat a Shortfall” (August 13, 2014), Wall Street Journal reporter Dan Fitzpatrick refers to their approach as “one of the most extreme examples yet of a public pension using leverage – including instruments such as derivatives – to boost performance.” Comments from readers range from intimations of gambling to imprudence. Bloomberg commentator Barry Ritholtz predicts that “San Diego County’s pension fund blows up” or “…the townsfolk figure out how much risk is being put on their shoulders, and fires everyone involved…” Click to read “Doing the Right Thing” (August 12, 2014).

My reaction to the announcement about this newly approved strategy is objective. I am interested in learning more about (a) what exactly SDCERA intends to do (b) how they will carry out their plan and the © basis for monitoring the third parties that are tasked with implementing levered actions, including the purchase of financial futures contracts. Although not an ERISA plan, SDCERA trustees are tasked with a duty to “act with skill, care and diligence” and “follow the prudent person rule” and to “act in good faith and in the best interest of members, beneficiaries and the fund as a whole.” It is therefore critical to know whether the intention to add more investment risk, in anticipation of greater returns, is something that SDCERA is allowed to do and whether a structural foundation has been created to support procedural prudence.

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According to an August 8, 2013 memo from Mr. Lee Partridge, one of SDCERA’s outside consultants, the Investment Policy Statement that was in the process of being revised for this California-based pension plan would allow for the use of leverage as long as doing so “does not materially alter the risk level of the investment program given the current asset allocation as approved by the Board. Risk constraints established by the Board (for the total portfolio, the individual asset classes, and individual managers) control the use of leverage.” The text further states that “Under no circumstances may derivatives or leverage be used to circumvent the intent or limits otherwise prescribed by this policy.” (My researcher has asked SDCERA for a final version of the current Investment Policy Statement)

Some of the many questions that need to be answered are listed below:

*What types of futures contracts will be purchased to gain exposure to stocks, bonds and commodities?

*Will these positions help to hedge any asset class exposures or instead serve as “substitutes,” recognizing that derivative contracts are not the same thing as securities?

*How will the performance of this derivatives-heavy strategy be evaluated in terms of quantifying tracking error, operational and financial risks and opportunity costs of doing something else?

*How often will the size of positions be altered and on what basis?

*How will the strategic and tactical asset allocation percentages change, and on what basis, as the result of implementing this levered approach?

*Why was it decided that this significant use of futures would be superior to either investing directly or allocating monies to asset managers that employ futures as part of their strategy?

*Did the trustees examine the use of indirect leverage already in place by virtue of asset managers to which SDCERA has allocated monies?

*How does SDCERA plan to keep its total portfolio adequately diversified, once this futures program has commenced?

*Which outside asset managers will be terminated, if any, to make room for the direct use of futures? Is there an early termination cost that SDCERA will incur with any or all of the asset managers to be terminated by SDCERA?

*On what basis could this new strategy lead to a violation of the SDCERA Investment Policy Statement?

*Should that occur, how would SDCERA correct its breach of asset class limits and risk tolerance threshold?

*How will the SDCERA risk management infrastructure change? Will someone be hired as a Chief Risk Officer? Who will establish and monitor a risk budget framework that takes into account this newly approved active futures strategy?

I am unsure that any of these questions have been answered, by the way. They are legitimate, but I don’t think you need to ask them to see how risky the strategy is.

Others have been digging into the riskiness of San Diego’s strategy

Statement: The San Diego County pension fund’s “investment strategy is purposely designed to be no riskier than traditional pension fund asset allocation strategies,” SDCERA CEO Brian White wrote in an Aug. 15 op-ed in U-T San Diego.

Determination: Misleading

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Brian White, SDCERA’s CEO, responded in letters to the editor in U-T San Diego and the Wall Street Journal defending the agency’s investment strategy as responsible and “the opposite of gambling.”

In both letters, he basically repeated the same statement: “SDCERA’s investment strategy is purposely designed to be no riskier than traditional pension fund asset allocation strategies.”

I decided to look into how risky SDCERA’s investment strategy is.

By two important metrics used to evaluate risk in pension funds, White is wrong and SDCERA’s investment strategy is riskier than the norm. SDCERA is taking on significantly more exposure to the market than many other funds and much more than it used as recently as last year. And SDCERA is using what’s generally considered a higher-risk investment tool in a larger share of their fund than others.

Let’s first look at SDCERA’s potential exposure to the market (this means how much money SDCERA has invested in the market versus how much money SDCERA actually has in the bank).

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Last year, SDCERA had an overall market exposure of 135 percent. That means for every $1 they actually had in hand, they had $1.35 invested in the market.

In April, SDCERA’s board decided to give the fund’s investment manager the authority to go even higher and that was the decision that’s attracted all the attention. Now, SDCERA could potentially have a market exposure of 195 percent of its assets, fund spokesman Dan Flores said.

That means SDCERA could have almost $20 billion invested in the market even though it only has $10 billion in assets.

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By another measure, SDCERA is also taking on more risk than many comparable funds.

The agency says it will confine the use of leverage strategies to 25 percent of its total portfolio of investments, but that’s already way ahead of its peers.

Again, the city’s pension fund doesn’t use leverage, so its percentage of that kind of investment is zero; the Wisconsin pension fund’s leverage percentage is roughly 6 percent with the ability to go up to 20 percent.

Much more at link.

Yes, this is a very risky strategy, it’s questionable whether a public pension fund should use leverage at all much less in this manner, and it’s a very attractive maneuver for public pensions because, at least in the short term, it makes the pension plan to be in a better position than otherwise.