Wednesday, August 20, 2014

Leverage Spells Headline Risk for SDCERA?

Dan McSwain of U-T San Diego reports, Leverage spells headline risk for pension fund:
By tradition, a public pension fund is safe and boring.

If you run one of these multibillion-dollar funds, replacing a lost benefit check should be your biggest problem on any given day. Same goes for taxpayers who support the pension system, and retirees who depend on it.

Here’s what you don't want: A front-page article about your fund in The Wall Street Journal.

Yet that’s precisely where San Diego County’s fund landed Thursday morning, as it has on many U-T San Diego covers in recent years.

Here’s how Journal reporter Dan Fitzpatrick described the situation: “A large California pension manager is using complex derivatives to supercharge its bets as it looks to cover a funding shortfall and diversify its holdings.”

That sounds neither safe nor boring.

Until the 1980s, when pension managers began adding stocks to portfolios, most funds were restricted to ultrasafe government bonds. But by the 2000s, many had added hedge funds, commodities, private equity and other alternative investments.

Now fund managers are reconsidering whether the returns have justified the additional risk. On Monday, The Wall Street Journal reported that managers of CalPERS, the nation’s largest fund, are considering a move away from alternatives.

The trend leaves San Diego County increasingly alone at the cutting edge of complexity.

And this story isn't over, because members of the fund’s governing board face important decisions about how their manager will make highly leveraged bets.

In April, the fund’s governing board voted unanimously for a new investment strategy.

Under the previous strategy, the county fund was among the nation’s most aggressive in its use of leverage. The board allowed investment strategist Lee Partridge of Houston to effectively borrow 35 percent of the fund’s assets for bets on Treasury prices.

But now, as of July 1, Partridge has a green light for 100 percent leverage, according to Brian White, the fund’s chief executive.

Put another way, Partridge can leverage the county’s $10 billion retirement fund, using derivatives, to place at least $20 billion at risk in stock, bond and commodities markets.

I use the term “at least” advisedly, because board member Richard Vortmann estimated at a July 17 board meeting that the actual leverage could easily approach 150 percent.

Partridge didn't correct him. Nor did officials with Wurts Associates, the independent consultant hired to monitor the fund’s risk management.

Given the history of spectacular collapses of leveraged investment funds, why does the county use such complex financial tools?

Because it needs money.

Partridge and Wurts have forecast average annual returns of about 6 percent over the next decade, using a traditional investment portfolio of 60 percent stocks and 40 percent bonds.

This would be very bad news for the county’s fund, which assumes it will earn at least 7.75 percent a year to meet retirement obligations.

For perspective, the fund’s actuarial debt to its members increased 4.7 percent last year to $2.45 billion — mostly because its portfolio earned 7.73 percent. Cutting returns to 6 percent could add billions to its liability.

So the fund’s board, in the clearest terms possible, has instructed Partridge to boost those returns. His strategy, stated explicitly in public meetings, is increasing risks to the pension fund — using leverage — to raise returns.

“We’re trying to bring up the risk, not keep the return and dial down the risk,” he said in April.

To be clear, Partridge and Wurts officials say there are plenty of circuit breakers built into the strategy to prevent the entire fund from disappearing.

However, large “downdrafts” are possible, Partridge said. Such losses could very well equal those of a traditional pension fund, which holds 60 percent in stocks and 40 percent in bonds, he said.

At its Sept. 18 meeting, the board could approve an “investment policy statement,” a document following the April decision that is supposed to define the fund’s complex strategy.

The effort has not gone well. In July, the board rejected the 18th draft of this key document.

What’s been missing is much discussion of the fund’s headline-grabbing history with leverage.

In 2001, the San Diego County Board of Supervisors approved a 50 percent increase in lifetime benefits to retirees, instantly creating $1.4 billion in debt for the pension fund, which was worth $3.7 billion at the time. The board then borrowed $900 million.

In 2006, an $87 million county investment collapsed after a young trader at a “multistrategy” hedge fund lost $6 billion in a week. Then, in 2008, the county’s portfolio lost 25 percent of its value, much of it on leveraged equity hedge funds.

Like most funds, the county’s has bounced back, earning an average 9.7 percent a year since 2009.

But the board's fondness for risk is still earning it headlines.
Last year the fund sent three board members to a training session in Hawaii, where one of the sessions was called “Avoiding a Front Page Scandal at Your Pension Fund.”

Perhaps they weren't taking notes.
Brian White, SDCERA's CEO, responded to these claims in a comment published in U-T San Diego,  SDCERA uses smart investment strategy for pension fund:
Recent media coverage of the San Diego County Employees Retirement Association (SDCERA) has suggested its retirement fund’s portfolio managers have recklessly pursued riskier investments in pursuit of higher returns to close the pension funding gap. In fact, nothing could be further from the truth. SDCERA is answering the real concern impacting public pensions by using tried and true principles of asset liability management and diversification, and not relying heavily on more volatile equities to close this gap.

The fund is responsible for paying the retirement benefits for thousands of individuals, and has done so consistently since 1939. SDCERA’s administration of the retirement contributions and the fund’s investment earnings have pre-funded 80 percent of the assets necessary to pay for members’ promised future benefits. SDCERA’s Board of Retirement, which includes county representatives, active employees, and retirees, monitors the risk in the portfolio and periodically adjusts the strategy to account for changing macroeconomic and market conditions.

For the past decade, San Diego County and its employees paid 100 percent or more of their annually required contribution to the SDCERA retirement fund. Consistent employee and employer contributions over the years have laid a foundation for investment gains and asset growth. SDCERA’s investment strategy helps the employer’s budgeting process and stabilizes employer costs by reducing the volatility of returns and steadily achieving the rate of return needed to fund the benefit.

At $10 billion, the SDCERA fund is able to pursue certain investment strategies that larger plans like CalPERS cannot access and smaller plans do not have the resources to deploy. SDCERA’s investment strategy is purposely designed to be no riskier than traditional pension fund asset allocation strategies. Risk-parity and trend strategies, which utilize leverage, are limited to 25 percent of the SDCERA portfolio, not the entire set of portfolio assets. The other 75 percent of the portfolio is managed using traditional asset allocation and rebalancing approaches.

SDCERA focuses on controlling the volatility of the investment portfolio and diversifying across a range of investments suited for a variety of economic environments. The use of leverage is a useful and effective tool that allows us to increase exposure to diversifying assets while reducing exposure to more volatile assets like equities. Different portions of the portfolio have different levels of risk, all of which together contribute to a diversified fund designed to moderate risk over the long term across different economic conditions.

SDCERA utilizes leverage in an attempt to obtain superior risk-adjusted returns and long-term, prudent growth through diversification, not to achieve higher returns or reduce funding shortfalls. This point has been discussed in public at many SDCERA board meetings since before the initial adoption of the strategy in October 2009. At that time, SDCERA adopted an investment strategy with the objectives of diversifying the portfolio across a wide range of economic scenarios; managing exposure levels to various asset classes more dynamically to maintain predetermined risk and diversification targets; and adopting a more conservative approach, as measured both by the variability of returns and by the reduced likelihood and potential magnitude of a significant loss of capital. With this investment strategy in place, SDCERA’s portfolio has performed as expected — preserving capital in difficult markets and generating strong returns in up markets.

Of course, no investment program offers guaranteed success, and as shown throughout history, drawdowns can have an enormously negative impact on the overall financial health of an investment program. With these important considerations in mind, SDCERA’s board adopted an asset allocation designed to serve the dual objectives of maximizing the fund’s likelihood of meeting its return objective while minimizing the risk of significant loss. This is clearly much different from using leverage to increase risk in an ill-conceived pursuit of higher returns. This change was adopted by a unanimous vote of SDCERA’s board after months of public discussion, consideration of a wide range of options, and stress-testing in various economic conditions.

SDCERA’s meticulous risk management is the opposite of “gambling” — it is prudent governance. Managing risk exposure has been a long-standing practice at SDCERA, and one that continues in the fund’s current investment strategy. This context is crucial to fully understanding SDCERA’s approach to portfolio management.
Last week, I posted a comment on how some pensions are using more leverage to combat pension shortfalls, discussing SDCERA's use of leverage. Following my comment, Doug Rose, a former trustee at SDCERA (served from 2002- June, 2014) and a long time reader of my blog, shared these comments with me:
It’s unfortunate that the Wall Street Journal relied on the report of a local business columnist in writing about the SDCERA portfolio, as what that columnist wrote and what the facts are happen to be exactly opposite. For example, the leverage is not across the entire portfolio. I won’t go point by point--- I have attached below the SDCERA response printed today in the local newspaper.

I noted you poked around the SDCERA website. I am proud to say that SDCERA is one of the most transparent pension funds in the country. Since 2010, every meeting is broadcast live over the internet, with all supporting documents the trustees use posted on the broadcasts as well. In addition, those meetings are then archived so that anybody can review the meeting and the documents at a later time. The link is found at the “meetings online” section of the website, where you can scroll through to any meeting you want. The discussions of the trustees and staff, and the documents that we relied on are publicly available—see the “investment meetings” dating back through last year when discussion of the structure of the current portfolio first began, and investment meetings going back to 2010 where the prior portfolio with similar objectives was first constructed.

As far as Chris Tobe goes, let me be blunt----he’s full of crap. The “whistleblower” he refers to is an investment analyst who was fired for repeatedly disclosing confidential documents to the press. That firing was upheld by a Civil Service Commission following a three day hearing, and his federal lawsuit against SDCERA for his firing was dismissed by the judge. There aren’t shady dealings at SDCERA, nor dozens of articles about the shady dealing at SDCERA.

Short term performance is meaningless to draw conclusions about a portfolio, but while we are on the topic—the SDCERA portfolio, designed to minimize volatility and guard against downside risk, returned 6.5% in fiscal year 2012, vs equity heavy peers that were negative or returned 1-2%. As expected, last year SDCERA returns lagged more equity heavy peers, and in every year where equity markets soar, SDCERA will lag but still beat its assumed rate of return.
I thank Mr. Rose for sharing these comments with my readers and I am glad SDCERA is very open and transparent about their board meetings (other public funds should follow this level of openness).

I think the intelligent use of leverage can actually increase risk-adjusted returns, but SDCERA needs to be very careful in implementing this "risk-parity" strategy at this point in time. Go read my previous comment on Leo de Bever discussing the long, long view. Listen carefully to his presentation and the follow-up discussion where he discusses how the intelligent use of leverage can decrease risk of the overall fund, as well as the risks of implementing risk-parity and the LDI approach at this time.

But Leo is outspoken on the terrible returns for bonds he sees over the next decade and he discusses the perils of implementing risk-parity strategies and liability-driven investment approach (LDI) at this time (roughly 45 minutes into the clip).

However, I received this comment from an astute investor who agreed with me and disagreed with Leo on where rates are heading:
The advice to stay short duration in fixed income was pretty much good advice from about a year post credit crisis, more or less til this year. Short and long rates have since been falling, and the yield curve is flattening. Despite all central bank efforts, I tend to see a mild deflation scenario playing out, something you have commented on. With that in mind, I think fixed income holders are best served to be diversified in credit and interest rate duration, and currency, definitely avoid an all in directional bet on rates.
Go back to read my comment on the Caisse warning of headwinds ahead. I discuss my views on why I think deflation is the ultimate endgame and why rates aren't going to rise anytime soon.

I have a question for all of you who see "terrible" or "disastrous"returns on bonds over the next decade. Where are the jobs going to come from? Where is wage pressure? Where is inflation except for risk assets which can collapse at any time?

I'm trying to be optimistic but the global economy isn't exactly firing on all cylinders. Employment growth is picking up in the U.S. but too many consumers are just getting by, saddled with unprecedented debt. The euro deflation crisis will drag Euroland into a protracted period of subpar growth. Japan is pulling out all the stops to lift inflation expectations but that country is not out of deflation yet. And if Abenomics fails, watch out, it's headed for an even worse bout of deflation.

What about emerging markets? They have staged a comeback in recent months, but growth prospects remain tempered and uneven in various countries and the threat of geopolitical turmoil, Fed tapering and lower oil and commodity prices can wreak havoc in these markets. And despite the secular trend of growth, it's still unclear how this growth will develop and what pitfalls investors will endure along the way.

All this to say that the biggest risk out there, in my humble opinion, remains deflation, not inflation. If that's the case, pension funds should still be adopting an LDI approach despite historically low rates (see Jim Keohane's comments here) and/or increase leverage to implement a risk-parity framework despite the dangers of fighting the last investment war.

The most important question for any pension fund or asset manager going forward is who will win the titanic battle over deflation? I've repeatedly warned you that deflation is coming and it will expose naked swimmers. That's why bond yields are falling even though the Fed is tapering. And despite unprecedented monetary stimulus, there is a jobs crisis and private debt crisis going on all over the world and the risks of deflation remain high.

The only place where I see inflation is in risk assets like stocks and high yield bonds. But you have to pick your spots right and deal with huge volatility or else you'll get crushed. This is one reason why I think the Caisse has opted to invest $25 billion in a global portfolio made up of major companies positioned for growth in emerging markets, including Procter & Gamble Inc., Unilever Group and Nestlé SA. In a deflationary world, they're opting to focus on big, safe companies with pricing power.

That is one approach but another one which I recommended is to co-invest with top hedge funds they're investing with or just track my quarterly comments on top funds' activity and take smarter risks in public equities as opportunities arise.

For example, when Twitter (TWTR) fell below $30, I would have been pounding the table at the Caisse or PSP to pounce and take an overweight position. Admittedly, I'm getting a little ahead of myself but there are some dips on specific stocks pension funds have to buy -- and buy big. Why should they pay some hedge fund 2 & 20 when they can do it themselves?

The same thing goes for the biotech companies I recommended. It's still early in the game but when I tell you there is a biotech revolution going on, I know what I'm talking about. I'm not just looking at the Baker Brothers' portfolio, I've got real skin in the game. I was diagnosed with MS almost 20 years ago and have tracked unbelievable advances in drug therapies and other treatments which include stem cells and advances in genomics. I see the future now and taking part in drug trials that are revolutionary!

Too many pension funds are not thinking long term. They're working in silos, worried about ramping up a specific asset class, listening to recommendations from their useless investment consultants. They are not thinking about investing through the cracks or taking risks where others refuse to take risks.

Anyways, everyone has their views on how to manage pension assets. I happen to think that far too many pension funds are worried about headline risk and not rocking the boat with their board of directors. They're not thinking about using their long, long investment horizon to take intelligent risks across all asset classes, in between asset classes and in under-invested sectors (like biotech, renewable energy, big data, etc.).

I know, it doesn't pay to be a hero, you risk getting your head handed to you, especially if your timing is off by several years. I know the Fed is tapering but I'm warning all of you, there is plenty of liquidity to drive risk assets much, much higher. And all the sectors Fed Chair Yellen warned about (biotech,  social media, etc.) are where the biggest moves will happen and short sellers focusing their attention in these sectors are going to get killed. I stick by this call even if we get a mild or severe correction this Fall.

Below, Bob Rice, general managing partner with Tangent Capital Partners LLC, explains "Risk Parity" in an older Bloomberg clip (June, 2013). And Bloomberg's Scarlet Fu displays the current valuations of biotech and internet stocks compared to the bubble of 1999. She speaks on "Bloomberg Surveillance."

The second clip is almost a month old and since then, both these sectors have continued rising on growth prospects. And just wait, it's far from over which is why the Fidelities and Blackrocks of this world continue to ramp up their exposure to these sectors.

Finally, take the time to listen to Janet Tavakoli on the return of the complex financial instruments that fuelled the 2007 credit bubble. Great interview with a very sharp lady who really knows her stuff.

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