CHICAGO -- What seemed like a brilliant international fixed-income strategy for Brinson Partners Inc. pension clients two years ago has gone bad.
"What we have seen is yields go from 3-plus (percent) to under 2 (percent) on (Japanese) long bonds. Now, we were wrong -- thinking that, you know, -- the government could be so inept in Japan to allow that to happen," said Ron Martinez, a partner with Brinson Partners, Chicago.
"And we were wrong. We have no excuses. . . . That is the strategy that has hurt and plagued us from the very beginning."
Two years ago, Brinson sharply underweighted Japanese long bonds and shortened the duration of its remaining Japanese bonds -- only to see prices shoot up.
Brinson executives spoke recently about the strategy at a Los Angeles County Employees Retirement Association board meeting. At the meeting, Brinson officials asked the staff of the $24 billion fund to be patient in turning their investment performance around. Brinson manages a non-dollar $395 million portfolio for LACERA.
For the year ended March 31, that portfolio returned, net of fees, 11.79%, vs. 12.78% for the Salomon Non U.S. Government Bond index-hedged. For two years ended March 31, Brinson's portfolio returned 11.84%, vs. 12.60% for the index.
Brinson executives continue to believe the strategy they began two years ago will work, and they can see a light at the end of the proverbial tunnel.
"We're finally turning the corner," Mr. Martinez said at the meeting.
He couldn't be reached later by Pensions & Investments for additional comment. A spokesman for the firm said no one from Brinson could comment.
But LACERA's staff and trustees are becoming skeptical about a turnaround soon for Brinson.
Brinson's performance doesn't so far "warrant a termination. But it is something we really need to keep an eye on and get some answers," said Juan Almaguer, a vice president for fixed income at the pension fund.
Brinson executives made the same complaint about the Japanese strategy hurting the performance of the LACERA portfolio a year ago, said Mr. Almaguer.
"I think the message is very loud and clear. We are very concerned about this bet," he said.
While Brinson's performance is between 80 and 100 basis points below the index in recent periods, the LACERA portfolio is supposed to do substantially better than the index, according to the pension fund's performance policy.
OTHERS DO BETTER
Over a three-year time horizon, Brinson is supposed to add 75 basis points over the index. If its performance falls 75 basis points below the benchmark over any 12-month period -- which it has for two years -- LACERA's contract with Brinson specifies the pension fund can order a full performance review of Brinson and determine if any action should be taken, including firing.
Meanwhile, some other international fixed-income bond managers for LACERA are doing far better against the same index.
For the year ended March 31, Morgan Grenfell Asset Management Ltd. returned, before fees, 14.6%, vs. 12.8% for the index. J.P. Morgan Investment Management Inc., during the same one-year period, returned 14% before fees.
Two-year numbers weren't available for the managers.
Carl Gargula, a spokesman for Brinson, declined to comment on the extent to which Brinson has used its Japan strategy for other pension fund clients. But a pension source said Brinson underweighted its unhedged non-U.S. bond portfolios about 13% over the last three years.
As of March 31, Brinson had underweighted LACERA's portfolio 15.5% in Japanese bonds relative to its benchmark.
A $380 million global fixed-income portfolio Brinson manages for the $10 billion San Francisco City & County Employees' Retirement System also was underweighted in Japanese bonds. A report on that portfolio shows its weighting in Japanese bonds was six times below the weighting of the Salomon Brothers World Government bond index, unhedged -- the portfolio's performance bogey. (Those statistics were as of Sept. 30, the latest available.)
Still, Brinson's performance for the San Francisco global bond portfolio was above the index, partly because the San Francisco portfolio included a 41% weighting in U.S. government bonds. (The LACERA portfolio doesn't include U.S. fixed income and is benchmarked against a different index.)
DIFFICULTY WITH JAPAN
However, had Brinson's strategy gone as planned, its investment return for San Francisco and other funds might have been spectacular.
Brinson strategists are among many -- including economists, bankers, stock and bond investors and the Clinton administration --having difficulty figuring out the Japanese economy and wondering when it will revive.
Brinson strategists took what they call a "large" bet two years ago that Japanese yields on long-term bonds would go up, which would cause bond prices to fall.
Brinson strategists -- and most everyone else -- expected the Japanese government to re-energize the country's economy so that interest rates and long-bond yields would increase. It turned out Brinson's strategy was dead wrong. Japanese bond prices climbed and the Brinson portfolios missed out on a big part of the Japanese long bond price runup. By shortening their bonds' duration, Brinson strategists took a defensive position relative to the index.
Consequently, what Japanese bonds they did have left after underweighting them earned less of a price boost relative to the index, according to what Brinson executives and LACERA board and staff members say happened.
"It's a double whammy," said LACERA's Mr. Almaguer.
Now Brinson is fighting to save face in its strategy.
Brinson "is asking for a little more patience until this strategy that is causing our problem turns around," Mr. Martinez said at the meeting.
But some Western economists believe Japan's economy could worsen, which could make Brinson's performance even worse. One worry is that Japanese debt problems are under-reported and Japan might be headed for what some observers call a meltdown.
"Yeah, it is a risk. No question about it," Mr. Martinez said about the potential for a Japanese meltdown. "We have had to factor that in, and to some extent that is what is built into where yields have gone at this point."
Brinson strategists remain stuck in their Japan strategy, only recently beginning to believe yields are on their way back up.
"We are not going to make a decision today that is simply is a function of having been wrong in the past because, then, we run the risk of switching back and being wrong twice. . . . We stick to our guns on these kinds of things," said Joseph Pratt, a global bond strategist with Brinson said at the LACERA meeting.
But one source said Japanese long-bond yields would have to go up sharply for Brinson to recoup its former position.