PASADENA, Calif. -- The Los Angeles County Employees Retirement Association is poised to remove Brinson Partners Inc. and Capital Guardian Inc. as non-U.S. dollar government bond managers because of performance and risk issues.
Brinson, Chicago, manages $418 million in that strategy for the $24 billion pension fund; Capital Guardian, Los Angeles, manages $522 million.
Previously, LACERA officials expressed concerns about the managers' investment performance. Now, their investment process is an issue as well.
LACERA will force both managers to compete for a single, nondollar bond assignment in a search along with other managers, still to be identified. LACERA will send out a request for proposals in September.
The search is expected to be completed by January. In the meantime, LACERA will take $250 million in assets from Capital Guardian and $130 million from Brinson.
Of that money, $100 million each will go to LACERA nondollar government bond managers J.P. Morgan Investment Management Inc. and Morgan Grenfell Capital Management Inc., both of New York. Another $60 million each will go to the fund's high-yield bond managers -- Oaktree Capital Management LLC, Los Angeles, and Loomis Sayles & Co. LP, Boston. The remainder will go to LACERA's $1.3 billion Lehman aggregate bond index fund with Bankers Trust Co., New York.
That reduction leaves Brinson and Capital Guardian still with $250 million each to manage until the search is completed.
BOTH COULD LOSE
Neither appears likely to win the contest.
"The performance (of the two managers) has not been great. Right now, we don't feel that we can make a good case to keep either one," said Juan Almaguer, LACERA's investment officer for fixed income.
Another LACERA concern is that Brinson, which had sharply underweighted the Japanese government bond market relative to its benchmark (the Salomon Non-Dollar Government Bond Index-hedged) has since pulled out of the Japanese bond market entirely.
But Dennis Hesse, co-head of fixed income at Brinson, said Japanese bonds are yielding about 1.5%, whereas government bonds in most developed markets are yielding 5% to 6%. He predicted Brinson's absence from the Japanese bond market will have a positive impact on client portfolios.
For the year ended June 30, LACERA's portfolio with Brinson returned 10.13%, vs. 11.89% for its benchmark. For three years, Brinson has a compound annual return of 11.97%, vs. 12.14% for the index.
Capital Guardian's portfolio returned 10.99% for the year and an annualized 12.15% for the three-year period. Its three-year return was slightly above the Salomon index, but LACERA requires nondollar government bond managers to produce returns that are 75 basis points per year above its benchmark over a full market cycle.
Capital Guardian had been LACERA's "worst-performing nondollar bond manager" until recently, when Brinson won the dubious distinction, Mr. Almaguer said.
Both managers have asked LACERA for more time to improve their performance, said Mr. Almaguer. Neither manager would give a public comment on its performance for LACERA.
RISK AN ISSUE
Besides performance, Mr. Almaguer has risk issues with Brinson and Cap Guardian.
LACERA staff members said Brinson underperformed largely because it underweighted the Japanese bond market. But since Brinson pulled out of the Japanese bond market entirely, it makes the bet against the Japanese bond market even bigger.
Japan represented 26.7% of the Salomon Brothers Non-U.S. Government Bond Index (100% hedged) as of June 30, the largest country in it.
If Brinson's bet turns out to be right, Brinson could make up a significant amount of its past underperformance, although Mr. Almaguer doubts it could recoup all of it.
But even if the bet is correct, Brinson is subjecting LACERA's nondollar bond portfolio to significant risk, Mr. Almaguer said. He told the LACERA board he is concerned with the "magnitude of Brinson's country bets. Large bets increase a portfolio's tracking error relative to the index, causing undesirable levels of volatility in the overall portfolio."
But Mr. Hesse said Brinson's fixed-income bets, while large from time to time relative to an index, are not large relative to the underlying bond markets in which they invest.
In the past three years, Mr. Almaguer said, Brinson underperformed its index by 40 basis points and produced 10% more volatility than the index. In four years, it underperformed by six basis points, but generated 34% greater risk than its index.
Mr. Hesse said over the long term, Brinson's volatility on nondollar portfolios has been less than the leading indexes. He added Brinson is an active manager that takes bets.
As for Capital Guardian, Mr. Almaguer said its multiple portfolio manager approach could lead to construction of portfolios sometimes overdiversified and other times concentrated with significant investment bets made.
Capital Guardian has four different portfolio managers responsible for managing one-quarter each of the LACERA portfolio. Each portfolio manager can individually make bets, but in combination, some bets might be unintended, said Mr. Almaguer.
If unintended bets happen, they could significantly deviate from the benchmark and lead to high levels of tracking error. Mr. Almaguer said it is not clear to him that Capital Guardian has risk-control mechanisms in place to prevent such error.
However, Charles Freadhoff, a spokesman for Capital Guardian, said the firm's accounting process and traders monitor the portfolio as a whole.
If a portfolio guideline, for example, put a percentage limit on investment in a certain category, the accounting and trading personnel would prevent any individual portfolio manager from going over that limit.
Mr. Freadhoff said it is "in theory" possible for the managers to make an unintended bet relative to a benchmark if no specific parameter prevented it. Such a scenario is unlikely, he said, because the portfolio managers all keep in continual contact with each other and they know what investments the others are making.
CHANGES AT BRINSON
Mr. Almaguer also expressed concern about recent and potential organizational changes resulting from the merger of Swiss Bank Corp. -- Brinson's parent -- with Union Bank of Switzerland .
Mr. Almaguer noted Richard Carr, formerly in charge of global fixed-income and equity strategies for Brinson, now will focus only on equities. He said Norman Cumming is now in charge of global fixed income.
Another issue for Mr. Almaguer is the sheer size of UBS Brinson --$360 billion in total assets under management. When Brinson moves in or out of a market, the firm can significantly affect that market, Mr. Almaguer said.
Further organizational changes as a result of the merger are likely, said Mr. Almaguer. He said he will monitor Brinson closely.
Mr. Hesse -- co-head of fixed income along with Mr. Cumming -- said no further reorganization is likely at Brinson. He also said both he and Mr. Cumming had been in the fixed-income department for a long time, giving Brinson continuity in fixed-income leadership.