San Diego County hit by performance blip

A strategy that was supposed to smooth out returns has instead taken the $9.62 billion San Diego County Employees' Retirement Association on a wild ride, putting its investment performance in the bottom quartile last year after scaling top-quartile heights in 2012.

The pension fund is experiencing a fate similar to asset owners that added a risk parity-type strategy to their portfolios. In 2010, the San Diego County fund adopted a new asset allocation that included leverage to bring the total target allocation to 135%.

Among the biggest changes, the fund cut its overall equity target almost in half to 25% from 47% while fixed income was beefed up, including 40% to Treasury securities, 10% to emerging markets debt and 5% to high yield. Before the changes, the fund had 29% in domestic and international fixed income. The fund also added a 25% allocation to inflation-sensitive assets such as a new 10% target to natural resources.

The new asset allocation was designed to provide steady gains in up markets and protect those gains in volatile markets.

San Diego County fund officials say their strategy is not risk parity. Rather, it “uses elements of the risk-parity investment strategy,” Dan Flores, SDCERA spokesman, said in e-mailed response to questions. “Despite SDCERA's lower allocation to equities relative to its peers, a majority of the fund's risk still emanates from equity market exposure,” Mr. Flores wrote. (According to the agenda for a board retreat in October, SDCERA also considers high-yield bonds to be part of its equity risk exposure.)

Mr. Flores also said the fund's exposure to illiquid strategies is “inconsistent with the liquid nature of risk-parity strategies.”

Whatever it is called, the returns in 2013 fell significantly after flying high when the new strategy was adopted. The asset allocation/active risk strategy that was advertised to the board as low-risk/high-return appears to have faltered.

In the third quarter of 2013, SDCERA's portfolio earned a gross return of 3.26%, lagging its 3.36% custom benchmark and putting the fund in the 89th percentile among public pension plans with more than $1 billion in the Wilshire Associates Trust Universe Comparison Service universe. Its gross return for the year ended Sept. 30 was 6.71%, outperforming its custom benchmark of 5.74% but still landing in the 91st percentile.

For the five years ended Sept. 30, the fund returned an annualized 7.35%, above its custom benchmark of 7.22% but in the 73rd percentile.

But the story was different a year earlier. In multiple periods ended Sept. 30, 2012, the San Diego County fund outperformed or was near par with its benchmark. The fund was in TUCS' first percentile for the two-, three- and 10-year periods.

SDCERA officials say the strategy did what it was supposed to do. “As expected with SDCERA's strategy, the fund met the investment goal of outperforming our assumed rate of return and portfolio benchmark” for the year ended June 30, Mr. Flores said. “SDCERA produced investment returns that met the portfolio's goals, despite having a lower risk profile and a lower ranking compared to public pension peers.” Mr. Flores did not address questions about returns after the fiscal year by press time.

Institutional investors should not be surprised if performance differs from their peers when their strategy is very different, Mark Ruloff, director of asset allocation at Towers Watson & Co. in Arlington, Va., said Investors that reduce their equity risk and deviate from the traditional 60% equity/40% fixed-income mix will have different results than their peers that maintain the 60/40 split.

“Any year when equities are up, they will look terrible compared to their peers,” Mr. Ruloff said.

Investors hope that over the long-term their investment strategy will produce alpha, but in the short term, they should be accustomed to sometimes having negative returns if they take active risk compared to the benchmark, he said.

For the fiscal year ended June 30, SDCERA ranked in the 91st percentile in the TUCS report with an 8.25% gross return, Mr. Flores noted. The benchmark for the year ended June 30 was 6.09%. SDCERA's assumed rate of return is 7.75%.

It would appear the pension fund had enough risk-parity elements to be caught up in the same downside as those that adopted pure risk parity. The run-up in U.S. and developed equities combined with leverage and a higher allocation to fixed income made risk-parity portfolios appear to be lagging, said Eugene Podkaminer, vice president in the San Francisco office of investment consulting firm Callan Associates, who spoke about risk parity in general and not the San Diego fund.

The San Diego fund appeared to have many of the elements: a relatively low equity allocation, a high fixed-income allocation and leverage.

“Risk parity is part of a family of strategies and approaches,” Mr. Podkaminer said. Instead of focusing on asset allocation, the strategy peeks at the risk factors behind allocations, such as changes in a country's gross domestic product, he said. “One way to group factors together is risk parity, where each factor gets an equal weighting.”

While there is a plethora of strategies called risk parity, no two are exactly alike, which can lead to arguments about whether a plan like San Diego really adopted the strategy.

“There are a lot of loose definitions in the space. Many portfolios are put together radically differently,” Mr. Podkaminer said. “Risk parity is a marketing term.”

In March 2010, the San Diego board adopted an investment policy statement that included its leveraged asset allocation as well as active risk targets for each asset class. The general investment consultant at the time, Ennis Knupp & Associates, stated in a report to the board that “the strategy envisions leveraging high-quality Treasury securities that exhibit low/negative correlations to traditional asset classes with the goal of moderating overall portfolio volatility, while maintaining an acceptable return.”

Lee Partridge, chief investment officer and managing director of Salient Partners LP, Houston, is SDCERA's outsourced portfolio strategist. He helped fund officials craft the strategy after its earlier asset allocation, which included $1.1 billion in hedge fund assets, experienced losses in 2008. (Brian White, SDCERA's CEO since 1996, was given the added title of CIO on June 6, 2013.)

In a written response to questions, Mr. Partridge stressed SDCERA does not have a risk-parity portfolio. He noted that while some pension funds with risk-parity strategies might have suffered lower returns, he was more concerned with long-term performance of the portfolio.

“Risk parity is about increasing portfolio efficiency in terms of return per unit of risk and, more importantly, return per unit of downside risk,” Mr. Partridge wrote. “In the long run, a diversified portfolio of stocks, bonds and commodities typically produces better returns on a risk-adjusted basis than does a portfolio concentrated in equity-like assets.”

A source with knowledge of the situation disagreed. The relatively poor returns in 2013 “was bound to happen,” the source said. The board was “sold a Goldilocks scenario that everything would be perfect.”

So, SDCERA added leverage, bulking up on fixed income and fixed-income futures, the source said. “The strategy will do great when bonds do well and will do terribly when bonds do poorly.”

Dan Loewy, CIO for multiasset solutions at AllianceBernstein LP, New York, called underperformance of asset owners that adopted risk-parity strategies a “bump in the road, which could be expected.”

“Every time you diversify out of the winner, you are subject to the risk of short-term underperformance, which happened in the last year or so,” said Mr. Loewy, who did not speak specifically about SDCERA. “Last year was not a good time to be in a risk-parity strategy.”

Mr. Partridge agreed. “Over short periods of time it is natural for a single asset class to dominate the others, and the dominant asset recently has been stocks,” Mr. Partridge wrote. “A majority of asset owners and asset managers alike maintain equity-centric portfolios. It should be no surprise that during the recent period, the returns of core equity markets have dominated those of other asset classes (and) risk parity-oriented funds are lagging the pack.”