This letter responds to Pensions & Investments' article entitled “San Francisco CIO proposes major asset allocation overhaul” (P&I Daily, May 22), which reported that San Francisco Employees' Retirement System's new chief investment officer proposed that the fund invest 15% of its assets ($3 billion) in hedge funds. As chairman of the investment committee, I presided over the meeting on May 21 where the CIO and the general consultant, Angeles Consulting, concluded that hedge funds would have mitigated the fund's losses during the Great Recession of 2008, and that they will be the only means to protect the fund in future bear markets. This conclusion is spurious because the underlying analysis is fatally flawed.
At SFERS, we use a mean-variance optimizer to obtain efficient portfolios, as do most pension funds. The asset classes are selected, and their weights in the “efficient” portfolios are determined solely on three factors: 1) expected returns, 2) standard deviations and 3) correlations among them. The entire risk of the asset class is captured with one number, the standard deviation. I believe the mean-variance optimizer is important in the process, but has limitations as well as the key underlying assumption of a standard normal distribution, or a bell-shaped curve.
Further, the analysis uses a low standard deviation for hedge funds, which was half that of stocks. The low standard deviation doesn't capture all of the risks of hedge funds, including business risk (San Diego County Employees Retirement Association, for example), agency issues and fees, benchmark and survivorship issues, as well as staff requirements and distractions. This error is most obvious in staff's lowest risk efficient portfolio, comprising 25% in hedge funds! Are hedge funds truly less risky than stocks?
When asked if hedge funds are more risky or less risky than the broad stock market, the executive director, who approved and supports the CIO's recommendation, stated: “I think the right hedge funds potentially could be equally risky as the stock market.”
Staff's May 21 recommendation failed to discuss fees. In the Feb. 12 memo to the board on including hedge funds as a strategy, under “Issues for Consideration,” the CIO simply stated, “Management fees usually range between 1% and 3%” and “the performance fee is typically 20% of the fund's profits during any year.”
How much are the fees? With a $3 billion allocation to hedge funds earning 10%, the management fees would be about $120 million. Additional consultants and staff add several more millions. Currently, management fees are about $15 million. Will San Francisco's Board of Supervisors approve an additional $100 million in fees with the expectation of similar or lower returns?
In contrast to hedge funds, I suggest that options strategies would create powerful protections against future bear markets. In any case, these strategies should be examined. For example, the volatility index, or VIX, contracts, trading on the Chicago Board Options Exchange, offered the best downside protection in 2008, and may be the best “insurance” for a bear market. Covered options strategies also accomplish similar objectives with substantial advantages over hedge funds.
Pensions & Investments' article states, “Joseph Driscoll, another board member, said such insurance would be too expensive.” I've asked Commissioner Driscoll to share his due diligence with the board, and await his reply.
Pensions & Investments' article states, “Mr. Coaker (William Coaker Jr., CIO) insisted that the pension fund would assemble a top-grade hedge fund staff and a top hedge fund consultant, and would do extensive due diligence to ensure that only top-grade hedge funds with strong return potential would be hired.” Does this guarantee success? Do public pension funds have the culture to facilitate success?
I do not believe a credible case has been made for hedge funds.
Retirement Board of the San Francisco Employees' Retirement System
EDITOR'S NOTE: A version of the article to which Mr. Meiberger refers was on Page 1 of the May 26 issue of Pensions & Investments under the headline, “San Francisco overhaul?”