San Diego County reconsiders leverage, outsourced CIO

The next time Alice falls through the rabbit hole, she may find herself at a meeting of the San Diego County Employees Retirement Association as trustees struggle to make sense of a new asset allocation that they recently realized could be leveraged more than 200%.

Board members will have to decide on Oct. 2 whether to press the restart button or the reject switch on the $10.1 billion pension fund's new allocation and outsourced CIO governance structure they've been touting for five years. They are expected to decide whether to terminate outsourced CIO Integrity Capital LLC and Integrity parent Salient Partners LP, both of Houston. Salient manages $3.5 billion or about 35% of the pension fund's assets.

The board is also scheduled to decide whether to adopt a new investment policy statement that gives Salient expansive powers and the ability to add leverage to every asset class.

Nevertheless, executives at Salient and the pension plan's general investment consultant are implementing the new asset allocation before a new investment policy statement has been adopted.

“Somebody jumped the gun and started implementing before the board authorized them to do so,” Dianne Jacob, SDCERA trustee, who is also on the county's Board of Supervisors, said in an interview.

The investment policy statement is not a completed document, she said.

When Ms. Jacob posed the issue to Scott Whalen, executive vice president and senior consultant at Wurts & Associates, SDCERA's general investment consultant, he acknowledged this is not the typical process, but added that Salient had given the board updates on the implementation.

Implementation began at the end of the second quarter and is nearly complete, Mr. Whalen said. He declined to comment for this story.

It was not until the summer that the board had any notion of how much leverage would be involved with the new asset allocation. Earlier drafts of the investment policy statement “had no numbers associated with leverage, and the amount of exposure was unclear,” Ms. Jacob said. It was at the last meeting's update on Sept. 18 when the board discovered it would have $22 billion of exposure, Ms. Jacob said.

At press time, Lee Partridge, founder of Intregity Capital and CIO of parent Salient, had not responded to e-mailed questions.

Salient earns more than $10 million a year under the new structure, which started when the board hired Integrity as its outsourced CIO, effectively outsourcing SDCERA's investment staff in June.

By comparison, Integrity earned $1.9 million a year when it was first hired by SDCERA to replace former Chief Investment Officer David Deutsch in 2009. Mr. Deutsch's annual salary was $209,000.

Use of large amounts of leverage is not typical, although broad industry data is not readily available, said Julia Bonafede, president, Wilshire Consulting, Santa Monica, Calif.

“Despite its potential benefit in constructing more diversified portfolios, it is very rare to see significant amounts of leverage explicitly deployed at the total plan level,” she said, speaking generally.

The board has been scrapping over the investment policy statement since April, when the new asset allocation was approved. Along the way, some trustees have said they lost confidence in CEO Brian White as well as in Mr. Partridge.

Returns have been lackluster. From July 1, 2010, when Salient began overseeing the pension fund's investments, through July 2014, SDCERA had a 12% annual net return with costs ranging between $89 million and $100.4 million per year. By contrast, the $7 billion San Diego City Employees Retirement System has earned a 14% annual return with $23.2 million to $32.6 million in fees during the same period.

The total return for the 12 months ended June 30 was 13.44% for the county fund with $104.2 million in investment expenses vs. 17.3% for the city fund with $32.6 million in expenses, according to Ms. Jacob.

In a written reply to trustees, Mr. Whelan acknowledged the asset allocation and yet-to-be-adopted investment policy statement add 200% leverage. One report to the board from Wurts indicated that $22 billion would be at risk.

So far, the only leverage limits in the proposed investment policy statement are for separately managed accounts, at five times invested capital. Real estate separate accounts are limited to two times equity. Currently, 32% of plan assets are in separately managed accounts, Dan Flores, SDCERA spokesman, said in an e-mail.

On Sept. 18, the board reduced risk-parity leverage to two times from five times invested capital, Ms. Jacob said.

The new asset allocation cuts equities and domestic fixed income, added the 20% risk parity allocation, added a new 5% private credit allocation and reduced a liquid alternatives/hedge fund-of-funds allocation to 10% from 20%. The liquid alternatives/hedge fund-of-funds allocation includes a managed futures allocation of 5% of total assets. However, the asset allocation accepted by the board April 17 differs from the asset allocation included in materials for an implementation presentation by Wurts on the same day, and also differs from the asset allocation in the proposed investment policy statement.

For example, the asset allocation has 5% to commodities as part of a 15% real assets allocation. The implementation materials include 20% to real assets, made up of 10% natural resources and 10% real estate, and the proposed policy statement again shows a 20% to real assets, with 10% real estate and 10% other real assets.

Ms. Jacob said Salient doubling as CIO and one of the pension fund's money managers is a conflict of interest. “I do not believe there is total transparency when you have an individual who is the CIO of Salient and also the outsourced CIO for SDCERA who is also managing the managers and managing money for us,” Ms. Jacob said.

But some board members want to stay the course. ”Every investment carries with it some level of risk,” David A. Myers, vice chairman of the SDCERA board, said in a letter to a county employee and retiree newsletter. SDCERA is more diversified, “spreads the risk better, and includes hedging of investments that play off each other ... something which the typical mutual fund and fund of funds do not do,” Mr. Myers said in the newsletter.

Pension plans are adding risk to boost returns. SDCERA was 79% funded as of June 30.

Pension plans should take care when using leveraged instruments, said Mark Ruloff, director of asset allocation at Tower Watson, New York. For example, swap rates are “nowhere back to as beneficial as they would have been prior to the financial crisis,” he said.

Other industry experts say that leveraging low-volatility assets like fixed income right now is a recipe for disaster. “It doesn't make sense today,” said Timothy C. Ng, CIO of New York-based manager Clearbrook Global Advisors.

The idea behind strategies like managed futures and risk parity is to mimic the long-term returns of a 60% equity/40% bond portfolio without the inherent volatility, he said. Returns are lower in a low-volatility portfolio and so leverage is added to the perceived least risky asset class, fixed income, to bump up returns. But this is not a great strategy when interest rates are expected to rise, he said. Bonds tend to go down in value when interest rates go up.

“If rates normalize, you are in trouble,” Mr. Ng said.

What's more, lower volatility assets like fixed income are typically overpriced, he said. A better strategy is to blend in higher volatility but cheaper assets such as high yield, emerging market debt and international small-cap stocks, Mr. Ng said.

“They are equating volatility with risk, which is not true,” he said.