San Bernardino County (Calif.) Employees' Retirement Association's approach to credit investments is somewhat unusual in that they don’t differentiate between public and private credit. Rather, they identify those assets by region (U.S. vs. non-U.S.).
“Differentiating by geography with the various bankruptcy provisions for lenders seems a better demarcation for us rather than the liquidity of a credit instrument,” said Donald Pierce, chief investment officer.
“That said, we do consider liquidity in that a private bond has to pay more than a liquid alternative all else (being) equal. Moreover, that isn’t necessarily a linear function," he said. As a pension fund, "the marginal utility of locking up capital if investment-grade public market debt was 8% would be very low. We could satisfy our annual funding need without taking undue risk. As it is, we aren’t there on the investment-grade side as yields are in the mid-to-high 4%.”
When Pierce initially joined SBCERA as an investment analyst in August 2001, the pension fund had $3.4 billion in assets and the investment staff comprised just two people. Now, SBCERA boasts $15.6 billion in assets, seven investment staff members and two administrative staff.
“I started at Watson Wyatt (a predecessor to Willis Towers Watson) as an actuarial analyst working on healthcare and pension plans, later transitioning to an investment analyst position,” he said. “In 2001, my now former boss and mentor (former SBCERA CIO) Tim Barrett was looking to hire an investment analyst, and it was a wonderful opportunity that I couldn’t pass up.”
Pierce was named CIO in 2011 after Barrett departed.
“Philosophically, I was very much in-line with Tim’s approach, so the initial changes when I became CIO were focused on some existing hedge fund-of-funds that had disappointing results during the financial crises,” he said. “As a result, by early 2012 we had terminated those relationships.”
In 2012, another initiative Pierce started was a direct lending strategy with private credit manager Tennenbaum Capital Partners (which was acquired by BlackRock in 2018). Among other private credit funds, SBCERA also invests in Ares' Private Credit Solutions Fund and Senior Direct Lending Fund III, according to its latest annual report.
“The main philosophy that drove us then — and now — is that the more return we can get from income, the less we have to rely on capital gains to meet our funding goals for the plan and provide a secure retirement for our now over 48,000 members,” Pierce noted.
SBCERA currently has a 7.25% assumed rate of return.
Asset allocation changes
During his tenure as CIO, SBCERA's asset allocation has undergone some significant changes, Pierce said.
“Private equity has increased, while real estate has decreased,” he stated. “We’ve eliminated timber and commodity futures while adding physical commodity infrastructure and energy (assets).”
He explained that commodity futures had zero income, and timber, “much to our disappointment had little to no income over our hold period.”
“Our income-focused philosophy reinforces an income component to our asset choices, and our view is that all assets must compete for allocation,” he explained. “Strategies that rely entirely on speculative price change as a return driver would need to have an enormous upside potential vs. a relatively straightforward income investment of comparable risk.”
The attraction of holding ”real assets” like physical commodity infrastructure, he noted, is “the income we receive and the value proposition they promise.”
As of June 30, the pension fund's actual allocation was 19.9% private equity, 13.3% U.S. credit, 12.4% U.S. equities, 11.1% non-U.S. credit, 8.1% international equities, 6.8% cash, 6.4% absolute-return strategies, 5.3% real assets, 5.1% emerging markets debt, 5% non-U.S. core fixed income, 3.7% real estate, and the remainder in U.S. core fixed income.
SBCERA returned a net 9.3% for the fiscal year ended June 30, 2024, below the 10.3% return of its benchmark. For the three, five and 10 years ended June 30, it returned an annualized net 4.7%, 8.2% and 7.1%.
Domestic equity with beta overlay led all asset classes over the latest fiscal year with a net return of 20.6%; followed by the non-U.S. credit composite at 16.3%; alpha pool composite at 12.7%; U.S. credit strategies, 9.8%; real assets composite, 9%; international equity with beta overlay, 8.3%; global fixed income with beta overlay, 7.5%; private equity composite, 7.2%; and emerging markets debt composite, 4.5%. The poorest performer was its real estate composite, which returned a net -7.3%.
All assets in the portfolio are externally managed, Pierce said. NEPC has served as the investment consultant since March 2003.
Pierce also said he had "less confidence in domestic public equity.”
“As has been well documented, until just recently (August), nearly 90% of the returns of the S&P 500 (stock index) were driven by the top 10 stocks. That is a level of concentration that doesn’t engender a lot of confidence,” he said.
Investment team approach
Pierce currently works with three senior investment officers — Amit Thanki, Jake Abbott and Thomas Kim.
“Rather than align our team by asset class, I’ve divided up the program responsibility by manager relationships, while trying to give each investment officer a sliver of the entire portfolio where possible,” Pierce explained. “This has two advantages in my view. First, it focuses the team on our existing portfolio, and importantly allows us to access other assets the managers may invest in when those assets are attractive to us.”
Pierce emphasized that he and his investment team are “asset-focused rather than fund-focused. By focusing on assets, we can consider the relative attractiveness of those assets relative to the entire suite of assets available to us, and we allocate to those that we believe (will have) the highest return for the risk we are taking,” he added. “We describe this approach as ‘all assets must compete.’”
Pierce also said the board members at SBCERA are “very supportive” and that they have “broadly delegated” investment decisions to the investment team. This relationship allows the investment team to be “nimble enough to make quick decisions” and also allows them “to take advantage of market opportunities that may have been otherwise lost if we had to wait for the next scheduled board meeting.”
Economic outlook
With respect to the current macroeconomic climate, Pierce says his biggest focus is on the Federal Reserve’s monetary policy.
“While I would like to have (interest) rates stay at these levels for longer, it seems the market, at least for now, is pricing in rate cuts in September,” he said. “Higher rates coincide with higher income for SBCERA’s portfolio. However, our fund is positioned well for various economic climates and is prepared to adapt as the rates shift over time.”
Pierce noted that at the end of 2021, SBCERA had a very sizable allocation to floating-rate debt — with an effective duration of 0.25 years — and the portfolio was “defensively postured largely because of what we saw as a very extended equity rally.” As a result, he observed, “our credit portfolio did terrific in this time period.”
While the portfolio can be subject to market volatility like everyone else, he added, with “a strong bedrock of income we know we will be able to weather bouts of volatility by opportunistically buying when assets are priced favorably.” The ability to buy assets when markets are in disarray is a very important component of his approach, he said.
In the event of a recession — which can be challenging to credit assets in general — Pierce counters that he has “confidence our managers have done a good job underwriting risk.”
