Moving Around the Pieces: San Diego County Rejiggers Its Asset Allocation -- Part 1
I haven’t posted in a few days because I’ve been trying to understand what’s going on at the San Diego County Retirement System. Last Wednesday The Wall Street Journal reported
A large California pension manager is using complex derivatives to supercharge its bets as it looks to cover a funding shortfall and diversify its holdings.
It sounded straightforward. San Diego County Retirement System (SDCRS) is cranking its pension plan’s risk in hopes of earning higher returns. However, the second paragraph contradicts the second one:
[O]fficials close to the system say it is designed to balance out the fund's holdings and protect it against big losses in the event of a stock-market meltdown.
In other words, pension officials are claiming that their strategy is designed to reduce risk rather than ramp it up. Which statement is correct? I don’t think either statement is correct. I don’t think SDCRS is swinging for the fences or reducing its risk. Instead they have found a way to become less transparent and reward their externally hired chief investment officer. Several years ago the county outsourced investment responsibility to Integrity Capital, which was operated by its sole employee, Lee Partridge. Mr. Partridge sold his firm to Salient Partners, which manages all but San Diego’s private investments. While Salient already managed the assets, it won a “competitive” search to run a series of new strategies for SDCRS. The public pension manager used an investment consultant, Wurts & Associates, to make this bit of kabuki look like it’s infused with sound due diligence.
It’s going to take a bit of work to explain what’s going on. We’ll begin with San Diego’s shift in investment strategy and then examine how they structured their investment process to make this happen.
The County is making three new bets: risk parity, trend, and private credit. The first two bets are called “dynamic” because the external CIO will have the authority to rapidly change these bets as economic and market conditions change. Dynamic management is every investors dream. Imagine being able to anticipate the twists and turns in the financial markets or the economy and adjust the portfolio accordingly. Many managers have developed back-tests that purport to achieve this result. Others have a bit of a track record. Unfortunately, dynamic management usually fails just about the time a pension or endowment actually commits to the strategy. SDCRS can expect to incur substantial trading costs as Salient attempts to manage the dynamic portion of the county’s pension assets. In the end, SDCRS will eventually be very disappointed because there isn’t a dynamic model on the planet that works effectively in the long run.
What are the underlying strategies? Risk-parity simply means adjusting the weight of asset classes (stocks, bonds, and commodities) based on their contribution to risk (measured by volatility), rather than based on expected returns. The idea is that conventional portfolios get too little return for the risk they’re taking by investing too heavily in equities. A risk-parity portfolio uses leveraged fixed income in lieu of a higher commitment to unleveraged equity. The idea of allocating capital based upon its contribution to risk is by no means radical. Risk parity is like a commercial airline pilot looking for a smoother ride. On most days, the pilot has no problem finding clear air. However, during a big storm he just wastes fuel trying to fly higher and lower. Risk parity is much the same.
Interestingly, SDCRS was already using leveraged fixed income as part of its strategic asset allocation. When it signed up for risk parity it eliminated this feature of its existing portfolio. As a result, SDCRS’s use of leverage will be more effectively hidden from auditors, regulators, and beneficiaries.
Trend is merely a momentum strategy in which the external CIO will use a “proprietary” model to speculate on trends in financial markets, currencies, or commodities using futures. Since SDCRS is eliminating exposure to a category called “macro,” this move is nothing more than transferring responsibility from an external hedge fund to the external CIO, Salient. At best, the SDCRS will save a bit of money on management fees.
The third new strategy is called private credit. SDCRS doesn’t provide a clear definition of private credit. This strategy seems to involve illiquid fixed income that provides somewhat higher yields than more liquid bonds. While this allocation is small (5%), the county had better not lose its appetite for private credit during the next crisis. These strategies will sell at cents on the dollar during a crisis.
The three new strategies are being funded by reducing public equities, fixed income, and some hedge fund commitments. Since the new strategies produce exposure to the same asset classes, there’s not much change in the asset allocation other than Salient’s promise to manage the exposure dynamically.
Tomorrow I’ll try to figure out how Salient won this mandate.