Compromise and Investing: A Bad Mix in San Francisco
While it’s not yet a fait accompli, the trustees of the San Francisco City and County Retirement System have indicated a willingness to commit 5% of their assets to hedge funds. The plan’s CIO, William Coaker, Jr., had proposed a 15% allocation, which met with a great deal of opposition. I criticized the original proposal in “Creating a Muddle: San Francisco Contemplates Hedge Funds [May 23, 2014]. It looks like the board has reached a compromise. In making investments, compromise is almost always the wrong thing to do. Nonetheless, pension trustees do it all the time.
As a money manager I was a witness to compromises all the time. A pension fund would seek an international manager for $500 million worth of assets. After the presentations, the board would split the mandate into two or three parts instead of hiring a single manager as originally intended. Whether the compromise was due to board politics or disagreements with staff, splitting the mandate into pieces was easier than reaching the right decision. I must admit that I was elated when my firm hauled away a new assignment even though it was less than we had hoped for and wasn’t in the best interest of the pension plan
Why is compromise bad? By splitting mandates into small pieces or, as in the case of San Francisco, settling on a small asset allocation, compromise makes the pension plan much more difficult to manage. Over time, the plan becomes cluttered with far too many managers, undermining effective due diligence and monitoring. Moreover, all those bits and pieces ensure that the investment results will be mediocre. The plan becomes overly diversified. Compromise always has negative consequences when it comes to fees. Since the mandates are smaller, the pension has less bargaining power with managers and receives fewer discounts.
Compromise also creates staffing problems. By only allocating 5% to hedge funds, San Francisco will find it harder to justify building out the required staff. It will also discover that it is difficult to recruit professional staff. In addition, divvying up mandates into small pieces tends to make it impossible for staff to properly oversee managers.
San Francisco is going to find that the small 5% allocation soaks up a disproportionate amount of the board’s time. You can be rest assured that the CIO will be back within the next 12 to 18 months with a proposal to nudge up to a more meaningful allocation of perhaps 10%. His proposal will reignite the contentious debate, and the trustees will not yet have any meaningful evidence about the efficacy of their initial 5% allocation.
While I disagree with Mr. Coaker’s advocacy for a hedge fund program, he is right about one thing. Allocating 15% to a broad area such as hedge funds makes sense. An allocation of 5% isn’t enough to make a difference to the pension plan, and yet the small allocation comes with all the costs of hiring staff, consultants, lawyers, and risk managers. In this case, compromise is easy, but it is wrong.