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Trouble in Paradise

By Robert Seawright, Above the Market

It’s a problem that is now — finally — discussed and sometimes dealt with. Increasingly, investors of various type are questioning high-cost, high-risk strategies (often purveyed by hedge funds) because they have performed so poorly. Indeed, hedge funds as a class have performedmuch worse even than U.S. Treasury bills. As a consequence, few can expect to achieve success in that market, as I have argued repeatedly (see hereherehere and here, for example). Calpers, the public pension giant here in California, is a leader in this trend that is demanding accountability, putting new investment proposals on hold while weighing whether to exit or substantially reduce bets on commodities, actively managed company stocks and hedge funds.

The general problem is well illustrated right here in San Diego and outlined in a terrificcolumn in the San Diego Union-Tribune yesterday by Dan McSwain. Many cities have a pension crisis. San Diego’s is particularly bad, as outlined definitively by the great Roger Lowenstein in While America Aged. McSwain’s piece does an excellent job of examining how the City is responding to the problem in terms of investment management and contrasting the City’s efforts with what the County of San Diego is doing with its pension dollars. 

To be sure, the City’s pension crisis is much more a matter of political mistakes — mostly by promising too much to City workers — than investment mistakes, as Lowenstein so clearly explains. However, it is still good to see that the City now invests fairly prudently and carefully, with no leverage. And, over roughly the past five years, the City has earned 13.6 percent annually, essentially equivalent to a standard 60:40 portfolio over that same period. That’s very good news.

The County, on the other hand, uses hedge fund-type strategies (almost anything is fair game) newly spiced up by leverage of up to 100 percent and wrapped in an extremely high fee structure (well over $100 million in fees during fiscal 2013). What could go wrong? For a clue to the answer, take a look at another Roger Lowenstein book, When Genius Failed. Not surprisingly, performance to date has lagged badly using this approach. Over the roughly five-year period during which the City earned 13.6 percent, the County paid a lot more and earned a whole lot less — only 9.7 percent — in thriving bull markets for both stocks and bonds. To make the magnitude of the problem a bit clearer, a $10 billion portfolio (that’s about the size of the County’s pension fund today) that earns 13.6 percent over five years grows to over $19 billion. Meanwhile, a $10 billion portfolio that earns 9.7 percent over that same period grows to nearly $16 billion, over $3 billion less. That’s three b-i-l-l-i-o-n dollars.*

Ouch.

As a citizen and taxpayer of both the City and the County, I hope both pension funds succeed spectacularly. Taxpayers will have to fund any shortfalls after all. From an investment standpoint, the City looks to be doing a pretty good job. The County — not so much. Sadly, this isn’t likely to turn out well for the County, and we taxpayers will be left holding the (empty) bag.

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* To be clear, I don’t mean to suggest that the County’s opportunity cost was necessarily $3 billion. The County had substantially less than $10 billion in its pension fund five years ago and made contributions to it between then and now.  But the investment scheme the County utilized still came with enormous opportunity costs in terms of returns and risk and the added leverage/risk that has been newly approved makes things even worse. It’s essentially impossible to make a reasonable case justifying it.

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