Friday, Dec. 19, 2008 | San Diego County’s pension fund is slashing its $1 billion hedge-fund portfolio and acknowledging that the investments it once championed have become too risky and no longer make sense.
The board of the San Diego County Employees Retirement Association voted unanimously Thursday to reduce the size of its hedge-fund portfolio by more than half. That will free up $600 million, half of which will be held as cash. The rest will be reinvested in the portfolio.
The pension board also agreed to curb the aggressive strategy the $7.5 billion fund used to finance its hedge fund investments. Under the “alpha engine” strategy, the county bought financial derivatives known as swaps that were essentially bets on the market. Much like bets on a Chargers game, the swaps cost nothing initially, which freed up cash for hedge fund investments. When the market rose, the swaps made money, but in recent months, they cost the pension fund millions of dollars. Last month, the board voted to free up $100 million in cash to protect against further declines.
The moves amounted to a marked shift in a strategy the board had stood by for a decade. “This is a major, major change in how we manage assets,” said board member Marc Doss.
The pension fund’s alpha engine — which includes the swaps and most of its hedge funds — lost 7.7 percent in three months ending Sept. 30, with only one of 18 hedge funds ending the quarter in positive territory. For the year to date, the alpha engine has declined 11.85 percent.
While that was better than the Dow Jones Industrial Average, which is down 35 percent this year, the pension fund expected more from its hedge funds. Instead of protecting the county from declines in the market, the hedge funds amplified those losses instead.
John Shearman of Albourne Partners, which advises the county on its hedge fund investments, apologized to the board for the alpha engine’s performance. “Fundamentally, we’re sorry this has occurred,” he said.
The poor performance by the alpha engine dragged the $7.5 billion pension fund’s overall performance down by more than 12 percent for a loss of nearly $900 million in the three months ending Sept. 30. By comparison, public pension funds with more than $1 billion in assets lost 8.7 percent on average in the quarter. For San Diego County, the fourth quarter, which ends Dec. 31, was expected to be even worse. The fund’s managers stressed that the benefits of 35,000 current employees and retirees are not at risk.
In a bit of good news, none of SDCERA’s hedge funds had any exposure to investments controlled by Bernard Madoff, a legendary Wall Street figure who has been accused of running a $50 billion Ponzi scheme. Albourne has had serious doubts about Madoff for 10 years and counseled clients to keep their money away from him, Shearman said. In a January SEC filing, Madoff said more than half his clients were pooled investors such as hedge funds.
The county adopted its alpha engine in 1998. Since then it has earned 3.2 percent, falling short of its benchmark, the London interbank loan rate, according to a report submitted by Ennis Knupp and Associates, the pension’s strategic investment advisor. Those results were hurt by the county’s $175 million investment in Amaranth Advisors, a hedge fund that in 2006 lost more than $6 billion in a bad bet on natural gas prices. The pension fund sued Amaranth last year.
San Diego County isn’t giving up on hedge funds altogether. The alpha engine will manage $465 million in hedge-fund investments plus cash for a total of 14 percent of the fund’s total assets. Six of its current hedge fund holdings will be shifted out of the alpha engine into the regular portfolio, including New York-based D.E. Shaw & Associates, Milwaukee-based Stark Investments, Chicago’s UBS O’Connor, and Greenwich, Conn.-based Silver Point Capital.
The moves by San Diego County are a symptom of the pain caused by the complex investment strategies that pension funds adopted during the stock market boom. The Wall Street Journal reported recently that an estimated $75 billion has been invested under alpha engine or “portable alpha” strategies. The Pennsylvania state employees’ pension fund has invested about a third of its $27 billion portfolio in hedge funds.
At the core of San Diego’s alpha engine was a belief that it was nearly impossible to generate “alpha” or above-market returns by picking undervalued stocks. Markets were seen as highly efficient, and a company’s share price reflected all known risks. In a memo to the board, Chief Investment Officer David Deutsch noted that recent events have proved him wrong. “The basic premise that that large cap markets are very efficient, the assumption underlying the use of a portable alpha program for this segment in the first place, is clearly no longer true,” Deutsch wrote.
The past few months have been brutal for the secretive hedge fund industry, which is on course for its worst year ever. The financial crisis has dried up the borrowed money or leverage that hedge funds used to generate returns. Even relatively healthy hedge funds have been forced to sell by their lenders — the big investment banks that are scrambling to shore up their own balance sheets.
“In a sense we are doing what the hedge fund industry is doing,” Doss said. “We are deleveraging.”
Clarification: This story originally stated that Madoff claimed half of his clients were pooled investors. It has been updated to say that he claimed that more than half of his clients were such. The story has also been updated to clarify what the alpha engine will continue to manage.
Seth Hettena is a San Diego-based freelance journalist and author. You can e-mail him at firstname.lastname@example.org with your complaints, thoughts or stories about San Diego reporters.