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Monday, March 2, 2009 | With losses piling up, questions about their investment strategy and high fees mounting, and a bleak forecast going forward, the last thing managers of the county’s pension system wanted to hear was that their fund might be the victim of a massive fraud.

But that’s the news they got last week. Authorities arrested two officers of the hedge fund WG Trading Investors LP, who were managing $78 million for the county’s retirement system. The revelations came as a particular blow to the county pension’s chief investment officer, David Deutsch, who said his investing philosophy had been inspired by his contact with a WG Trading company — Westridge Capital Management — that managed money for Deutsch’s previous employer, Kern County’s pension fund.

Even before the news, the fund’s trustees sought to reduce their reliance on hedge funds because of the risk. And the fund is already grappling with general investment losses at the same time it is paying higher-than-usual investment fees.

The San Diego County Employees Retirement Association spends more than twice as much on investment management fees — as a percentage of its investments — as comparable funds. Yet recent investment losses led a county supervisor to recently warn of the need to reform pension benefits or pour hundreds of millions into the fund just to keep its assets in reach of growing liabilities. And with the news of the arrests, memories resurfaced of a 2006 disaster in which the county’s pension watched more than $90 million evaporate when Amaranth Advisors LLC, a hedge fund, lost billions speculating on natural gas futures.

The notion that there might be risks hidden in the fund has been nagging at the pension fund’s board.

Earlier this year, SDCERA’s board called for an independent risk manager to evaluate the fund. A faction of the board, led by Douglas Rose, wanted to meet with the fund’s risk manager in secret to avoid what he described as “screaming headlines.”

The headlines about WG Trading last week brought SDCERA enough trouble. After news of the arrests broke, the fund released a statement saying it had already terminated its relationship with WG Trading in December and requested all its money back. Under its contract with WG Trading, however, the pension fund is not entitled to its money until June 30.

Fraud was not suspected when SDCERA broke off ties with WG Trading. In the statement issued Thursday, the pension fund reported that the request was based on WG Trading’s refusal to cooperate with Albourne Partners, an SDCERA consultant.

Stephen Walsh and Paul Greenwood of WG Trading were arrested Wednesday on charges they misappropriated $535 million of retirement plan and endowment money.

According to federal regulators, Walsh and Greenwood used money from investors like SDCERA as their “personal piggy-bank.” The pair spent more than $160 million on items like rare books, horses, and an $80,000 teddy bear.

Walsh and Greenwood also held a controlling interest in Westridge Capital Management Inc. of Santa Barbara. Deutsch, SDCERA’s chief investment officer, had a professional relationship with Westridge that goes back 15 years.

Deutsch said Friday that his 1994 meeting with Westridge’s chief executive James Carder was “a turning point for me.” Carder hasn’t been charged with wrongdoing.

Carder introduced Deutsch, then the manager of Kern County’s pension plan, to a strategy designed to reduce market risk that is now central to San Diego County’s investment portfolio. When urged in the past to lower the fund’s expected rate of return, pension officials have declined, citing this strategy — which they call an “alpha engine.”

In February 2004, Deutsch joined SDCERA. The San Diego County pension fund had an existing investment in Westridge Capital Management, a portion of which was being managed by WG Trading.

Deutsch said Westridge’s role was redundant, and within two months, the San Diego County pension fund had funneled $150 million invested directly in WG Trading. SDCERA cut that investment in half three years later.

The San Diego County pension fund used WG Trading to capitalize on small differences between the price of stocks in the popular S&P 500 index and the price of a futures contract on the same index. WG Trading offered comparatively lower fees.

SDCERA was an early backer of hedge funds, which are private pools of capital that employ sophisticated investment strategies. The pension fund adopted its “alpha engine” strategy in 1998.

In the last fiscal year, the alpha engine had grown to more than $1.3 billion, nearly 20 percent of the fund. The pension board voted in December to reduce the alpha engine to 14 percent of total assets, saying hedge funds had become too risky.

For all their flash, SDCERA’s hedge funds haven’t delivered. Over the past 10 years, the pension fund’s alpha engine earned 3.2 percent, falling short of its benchmark, the London Interbank Offered Rate, which is the interest rate banks pay for their cash.

This is a key point, because it means the pension fund would have earned better returns in money market funds or Treasury bonds, which carry far less risk and don’t require much expensive supervision.

A 2006 article in Alpha magazine described SDCERA’s hedge fund portfolio in glowing terms. Deutsch “has created what is in essence his own proprietary trading desk through his relationship with WG Trading,” the magazine reported. Deutsch said Friday in an e-mail this refers to the fact that any investor in WG Trading was investing in a registered broker-dealer, a company that trades securities for customers.

The bloom came off SDCERA’s hedge funds later that year with the collapse of Amaranth Advisors. The pension fund had $175 million invested in the hedge, but has since gotten most, but not all, of that money back. The fund’s lawsuit against Amaranth is still pending.

The Amaranth fiasco served as a wake-up call for SDCERA, and the notion that there might other risks hidden in the pension fund has been nagging at board members ever since. Earlier this year, SDCERA’s board called for an independent risk manager to report to the board. A search for a chief risk officer is underway.

Detecting trouble in hedge funds is a tall order because of their inherent lack of transparency, which leaves investors without the ability to scour their books. Hedge funds thrive on secrecy, which they believe is needed to prevent rivals from copying their investment strategies. Many are domiciled in offshore tax havens like the Cayman Islands. Another of SDCERA’s hedge funds, D.E. Shaw & Co., has a reputation for extreme secrecy.

A hedge fund that conducts its own trades, as WG Trading did, rather than using a third party, makes the job even harder. Bernie Madoff, a hedge fund manager accused of a $50 billion fraud, served as his own broker-dealer. Investigators said recently that they couldn’t find evidence of a single trade in the past 13 years.

California’s pension funds, which include the nation’s two biggest pensions, Calpers and Calstrs, have aided hedge fund secrecy. In 2007, the state amended the Brown Act, California’s open meetings law, to allow pension funds to make investments in hedge funds behind closed doors.

Hedge funds are just one of the many sophisticated strategies that SDCERA prides itself on. San Diego’s pension dollars flow around the world. It owns Mexican bonos (government bonds), as well as tugriks and kwachas, the currencies of Morocco and Zambia, respectively. Its biggest stock holdings as of June 30 weren’t in Exxon or General Electric, but Spain’s Telefonica, and RWE AG, a Dutch utility. SDCERA lends securities to short-sellers and has huge positions in exotic derivatives that carry risks and require close monitoring.

The result is a fund of enormous complexity that is expensive to manage. SDCERA spent $77.7 million in investment fees in fiscal 2008 — more than twice as much, on a percentage basis, as other pension systems in Orange and Los Angeles counties and Calpers, the nation’s biggest pension system. SDCERA’s investment fees were even higher in previous years.

What does SDCERA get in return? Not much, by at least one measure. Over the past five years, San Diego County’s pension fund has barely outperformed a “policy index” comprised of indexes of stocks, bonds, real estate, and other asset classes, according to a September report by Ennis Knupp, the pension’s general consultant. Such indexes would cost SDCERA a fraction of what it pays its legions of money managers.

At a recent board meeting of San Diego County’s beleaguered pension fund, Arun Muralidhar, a former research director at the World Bank who is now one of the fund’s many consultants, tried to interject some levity. “What’s the difference between a hedge fund and a rhinoceros?” he asked.

The answer, Muralidhar explained, is that one has a small brain, thick skin and charges too much, and the other is an animal in Africa.

Seth Hettena is a San Diego-based freelance journalist and author. Please contact him at seth@sethhettena.com with your thoughts, ideas, personal stories or tips. Or set the tone of the debate with a letter to the editor.

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